One of the strongest tools in a real estate investor’s kit is the holding company, a special legal structure that shields your personal assets (your house, car, bank accounts, etc.) from any problems having to do with your investment properties.
Two common types of business entities used for this purpose are limited liability companies (LLCs) and limited partnerships (LPs); in some cases, a combination of the two can offer an extra level of protection. Both entities offer maximum flexibility and pass-through taxation (the company doesn’t pay income taxes itself; the income “passes through” to the owners’ personal income tax returns).
Which structure would work best for your situation depends on your circumstances, but both offer legal liability protection when set up properly. In order for this strategy to work the way it’s supposed to, you have to keep business and personal finances completely separate.
That means, for example, you never make a rental property mortgage payment from your personal checking account, and you never deposit rent checks directly into your own bank account.
If you need to move money around between the two, you have to do it officially—make a formal contribution to the company so it can pay the mortgage, or write yourself a check from the company after it deposits the rent checks. You also have to run the business professionally, keeping up-to-date records and following all the state regulations to lock in that liability protection.
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LLC (Limited Liability Company)
LLCs are special business entities designed to protect the members’ (the official name for LLC owners) personal assets from company-related lawsuits, and they’ve become very popular among real estate investors. You can form an LLC whether you’re going it alone (a single-member LLC) or have partners.
The company is formed according to state law and governed by a legal operating agreement, which is even more important for multi-member LLCs. Any LLC member can take part in the day-to-day operations of the company unless the operating agreement specifically forbids it.
That agreement also dictates how income is distributed. Although there are state forms to fill out and fees to pay, LLCs require much less time, money, and paperwork than corporations but still offer their members solid personal liability protection.
LP (Limited Partnership)
Unlike an LLC, an LP requires at least two participants: one general partner and one limited partner, which can’t be the same person (although a general partner can also be a limited partner if there’s at least one other person involved).
Only the general partners can be directly involved in running the business; limited partners are strictly forbidden from taking part in any of the day-to-day activities (which is why they’re often called silent partners).
Basically, limited partners put up the money, and general partners run the company. General partners are 100 percent personally liable for any business obligations, which is why many LPs are set up with another company (often an LLC) as the general partner.
Limited partners can’t lose more than the money they contributed to the company, which can work well for a group of real estate investors who want to pool their money to buy properties without dealing with property management issues.
The LP is formed according to state law and governed by a partnership agreement, which spells out specifics such as the general partner’s responsibilities, ownership percentages, and how income will be distributed.
The Downsides of Holding Companies
Forming a holding company for your real estate investments offers solid legal protection, but it does come with some drawbacks.
First, it costs money to set up and maintain, and even more if you have an experienced real estate lawyer handle the paperwork. And to make sure your protection is as strong as possible, you want a legal expert on your side.
This is one of the times that it’s not better to DIY. In addition to having a lawyer set up your company (which can run anywhere from $300 to $2,000 depending on which state you’re in and the lawyer you hire), there are ongoing state fees and taxes to contend with.
Second, you may need a CPA to handle the extra tax prep, depending on the type of holding company you form.
Third, it can be hard to get financing in the company name when you’re just getting started. That means you may have to personally guarantee or co-sign for loans (which leaves you personally on the hook for mortgage payments).
As soon as you form the company, apply for a credit card or line of credit in the company name and tax ID number. Even though you’ll probably have to personally guarantee this credit initially, it will help the company begin to build its own credit rating for future loans.
Insurance Policies For Your Real Estate Holding Company
A separate company protects your personal assets from being attacked, but it doesn’t shield your rental properties from loss. The best way to do that is with the right insurance policies and enough coverage to make sure your company and your properties are protected against disaster.
The trick is to strike the right balance between the premiums you’re paying and the benefits you’re getting: too much coverage will shrink your profits and leave you cash poor, too little coverage could leave you financially devastated.
You also want to make sure you have the right kinds of insurance for your investment. Every property is different, and its unique features will determine the specific coverage you need. For example, a beachfront property calls for different insurance than a ski chalet. That said, there’s some coverage that all landlords should have.
Big picture: you’ll need to make sure you have both property and liability coverage. Specifically, rental property investors should purchase these policies (some companies may combine them):
- Liability insurance (for both the property and the company)
- Fire and hazard insurance
- Sewer/septic backup insurance
- Personal property coverage (for any contents, such as furniture or appliances, owned by the landlord)
- Loss-of-income insurance (to cover lost rental income if the home becomes uninhabitable)
- Workers compensation insurance (if there are employees such as a building super or maintenance workers on-site)
- Umbrella insurance (to cover anything that slips through the cracks)
Some companies may lump these policies together in one big landlord policy, but make sure it includes all the coverage you want. Depending on where the property is located, you may also want to consider flood insurance.
Technically, that’s only required if it’s in a designated flood zone, but if the property is at the bottom of a hill or in an area that gets battered by heavy rains and hurricanes, consider adding this on. Floods caused by outside sources, rather than things like burst pipes or a leaking water heater, aren’t covered by standard hazard policies.
If you aren’t sure what kind of insurance your investment property needs, work with a professional who can walk you through the process. Visit the National Association of Insurance Commissioners at www.naic.org for advice and help to find a reputable agent.