As a real estate investor, you want to make sure you are protected from liability. However, you may be wondering whether an umbrella insurance policy or limited liability company (LLC) structure is the right choice for you.
First, you need to understand what the two entities offer and how they work. In some cases, you could need both. In others, you may be fine with one or the other. When I help my clients with asset protection, I look at the size of their portfolios, their levels of exposure, and their goals.
You don’t need an elaborate plan if you have no plans for growth and almost no exposure. Identify the real risks you face. Then you can make the right decision and move forward with confidence. To that end, let’s look at umbrella policies and LLCs and their implications for real estate investors.
What Is an Umbrella Insurance Policy?
An umbrella insurance policy provides coverage above and beyond the typical property insurance. It can help you cover the cost of substantial claims.
Most small business owners pay between $500 and $1,500 a year for umbrella liability insurance. Many policies have $1 million of per-occurrence limits, but that depends on your claims history and on the type of property you own. Umbrella policies are usually paid monthly.
It’s important to understand that an umbrella policy doesn’t cover any additional risk or liability areas. Let’s say your LLC owns an apartment building and a tenant makes a claim for damages that resulted from a failed repair job.
You aren’t concerned at first because you have two layers of protection—liability insurance and an umbrella insurance policy. But when you present the claims to the insurance company, they may deny both of them.
Why? Your general liability policy didn’t include coverage for failed repairs. Since this policy didn’t provide coverage in this case, your umbrella policy also was useless.
Since you have an LLC, your personal assets are not at risk, but your business could have to pay a large settlement. Just because it’s called “umbrella” insurance does not mean you won’t get wet. In this example, your umbrella had some holes you didn’t know were there.
Does an LLC Offer Better Protections?
An LLC is a structure that combines the best parts of corporations, sole proprietorships, and partnerships into one entity. This structure offers owners liability protection, flexible management possibilities, and tax advantages.
When you have an LLC in place, it’s harder for a plaintiff to sue you personally. That means your personal assets like your home, car, and bank account are protected. All the assets of your business are at risk, however. For example, if your LLC owns multiple rental properties, a creditor could collect against those other assets.
It costs more to form and run an LLC than to work as a sole proprietor or as one member of a partnership. You must pay an initial filing fee to establish the LLC. The amount varies from state to state, and the average filing fee for an LLC in the U.S. was $132 in 2020. Annual fees also range widely, from $0 in Arizona to $800 in California.
You will need a Federal Tax ID Number (EIN) to open your business bank accounts. You’ll use this number when applying for credit cards, securing financing, and filing taxes.
Do You Need One or Both?
The choice between an umbrella policy or an LLC is not a one-size-fits-all decision. It depends on the type of investing you engage in. For example, you have more liability exposure when you have tenants. As we saw in the earlier example, if you own a multi-unit building or commercial property, you should probably have both an LLC and an umbrella policy.
If you rent out a single-family home in a stable neighborhood, you may need only an LLC OR an umbrella policy.
Four Pillars of Asset Protection
Think of asset protection as consisting of four pillars.
1. Insurance Policy
The first pillar is a good insurance policy that covers the majority of your exposure. However, it only protects you from one type of liability: accidents and negligence. Insurance doesn’t protect you from any part of the sale or acquisition of a property (e.g. somebody wanting to sue you for backing out of a bad deal or accusing you of selling them a property with defects like unknown termite damage).
2. Compartmentalized Assets
The second pillar is compartmentalized assets. This is often accomplished through the use of LLCs or corporations. Compartmentalization means that if something happens to one property, a lawsuit can’t touch you or the other properties. You should use either traditional LLCs or a series LLC (the new and more cost- and time-effective way).
No matter where you live or where you own assets, I personally recommend the series LLC as a tool for the individual investor who is planning to expand their operation. It allows them to scale infinitely for free.
3. Separate Operations and Assets
The third pillar is somewhat similar—you want to separate your operations from your assets. One company owns everything and does nothing. This is your SLLC, or your “asset holding company.” A completely separate company handles all of your operations (this is a traditional LLC, or your “operating company”).
The operating company serves as your face to the world and handles paying property management, paying contractors, collecting rent, and marketing your properties. The operating company takes on all of the liability that would otherwise fall back on you.
4. Anonymous Ownership
Finally, the fourth pillar of asset protection is owning everything anonymously. Anonymity can be accomplished by using trusts to own your companies as well as the assets.
Trusts remove your name from the public record. Even if someone can see you used to own a property, when properly transferred it will look like it was sold to investors. You are not the owner, legally speaking. The trust and the LLC are the owners of the asset/real estate, so you aren’t legally liable.
If you have questions on what coverage protects your assets in the most efficient and cost-effective way, it’s wise to consult a professional. That way, you can focus on making smart investments rather than worrying about your liability.
By Scott Smith, BiggerPockets.com
