Should I Put My Rental Properties In An LLC?

We bought our first investment property in 2018, and since then have built up a portfolio of 10 properties with 15 total units. I’ve been advised by friends that I should put my properties in an LLC for legal protection.  I’m not sold on the idea yet, but certainly am not opposed to it either. Here are the main reasons I don’t feel the need to rush out and put my properties in an LLC right now.

What Is an LLC?

An LLC is a limited liability company.  In theory the primary purpose of an LLC is to provide liability protection to its owners.  Essentially any assets contained in the LLC are the only assets that could be targeted by a lawsuit.

An LLC also provides anonymity.  Property records are public records. In my county with the click of a couple buttons anyone can enter my name into the search bar and a map will pop up showing all the properties I own.  With a bit of savvy another search can cross reference these property numbers and see how much I paid for the properties and what my loan amounts, if any are for.

If I have LLCs in place, the properties won’t show up when someone searches my name.  Nothing is linking 123 Blue Building LLC to me, or even 123 Blue Building LLC to Big Run 11 LLC.

LLCs are pass through entities, so effectively all the income the LLC receives directly transfers to the owners tax returns, making no real difference in taxation.

LLCs are also advantageous for estate planning.  People can own percentages of an LLC and an LLC can also have succession plans and effectively pass down to heirs without going through probate.  A dozen properties in my own name though? Potentially stuck in probate for a year when I die.

Is an LLC Necessary?

The primary benefit of an LLC is to protect you from a lawsuit.  For example, Let’s say I have a tenant who falls down the basement stairs and sues me for $5 million.  Without an LLC my insurance company would pay up to the limit my insurance is set up for liability, then I would be liable for the difference of any judgement awarded.  With all of my properties in my name I could lose all my rental properties, cash in our bank accounts, and even be forced to sell my house.  Thankfully retirement accounts are protected in Michigan.

Now without an LLC how can I protect against such an outcome?  Well for starters there is the insurance amount.  All of our properties up until last year had a $300,000 liability coverage.  We switched insurance agencies to simplify our insurance and part of this switch increased this coverage to $1,000,000 per occurrence.

We also have an umbrella policy which provided $1,000,000 of further coverage.  This means if we lost a lawsuit for $2,000,000 we still would have no negative financial implications.   I guarantee you the lawyers for the insurance company are not going to sit idly by and allow a $2,000,000 hit to go by.

So there are 3 questions here:

• How often are landlords of residential real estate sued?
• How often are any judgements over $2,000,000? 
• How can I reduce the likelihood of being sued in the first place?

How often are landlords sued?:

I could not find any definite statistics for how often landlords get sued.  I did find some anecdotal numbers through a reddit thread:

• Owns 800 units, sued about 2X a year. Effective rate: 1 per 400 unit years
• Owns 12 homes never sued over 40 years  Effective rate: 0 per 480 unit years
• Own 250 units sued about every other year. Effective rate: 1 per 500 unit years
• Owns 28 units sued once in 25 years. Effective rate: 1 per 700 unit years

On average this works out to roughly 1 lawsuit per 500 unit years, so for someone with 15 units, it is highly likely they will see only 1 lawsuit over a 30 year period.

How many judgments are for over $2 million?

Of the lawsuits filed 95% never make it to trial, which means they are settled, typically by the insurance company lawyers, who are limiting the insurance companies liability by settling, which means they are settling cases for far less than the maximum coverage.

For the 5% of cases that do go to trial, 50% of them fail at trial, and of those that succeed, the median value for personal injury cases against property owners is $90,000.

So highly unlikely to get sued at all, and if sued only a 2.5% chance of a summary against me, and even then a 50% chance the total is under $90,000 which is under 5% of our liability protection.

There are a few cases where landlords do get judgments for over a million dollars.  These are so rare that they tend to make headlines and demonstrate egregious behavior:

2008: $1 million settlement against James Mitchell for violating the Fair Housing Act.  This was at the time the largest judgment the Justice Department ever had.   “The complaint alleges that the defendants subjected female tenants to unwanted verbal sexual advances and unwanted sexual touching; entered the apartments of female tenants without permission or notice; granted and denied tangible housing benefits in exchange for sexual favors; and took adverse action against female tenants when they refused or objected to his sexual advances.”  It appears through court records James had 56 units and also had an LLC.  12 women testified to his egregious behavior.

So yeah, that is pretty easy to avoid. Not sexually harassing people is an easy one.

2015: Anne Kihagi $2.7 million judgement for harassing rent controlled tenants. This case was at the time the largest non injury landlord judgment in the U.S.  This one was in San Francisco and deals with rent control, which are both things I would never consider.  Effectively they evicted tenants of a rent controlled apartments stating they (the owners) would be moving into the unit, which is one of the few ways to get rid of a rent controlled tenant in SF.  The owners never moved in and SF requires a 36 month residency for such moves.  On top of that, Anne Kihagi had racked up over 1,612 total violations.  Anne also had an LLC.

Also, easy to avoid.  Don’t own property in California, especially rent controlled, and if you do, play by the rules, even if they are ridiculous.

How can I reduce the likelihood of being sued in the first place?

• Don’t discriminate: Discrimination suits for violating the fair housing act tend to be high dollar.  This is people refusing to rent property based on factors such as age, race, family status, religious affiliation, and disability. Having a clear criteria for evaluating tenants and the ability to show how all prospective tenants matched up.  Criteria such as income level, time on the job, credit rating, history of evictions, and criminal records are all objective measurements for selecting tenants.
• Don’t sexually harass.  Pretty straight forward.  The scumbags who offer rent reductions or late fee waivers in exchange for sexual favors put a massive target on their back.  It is really easy to treat people professionally and with respect.
• Fix known deficiencies, especially those that are safety related.  This tends to be what makes landlords lose personal injury cases.  If the tenant has a paper trail of reporting a known safety deficiency and the landlord takes no action, then it is much harder for the landlord to defend themselves.
• Have all communication via text or email for paper trail.  Keep records of repairs. For instance if a tenant states the railing for the front steps is missing, document your responses, keep the receipts for the materials and take pictures of the completed job.
• Don’t purchase properties with known safety hazards: things like pools and balconies come to mind.

I’m not saying an LLC isn’t helpful, just that there is a very high likelihood that I would never be sued for anything that would go over the $2 million of insurance protection I have.

Why I May Get An LLC

Although the anonymity of an LLC is appealing, it isn’t enough to be a deciding factor to go through the administrative burden of setting up an LLC, or multiple LLCs. The LLC protection will keep a casual sleuth from finding out who owns the property, but a determined individual can usually find out who owns an LLC.

I’m not sold on the idea of an LLC for anonymity or for liability protection, however there is another reason I may get an LLC. The Biggest Benefit For An LLC Isn’t liability protection or anonymity it’s estate planning.  Mrs. C. and I are in the process of updating our wills, which are 10 years old and ridiculously out of date.

Holding real estate inside on an LLC makes changing ownership to heirs easy…because ownership of the real estate doesn’t change.  The real estate stays inside of the LLC and the LLC is set up so upon the deaths of the  2 50 / 50 owners (Me and Mrs. C.) The 4 children each become co owners in the LLC at 25% each.

Alternatively we could start 4 separate LLCs and build them to be relatively equal so all kids would have 100% say over what happens.

This method misses out on the stepped up basis tax.

As an example, if I own a house that I paid $50,000 and as an old man I sell it for $200,000 I would be taxed on the $150,000 capital gain.  If rather than sell the property I die and it passes to one of my kids, their new basis will automatically be $200,000.  They will not be taxed on that $150,000 gain,  that gain effectively disappears.

If the property is owned by an LLC and has a basis of $50,000 and I die and my kids inherit my shares in the LLC, then the LLC is still the owner of the property and the LLC maintains the $50,000 basis.  If my kids go to sell the property they will be taxed capital gains on the $150,000 when selling the property.

So why on Earth would I do this?  Putting the LLC into their name seems to have some serious negative tax consequences.

It is possible that the stepped up basis tax break will go away anyways.  Joe Biden has targeted this as one of his many tax hikes if he is reelected.

Additionally one of my core beliefs in personal finance is to give away your assets before they appreciate AND while you are still alive.  The death tax has varied wildly over the last 60 years and it would not surprise me if the rules around stepped up basis change and if the exemption drops to $1 million or less in the future.  LLCs offer a great hedge against this.

What I really like about this system is that it develops positive cash flow for the kids from real estate.  It’s a way for them to get a fraction of the whole pie we have developed in addition to ownership of the actual assets.

Any person can give away up to $13K per year to any 1 individual without it counting against their lifetime estate tax.  I have 4 kids.  This means I can give away $52K per year, and so can Mrs. C. without triggering estate taxes.  One great way to do this is within an LLC.

If the net value of our LLC property values – mortgage debt is $1,000,000 and we start this as an LLC with 1 million shares that me and Mrs. C all own valued at $1 a share, we can give away 13,000 shares per year per kid each.  We maintain 51% of voting rights.

Setting up a system like this is very complicated and shouldn’t be undertaken lightly.  Originally I thought that this would be a great way to go because most of our properties are “cash cows”.  These are properties that are older, that generate substantial cash flow, but are not appreciating at a fast pace.  This was true up until the last 2 years.  The prices in my area have been relatively stagnant for similar condition properties, but over the last couple years have seen a major uptick in valuation.  This trend could continue over the coming decades and even though I originally thought that appreciation would be low,  I could be incorrect over the long term, especially if I live a normal lifespan that would give me another 50 years.

Inflation is another key factor as well. Regardless of the true value of the properties, if the dollar value decreases substantially, then inflation increases the price of assets with no actual gain.  Having the properties in an LLC with a high inflation environment while the stepped up basis tax deduction is still in play makes using LLCs less favorable.

Currently I am leaning towards not setting up LLCs, with a large reason being the up front and ongoing administrative burden.  What do you think of using LLCs for rental property?  Do you have an LLC?