If you are in the minority of Americans who are contemplating purchasing another home as a rental property or already own a rental property, you are probably doing fairly well in life to be in that position. Without running the numbers on your financial situation, the main question that we hope that you have the answer to is, “What happens to me financially if someone sues me?”. If your answer is anything other than “My household and personal assets are protected and I will be fine”, you hold your financial plan under the microscope and find out where the gaps in your financial plan are. Asset protection strategies like purchasing an umbrella insurance policy or putting your current or future rental property(ies) in an Limited Liability Company (LLC) can help fill in those holes in your financial plan. I’m sure that you worked hard to be in the position financially you are in today and would hate to see your success derailed by a car accident that was your fault or a tenant slipped and fell in your rental home and sued for damages. Let’s walk through a summary of how an umbrella policy and an LLC are used and how they can benefit you.
An umbrella policy is a type of insurance that is sold in increments of $1 million of coverage and is relatively inexpensive at around $20-40 per month per $1 million of coverage. If we take the example of a car accident that was your fault, the person you hit may not have good health insurance and may require substantial medical bills. If your auto insurance coverage is only good for $500,000, you are personally on the hook for the remainder. Think of auto insurance as a bucket, the money needed to pay the injured person’s medical bills as water, and umbrella insurance as an upside-down umbrella underneath the bucket. Assume that the total cost to make the injured party whole is $750,000. Let’s assume that your auto insurance coverage is only good for $500,000 and in one scenario you have a $1 million umbrella insurance policy and in the other scenario, you do not have umbrella insurance. The diagram below illustrates what happens to you in each case.
I assume that if this was you, you would rather be the person on the left who is dry, thanks to the umbrella policy stepping in and paying the additional $250,000 than having to come out of pocket personally for the $250,000. The person on the right may not have $250,000 in cash to be able to account for this cost and may have to sell stocks in investment accounts, take out a personal loan, or sell a rental property to cover the cost and could end up owing more than $250,000 in the long run due to taxes or loan repayments. This can be costly to your long-term financial goals and could have been resolved with a relatively inexpensive insurance policy.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is an entity that you can establish to allow you to have your rental property(ies) transferred to the LLC to separate your personal property from your rental property(ies). Assume that you have a tenant who slips and falls down your staircase because you didn’t repair the railing after an inspection. The tenant can then sue you for negligence. If that tenant decides to sue you and you have an LLC set up, the tenant is only suing the LLC and cannot go after your personal property. If you do not have an LLC set up, the tenant can also go after your personal property.
Another nice thing about umbrella insurance is that it can also be used to help cover legal damages incurred from a lawsuit at a rental property up to the coverage limits of the umbrella policy. Unlike umbrella insurance, setting up an LLC or multiple LLCs can be expensive to establish and administer. In California, there is an annual $800 fee that must be paid each year until you cancel your LLC. We also recommend that you go to a reputable attorney to establish the LLC and attorney fees can range from a few hundred dollars to a few thousand dollars. Properties owned outside your state of domicile might also require a separate LLC for each state you own real estate in.
The exact amount of umbrella coverage and whether or not an LLC is appropriate in your situation depends on your unique financial situation and if you are unsure of how to implement these asset protection strategies, our team of CFP® professionals at BFSG can diagnose your financial plan to help determine what asset protection strategies are appropriate for you. Please feel free to reach out to us at email@example.com or give us a call at 714-282-1566.
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