Asset Protection For New Investors

First, remember...Most new investors have a net worth of zip!

Throughout my years of teaching seminars and conducting Fixer Camps, there has always been a great deal of confusion among my students about asset protection. 

Below I’ve listed the most common questions I’m asked at my seminars. Bear in mind, the answers I provide are from my own personal experiences and helping other investors who start from scratch like I did.

                          SHOULD I FORM A CORPORATION?

                          SHOULD I HAVE A TRUST?

                          SHOULD I FORM AN LLC?

                          IS INSURANCE GOOD ENOUGH ...WHAT KIND DO I NEED?

The first question I always ask new investors is: Tell me what you wish to protect. As you might guess; the answers are all over the board! A financial statement is an excellent document that shows where you stand financially because it lists assets, liabilities and net worth. Many new investors are shocked when they discover they’re under water with a net worth of zip! This is perhaps the reason new investors are not overly interested in learning how to prepare this statement.

Let me start by saying, most real estate investors shouldn’t incorporate. Incorporating requires additional tax reporting. There’s also the cost of having a corporation prepared (attorney fees) and the possibility of double taxation. I would never recommend that any new investors attempt to use a “do-it-yourself” kit. Besides, you’ve got enough on your plate just learning to survive as a new investor. I’ve found that most new investors can barely spell corporation.  

My answer is just say no!

There are various opinions about hiding your real estate in a land trust to avoid having your name on the county records. These types of trusts sometimes referred to as an Illinois Land Trust are not separate legal entities. Most investors choose their friends to serve as trustees and many assign each new property they acquire to a different friend. I personally don’t care much about this strategy. Only a hand full of states even have statutes for these trusts. On a separate note, I don’t have enough friends I trust to assign properties in their names. Besides, protection is mostly limited to amateurs in search of hidden property owners. Let me say that if a serious issue is involved; say like a lawsuit and a hefty money judgement, trial attorneys can flush out the real property owner in a New York minute. Money takes all the fun outta playing hide ‘n seek!

LLC’s limited liability companies are the vehicle of choice for most real estate investors. LLC’s are separate legal entities and they do provide decent liability protection. 

Once again, I would stay away from do-it-yourself kits peddled by traveling salesmen. Spend a few bucks with an attorney as the statutes differ somewhat state to state. There are also big differences in annual fees. California, my state, is expensive, especially for newbies. A bare minimum to operate a single LLC in California is $1700 annually. If your gross income exceeds $250,000, the cost goes up dramatically. I’ve heard many seminar instructors suggest separate LLC’s for each investment house or property. I seriously doubt that new investors in California can afford LLC formation (attorney fees) and $1700 annually for multiple LLC’s. There’s no way I could have done so when I started out.

Because of the expense, which also includes separate tax reporting for each LLC; it’s my opinion that new investors should start out acquiring properties in their own names until they reach a point when they’re earning a decent income. 

You can’t drive a Cadillac on a teaspoon of gas. If you become a successful investor with cash flow you can count on, then I do recommend you transfer your properties into an LLC. Meanwhile, use the right kind of insurance for whatever protection you need. That’s what I did and I’m still here after 50 years investing.

A good insurance policy should always be your front line protection – don’t leave home without it, OKAY. First of all, insurance comes in several different flavors – each with a separate purpose. When I used to ask students at seminars: What kind of insurance do you have? Some of the answers were as strange as Mars! One that was somewhat common; “I’ll have to ask my wife”! Another favorite; what do you mean, what kind? For folks who own one or two rental houses, some insurance companies permit coverage under a homeowner policy. For the purpose of this writing, I’ll discuss what’s called a commercial policy, which is what I have. Most investor-landlords who invest beyond a house or two will end up with a commercial policy.

Commercial policies are basically divided into two types of coverage! 

There’s fire or property protection and coverage for general liability. Fire or property insurance will rebuild your rental property should you have a fire. With mortgaged properties, the lender will always require this protection. Total replacement cost is very expensive. Most investors settle for what’s called coinsurance clause at 80% or 90% of a loss. Ask your insurance agent what this means – also what amount of deductible should you have before insurance kicks in. $3000 to $5000 is about average today. It means you pay for small losses up to the deductible amount and leave the big losses for the insurance company. I always carry rent loss insurance as well. Normally insurance will pay my rents up to 12 months if property must be rebuilt. The cost is nominal.

The liability part of a commercial policy protects you from accidents such as trips on the stairs or falls in the bathtub at your rental properties. 

The most important part of the liability policy – it provides for your defense in case of a lawsuit. Countless investors I talk to are not aware of this coverage. If you’re sued after your tenant trips in the tub or falls through the bathroom floor, don’t panic and start looking for attorneys in the yellow pages. Instead, when you are served papers at the front door (a Summons and Complaint), immediately call your insurance agent and present him or her with the papers. The insurance company will provide you with an attorney and represent you in court if need be.

One question I always advise seminar students to ask their insurance agent: Does my liability insurance cover matters that are not associated with my rental units? In other words, if I’m sued for something that don’t involve my property, do I have protection? Following are a couple examples I’ve used at seminars. My tenant’s mother called me late last night to report her son, living in my duplex, stumbled on the steps to my wooden porch. Suddenly, without warning, a board popped up poking a nail in his forehead. It was an accident of course, but it’s also a lawsuit.

I call this kind of accident exploding liability because the problem exploded outward from my duplex. In other words, the duplex caused the problem!

Friday morning I sent my handsome young worker (helper) to the lumber yard to pick up a load of fence boards. While driving his pickup, he became distracted gawking at a band of high school cheerleaders working out in their skimpy outfits for Friday night’s big championship game. Without him noticing, the pickup veered off the roadway and side-swiped a troop of Girl Scouts on the sidewalk who were peddling their cookies. Once again, it was an accident, but several girls required medical help. Also, once again, I’m facing a lawsuit even though my property had nothing to do with the accident. 

I call this type of accident imploding liability because the lawsuit will be drawn back to my properties (assets) regardless of whom or what’s to blame!

The question you need to ask your insurance agent: Am I protected in both of the situations I’ve described above? Remember, exploding and imploding are my characterizations to describe problems caused by the properties versus problems caused by other actions not involving the property. Use my examples if you wish. Sometimes insurance legal terms written in the policy are difficult to understand unless you’re a PhD from Harvard.