How to Avoid the Top Mistakes Real Estate Investors Make

Written by Steven Tennies on August 28, 2013 at 3:33 pm

If you invest in real estate to use as rental properties you have likely heard that it would be wise to form a Limited Liability Company (LLC) to protect your personal assets. With any rental property you face the possibility of liabilities, such as a broken stair railing, faulty electrical wiring, or mold. When you form an LLC for your rental property your personal assets are not at risk if a tenant or their guest decides to sue you.

Forming an LLC is quick and easy to do. You can do it yourself or use a document filing service such as reference180.com. Even though forming an LLC is a relatively easy thing to do, maintaining it is quite another matter, and there are common mistakes that real estate investors often make that can impact the benefits of forming the LLC.

Mistake #1

The real estate investor fails to form a separate LLC for each property: if you own multiple properties a separate LLC should be created for each one. This will afford you the maximum amount of liability protection for each property. If your property at 123 Main Street is sued, only the assets belonging to 123 Main Street are at risk. Nether your personal assets nor the assets of your other LLCs can be touched.

Mistake #2

A real estate investor creates an LLC to own real estate but fails to transfer the property deed to the LLC. Once you have formed an LLC you need to sign a deed transferring the property to the LLC and record the deed in the county where the property is located. If you never deed the property to the LLC, you as an individual are still considered the owner of the property and will be held personally liable in the event of a lawsuit. The protection offered by the LLC does not apply and forming the LLC will be a complete waste of money if the deed is never transferred to the LLC.

Mistake #3

The LLC owns the rental property but the lease is between the owner of the LLC and the tenant. If the LLC has title to the property, but the landlord on the lease is the owner of the LLC, the owner will be the defendant in a breach of lease lawsuit, not the LLC. It is essential that the lease be between the LLC as landlord and the tenant. If the lease was signed by the owner before the property was deeded to the LLC then the owner needs to prepare a new lease that is identical to the old one except that it names the LLC as the landlord, has a new start date, and says the old lease is cancelled. The owner should then inform the tenant that there is a new owner of the property, the LLC, and that future rent checks must be made payable to the LLC. The owner must also have the tenant sign the new lease.

Mistake #4

The real estate investor hires an expensive lawyer to form the LLC. Hiring an attorney is not necessary to form an LLC. You can use a document filing service to form your LLC for you or you can form it yourself. In the eyes of the law and the IRS, your LLC is just as valid as if a costly attorney had filed the documents for you.

Mistake #5

The LLC does not keep a company records book. The lack of company records will be used against the owner of the LLC if someone sues and attempts to pierce the corporate veil and hold the owner liable for the LLCs debt. Company records are necessary for filing taxes as well. If the IRS or some other government agency decides to pay a visit, all of the company’s records should be immediately available to them.

Mistake #6

The LLC is not kept in compliance. If a plaintiff in a lawsuit against the LLC can show that you have not properly maintained your LLC to the letter of the law they can seek recovery against your personal assets. In other words, the veil that protects your personal assets is pierced. To make sure that your LLC remains compliant, open a company bank account and credit card; keep your personal funds separate from the LLC’s funds; file your annual report on time, if your state requires one; and do not engage in fraud of any kind.

Mistake #7

The property is not insured under the LLC. You should purchase a comprehensive landlord’s property insurance policy to protect your property from damage and liability. If your LLC owns your rental property and the house burns down the insurer will deny coverage unless the LLC is a named insured on the policy. If you own real estate you should talk to several business insurance agents to get their recommendations on what type of policies, coverage amounts, and other policy issues are right for you.

Mistake #8

The members of the LLC do not sign an operating agreement. Although most states do not require an LLC to have an operating agreement, not having one is a huge mistake. The following are some of the reasons why every LLC should have an operating agreement.

a)     To prove the percentage of the LLC each member owns. If you don’t have an operating agreement there may come a time when you and the other members cannot agree on how much of the LLC you each own, and the only way to settle it may be in court.

b)     To restrict the transfer of membership interests without the consent of the members. Without an operating agreement that contains these restrictions on transferring membership interests, a member can transfer all or a portion of their interest in the company to anyone at any time with or without consideration. You don’t want to wake up one morning and find out that your fellow member or members transferred all of their interest to some unknown person who now owns a percentage of your business. The operating agreement should also contain a provision that gives the company a first right of refusal to acquire the interest a member wants to transfer on the same terms and conditions as the proposed transfer.

c)     To prevent members from disclosing confidential information about the company. Unless a member signs an operating agreement with confidentiality provisions, the member is free to disclose the LLC’s confidential information such as financial statements, tax returns, and business plans.

d)     To limit the management powers of the managing member or the manager. The operating agreement should state what actions the managing member (in a member managed LLC) or the manager (in a manager managed LLC) can take without getting member approval and what actions require the vote of all members.

Whether you own ten properties or one, owning them personally can be a major liability. All of the hard work and planning that led to your ability to own the properties could be wiped out with one bad break. The best way to avoid this occurrence is to form an LLC for each property you own and keep those LLCs in compliance.