Investors Incorporate to Protect Assets

Q: I’m interested in investing in real estate. But I have a solid career, own my own home and have money in the bank. What is the liability I’ll be undertaking as a real estate investor?

A: Real estate investors enjoy extraordinary benefits from real estate ownership. The ready availability of financing provides leverage. The ability to deduct operating expenses and depreciation shelters rental income from taxation. And population growth combined with Chicago’s healthy economic climate seem to push property values steadily upward. It’s a wonderful scenario, building wealth for the informed investor.

But this opportunity is not without pitfalls for the unwary. Every business activity carries with it inherent hazards. So too with investment real estate.

Any property owner is subject to potential lawsuit by anyone injured on the property–even trespassers! Employees of uninsured contractors often have the right to sue the property owner in the event of job-related injury (a workman’s compensation claim). As owners of rental property, landlords are even more vulnerable.

Governmental agencies, generally supported by the courts, hold landlords accountable for the well being and conduct of their tenants. Hazardous conditions, known or unknown to the landlord, are nevertheless that owner’s responsibility. Latent environmental problems, such as lead based paint, asbestos and underground fuel storage tanks, when found will require often costly remediation. Illicit tenant behavior, such as drug dealing or methamphetamine production, can result in governmental seizure and confiscation of the entire property (not an insurable loss).

Any of these situations or events will pose serious threat to the investor. Scale is not important: being a little guy is not a defense. The unsuspecting owner of a two flat is just as vulnerable as the owner of a substantial rental portfolio. The prudent investor will take steps to limit this exposure to lawsuit and loss. A successful lawsuit puts at risk everything the investor has worked to build.

The first line of defense is properly drawn insurance, for both the investor and anyone employed by the investor. Few properties today lack insurance, a requirement of most mortgage lenders. Many contractors, however, carry general liability coverage but lack the crucial workman’s compensation insurance. It is failure to monitor workman’s comp. coverage that may prove the investor’s undoing; conventional property owner’s insurance policies generally exclude workman’s comp. claims. Nor do such policies cover such environmental issues as mentioned above.

The use of land trusts as an ownership vehicle is sometimes suggested as a protective device to shield the owner from potential litigants. But land trusts, wherein the land trust owns the asset and the investor, in turn, owns the beneficial interest, offer anonymity, not protection from litigation.

While recognizing there is little defense for a property owner’s overt negligence, for which one may well be sued personally, most other losses may be mitigated or contained by the use of corporate ownership. Generally speaking, corporate share holders cannot be held liable for actionable acts of the corporation. Regardless of the particular form of corporation used (the “C corp.,” the “S corp.” or the LLC), the corporate form of ownership properly conceived and maintained generally negates the owning shareholders’ personal liability arising from a lawsuit or other attack against the assets of the corporation.

The reason is simple. The investor owns the stock of the corporation rather than the real estate itself. While under certain circumstances this “corporate veil” may be “pierced,” corporate ownership is generally considered the appropriate ownership vehicle for an investor’s personal asset protection.

The objective here is to segregate real estate investment holdings from one’s personal assets. In the unfortunate event of a successful legal claim against the investor as owner of corporately owned real estate, the assets of the corporation may be reduced or lost. But the primary estate of the investor, absent a court finding of personal responsibility or negligence, may well survive intact. So effective is this business model many investors establish multiple corporations, each owning but a portion of the investor’s real estate holdings.

With proper planning, and with the advice of experienced legal counsel, it is possible to create a business model that both limits personal exposure to loss while creating an investment vehicle that will flourish over time.