Real Estate Investing: Lawsuit Avoidance 101

Posted February 26, 2008

"You need to be fair when dealing with all parties. You need to outline agreements with partners, vendors, contractors, etc. And you need to respond to tenants' complaints. These are good business practices - what I call Lawsuit Avoidance 101." — Darius Barazandeh

by Darius Barazandeh, Early to Rise

Baltimore – (TFN): One of the best ways to create massive, passive income is to invest in real estate. Even today, when real estate is in trouble in much of the country, you can still make a steady living as a real estate investor. But before you jump in, remember that, as with any business, you'll want to set up your real estate business in a way that not only maximizes your financial reward but also minimizes your risk.

Real estate requires you to deal with tenants, sellers, partners, investors, lenders, management companies, independent contractors, employees, and others. The more parties you deal with, the more likely it is that something may not go as planned.

The first step to protecting yourself is to learn how to run your business in a fair and careful manner, so you reduce the chances of getting sued. But it's also essential to protect your personal assets by doing business as a corporation, limited liability company (LLC), or limited partnership.

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Each of these structures creates a special legal relationship between the business owner(s) and the state and federal government. The idea behind them is to promote commerce by limiting an owner's liability to the amount of money he invests in his business - and, thus, limiting his risk. And they have been around for centuries, some pre-dating the founding of this country.

In England during the colonial period, creating a corporation required a grant from the King or the Queen. It's easier to form a corporation today, but it's good to remember that this liability protection is still a privilege.

A corporation, LLC, or limited partnership is not an excuse to act in a careless or negligent manner. You need to be fair when dealing with all parties. You need to outline agreements with partners, vendors, contractors, etc. And you need to respond to tenants' complaints.

These are good business practices - what I call Lawsuit Avoidance 101, because they reduce your risk of getting sued.

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But keep in mind that in your dealings with tenants, sellers, partners, investors, lenders, management companies, independent contractors, etc., you may occasionally need to take someone to court because your rights have been violated, a contract has been broken, or money has not been paid to you.

And that's where the protection of doing business as a corporate entity comes in.

When you assert your rights, it's not uncommon to be sued in return by the other party. This is called a cross claim. Usually it happens because the other party's attorney believes they have a claim or will be in a better position by using a cross claim - and it could put every asset available to your company at risk. But with the protection of a corporation, LLC, or limited partnership, your potential personal losses are limited to your investment in the business. Without that protection, you could lose your home, your car, your retirement savings, and anything else of value that you own.

So which of these business structures is right for you? Your individual situation will determine what works best, so be sure to consult with legal and financial advisors before you make a decision. But most real estate investors tend to fall into one of two categories:

Short-term buyers and sellers ("flippers")

Long-term investors in rental properties - what I call "buy-and-hold" investors

Short-term buyers and sellers will benefit most from an LLC taxed under Subchapter S of the IRS tax code. This structure allows you to minimize the self-employment taxes you'll owe from active income (such as buying and selling properties) by re-classifying some of it as passive distributions that are taxed at a lower rate. Both a corporation and an LLC will protect you personally from business liabilities, but the LLC can protect your business from your personal liabilities as well.

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Long-term buy-and-hold investors make most of their money from passive income (such as rents), so the self-employment tax isn't as much of a burden. For them, a Subchapter K LLC usually has the most tax benefits. The primary benefit here is that many real estate investors borrow money to purchase rental property. The savvy investor wants to ensure that any debt or remaining balance owed on the property can be used to reduce other reportable income earned outside of the business. The S election does not allow this.

A business that operates under Subchapter K can usually choose between an LLC and a limited partnership. The LLC is simpler to run, cheaper, and costs less to set up.

Many new investors balk at the time and expense of setting up a corporate entity, but over the long term, the costs of not doing it are usually much higher. A properly structured business faces far less risk of an IRS audit, protects your personal assets, and can dramatically reduce your annual taxes. You owe it to yourself and your investing business to use these entities to your best advantage.

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