There’s no sense building wealth if you aren’t also building a plan on how you’re going to keep it. There are two main risks that you’ll face as you build your real estate empire: risk from lawsuits and risk from excess tax.
Early on we explained how much easier it was to build wealth using real estate than it was to build wealth using stocks. But, there is one inherent risk to real estate that stocks do not have. We call them tenants! Real estate is a real, tangi- ble, physical proof of an asset. And there are semistrangers in contact with this asset every single day. You need to protect yourself and the property against frivolous lawsuits. Addition- ally, you might have a situation where you are personally sued. For example, let’s say you are a doctor and are suddenly per- sonally sued for something related to your practice. You need to protect your assets against claims that might come about because of your personal acts.
There are three ways to protect your real estate assets: 1. Insurance.
2. Debt.
3. Business structure.
Insurance
Property insurance protects the value of the property against cer- tain hazards. Notice that we said “certain” hazards. There are many catastrophic events that can be excluded from a traditional policy such as earthquakes and hurricanes. These so-called “Acts of God” will require supplemental insurance policies.
Insurance generally has insufficient limits to protect you in case of a lawsuit. In our lawsuit-happy culture, this is becom- ing a growing problem for real estate owners. If someone slips and falls and a jury determines that you, as landlord, were neg- ligent in some way, you might get hit with a huge judgment. With a judgment in hand, the litigant (the person who sued you) can take your apartment building, your other property, and even your personal residence.
The first level of defense is to make sure you have adequate insurance. Consider getting an “umbrella insurance policy” to cover higher limits of liability. This is a policy that is usually linked to your personal residence. The cost generally ranges about $500 to $1,000 per year for $1,000,000 of liability protec- tion. Is that enough? It’s hard to say. If you are sued for less than that, you’re fine. But, if something bad really does happen and your property is somehow found to be involved by a jury, then $1,000,000 probably won’t be enough.
Debt
You’ve probably heard the popular advice to pay off your mort- gages early so that you can have your properties free and clear. Maybe you’ve thought of that as well, as a way of reducing your risk for the property. But the fact is that you actually reduce risk when you have debt, not when you pay it off.
Let’s use an example of someone who has a home with a $150,000 mortgage. The house is currently worth $180,000, so there is $30,000 worth of equity. But, our homeowner is wor- ried about losing his job and so he makes the decision to start paying extra money on the note. Each month he pays an extra $1,000 toward the note balance. The mortgage balance keeps going down as his equity grows. And then, a few years later, the
thing he feared most happens—he loses his job! But, he thinks, I’m safer now because I have paid extra on my note balance. Imagine his shock when he discovers that the bank still expects the regular payment next month. It doesn’t matter that he has paid an extra $30,000 into the house. In fact, the bank is just all the more pleased when they foreclose on the property. You see the extra payments didn’t protect the homeowner, they pro- tected the bank!
If he had completely paid the house off and had it free and clear, he would lose the risk from foreclosure, but he would be even more of a target for lawsuits. Plus, he would have lost the wealth-building strategy of leverage of money.
Seen in this light, debt actually protects the property owner.
Business Structure
The most popular way to protect property is through a prop- erly set up and maintained business structure. There are four good business structures that can be used to own real estate. Selecting the best structure for your investments will depend on where the property is located and what you intend to do with the property.
Generally, if you are buying a property to flip, you will have earned income. Earned income is money you work for. This in- come is subject to a self-employment tax of 15.3 percent if you hold the property in your own name, in the name of an LLC taxed at the default of single-member status, or partnership or if the property is held in the name of a general partnership. If the property is held in your own name, you have extra tax due to the self-employment tax plus you put all of your other prop- erty at risk. The same risk occurs if the property is in the name of a general partnership. An LLC will give you asset protection,
but if you are the only owner (called a single member) and you do not elect to be taxed as an S corporation or C corporation, you will have self-employment tax. If you have an LLC with multiple owners (called a multimember LLC) and have not elected to be taxed as an S corporation or a C corporation, you will again have self-employment tax. Remember, though, there is self-employment tax only when you have earned income.
If you are buying property to hold, the income you earn is considered passive income. The best business structures for passive income properties are either the LLC with the default taxation structure or a limited partnership (LP).