Question: Should I invest using an LLC in order to keep my personal assets separate?

Answer: Protecting your assets by forming an LLC is a tried and true strategy but it comes with some significant hurdles to implement correctly. 

First, anyone can form an LLC by going to the Texas Secretary of State website,… Create an account with their SOS online portal, and for about $300 you can file a certificate of formation. This creates your LLC, legally. Since you are the only owner of the LLC, the IRS will consider you a “disregarded entity” for tax purposes, so you won’t need a separate tax id, and you file all the income and expenses on your personal return.

However, companies also have operating agreements, which specify all the big picture items of how the company will do business, who the officers are, how they get elected, etc.  You need a lawyer to craft that for you. They have their own form documents, so they can create a basic operating agreement for you at a nominal cost. 

Since the point of creating an LLC is to protect yourself and your non-business assets in the event you are ever sued, you have to run the business as an actual business.  Otherwise, an opposing lawyer will characterize the business as a fiction or sham and attempt to have a judge disregard the business.  Lawyers call this “piercing” the corporate veil.

In order to keep a lawyer from “piercing” the corporate veil, you must go through the motions to have an actual company. This means having annual meetings, and then signing minutes of those meetings, and storing them in a way you can find later.  A lawyer can help craft annual meeting minutes for you. 

Finally, you need to make sure you business has separate bank accounts, and the money is accounted for like a business would. So you may need to pay an accountant to keep your books proper if you’re not familiar with business bookkeeping.

Unfortunately, if you get sued over something, you will spend a lot of money paying a lawyer, whether you win or lose, so in a sense, you always lose because you are out the money. That’s why this strategy is not as successful as people hope it is, even after they spend all the money doing the things outlined above to protect themselves. 

As you grow your real estate portfolio, it is more cost effective to form the LLC as an additional asset protection method. If you buy an apartment complex, you must do it through an LLC, for example. But as the sole owner of a single rental home, you will find an LLC creates additional complications as well. For example, most banks will not provide a traditional home loan to an LLC. The banks consider that a commercial loan and those loans are in a different department and come with higher interest rates.  If you create the LLC and transfer title after buying the property, you will trigger a “due on sale” clause in your mortgage. Whenever the bank finds out that you’ve changed the title to the property, they can send a demand letter that you pay the entire mortgage balance immediately or they will start foreclosure proceedings, for example.

Here’s an alternative or additional strategy that works fairly well: buy insurance. Most of your liability in real estate can be insured away. Find an insurance company that specializes in helping small businesses, such as people who have dba’s, for example, and ask for a) property insurance for your REI investment, b) but also “completed products coverage” for your property rehab business. Best part, if you get sued for something, the insurance company’s lawyers will now go to bat for you at no charge. And if they settle with the person, the insurance company pays the settlement, not you.