Tag: Real estate

Real Estate Rental Investing: How to Protect Your Insurance Blind Spot

By: Jacob Ryder

Investing in rental real estate provides two main financial benefits: monthly cash flow from rental income and appreciation in home values. While these are substantial benefits for building wealth, there are also significant risks. The risk of extended vacancies, tenants who damage your property, and – the largest risk of all – the threat of personal exposure, can be daunting. The risk of being forced to use personal assets to satisfy debts incurred through rental activity has driven many investors to form LLCs for real estate investing. These types of investors (let’s call them ‘traditional LLC’ investors) purchase the rental property through an LLC to protect what they have worked so hard for – their personal assets. Personal ownership of rental property gives a creditor a direct line to use your personal assets to satisfy debts, including legal judgments.

When done properly, an LLC forms a ‘brick wall’ to cut off the direct line between creditors and your personal assets. While a traditional LLC investor might have an ‘LLC wall’ to protect personal assets from creditors, what about protecting the real estate asset that generates their financial returns? This is where the ‘traditional’ LLC investor’s formation falls short.

Will Property Insurance Cover it?

The traditional LLC investor’s rental property is not without any protection. If the investor went through the process of forming an LLC to avoid risk, there is a good chance the investor has also purchased insurance. While general property insurance will protect the structure from damage caused by wind, fire, hail, or lightning, this discussion centers on liability insurance and its shortfalls.

While a good thing to have, liability insurance protects the real estate investment from only a few, although arguably the most common, kinds of creditor actions in real estate investing. Generally, insurance protects against negligence – claims that the entity did not exercise ‘reasonable care’ in actions concerning the real estate asset and that the creditor was injured as a result. This ‘partial protection’ will fully protect the real estate asset in circumstances where there is coverage, but it will provide no protection where there is none. Claims that may not be covered by liability insurance include breach of contract, fraud, and other claims alleging intentional conduct. Without coverage, a direct line remains between the creditor and the real estate asset. The investor who already formed an LLC and purchased insurance to minimize risk has to ask, “How do I protect myself from this insurance blind spot?”

Two LLC Formation

As the traditional LLC investor, you already formed one LLC to protect your personal assets. Why not form another LLC to protect your real estate asset? Using two LLCs can offer protection for the insurance blind spot. The set-up is simple. The first of the two LLCs, the ‘traditional’ or ‘holding’ LLC, will only own the rental property. The second LLC, the ‘operating’ LLC, will handle everything, including every interaction with a tenant, repairman, or property management company. This LLC should have a bank account with enough money to pay for repairs as they become necessary. Therefore, the investor’s exposure is limited to the amount of money in the ‘operating’ LLC’s bank account. This protects in a similar way to the ‘LLC wall’ explained in the ‘traditional’ formation, but this time, it separates the rental property itself from creditors.

Illustration

Suppose Stacy, an investor, owns a multifamily rental property in town. The unit is valued at $100,000, and she used $30,000 of her own money to finance a purchase through an LLC. She has two happy tenants and collects $1,200 a month in rental income. Unfortunately, a tenant misunderstands what was promised in the lease, and the tenant brings a claim for breach of contract. While likely unrealistic, assume a court awards the tenant $75,000 in damages for the LLC’s breach of contract.

In the first scenario, let’s assume Stacy has the ‘traditional’ LLC formation to own her rental property. The lawsuit, in this case, would be against the same entity that owns the rental property. This is terrible news for Stacy. The creditor can attach the judgment against the property and possibly force the LLC to sell it. In this scenario, Stacy will only keep the rental property if she can fund the LLC with $75,000 and satisfy the debt. Otherwise, her best course of action will likely be to sell the rental property.

In the second scenario, let’s assume Stacy created the two LLC formation. In this case, the tenant will sue the entity it interacted with, the ‘operating LLC,’ which, as described above, only owns a bank account. Let’s assume there is $6,000, or five months of rental income, in the operating LLC’s bank account. By using two LLCs, Stacy has put up another ‘LLC wall’ between the creditor and her investment. Stacy’s risk in this scenario, instead of $75,000 worth of the rental unit, is only $6,000. Stacy can rest easy knowing that the creditor cannot force her to sell her rental property to pay off the debt.

Benefits and Costs

The two LLC formation not only protects personal assets, but it can also protect the rental property – something the investor worked equally hard for – when insurance does not. However, this is not a perfect solution. LLC ownership risks still exist, including the risks that a court will disregard the entity if the investor mixes business and personal funds and the risk that the individual will be directly liable for any acts they personally commit. There are also additional costs to form and maintain another LLC.

The ‘traditional LLC’ may protect your personal assets, but it leaves only the partial umbrella of insurance to protect your investment. Forming two LLCs can protect what insurance does not. Before choosing a form of entity, an investor should always weigh its costs and benefits. No solution fits every investor, and as always, an investor should always consult with an experienced attorney before making any legal decision.

This post has been reproduced with the author’s permission. It was originally authored on February 11, 2021, and can be found here.

Jacob Ryder, at the time of this post, is a 2021 graduate of Penn State Dickinson School of Law. Prior to moving to Carlisle, Pennsylvania to attend Dickinson Law, he was a resident of Olney, Maryland. He attended Towson University in Baltimore, Maryland where he earned his bachelors degree and played four years of Division 1AA football. Jacob was a comment editor for Dickinson Law Review and a research assistant for the professors who work in the Law Library. Following graduation, he will be pursuing his interest in business law as an associate at Morris, Nichols, Arsht & Tunnell in Wilmington, Delaware.

 

Sources

Smith v. Wells, 212 A.3d 554, 557 (Pa. Super. 2019).

Ward and Smith, P.A. (October 14, 2016) https://bit.ly/3p8aPiU.

Hyojung Lee, Joint Center for Housing Studies of Harvard University (August 18, 2017) https://bit.ly/2MRiy80.

Allstate, Homeowners Insurance vs. Landlord Insurance for a Rental Property (Updated January 2019) https://al.st/2Z2et3q.

Pennsylvania Department of State, Business Fees & Payments (last visited February 10, 2021) https://bit.ly/3p6ZyPV.

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Real Estate Investing’s Big (Legal) Picture

By: Jacob Ryder

While there are significant advantages to investing in real estate, like the ability to use leverage and real estate’s low correlation to the broad stock market, there are also disadvantages. Possibly the most daunting to a new investor is the risk of legal liability and the seemingly unending world of laws in which the investor doesn’t know what she doesn’t know.

This blog post will highlight federal, state, and local laws that impact real estate investing in Pennsylvania. Real estate investing can take the form of an investor acting as a landlord, so this post will include laws applicable to the landlord-tenant relationship. While not a complete list, the information below will help highlight some of the biggest ‘red flags’ and provide links to additional resources. Having an idea of the legal framework and significant issues can transform the unknown and daunting risk of legal liability into manageable management practices and necessary costs.

Federal Regulations

While property ownership rules are typically found at the state level, several federal regulations apply to landlords and real estate investors.

The Fair Housing Act prevents landlords from discriminating based on race, color, religion, sex, disability, familial status, or national origin when renting homes. These protections apply to most residential property with certain exceptions, including owner-occupied buildings consisting of four or fewer units.

The Fair Credit Reporting Act protects consumers’ sensitive information within the credit reporting system. Unlike the general public, landlords are entitled to review ‘consumer reports’ (which include credit reports and rental histories) to screen prospective tenants. Importantly, landlords engaging in this screening method must comply with the Act’s requirements and use limitations, including providing adverse action notices to applicants. For more information on the requirements, visit the Federal Trade Commission’s page on a landlord’s use of consumer reports.

Possibly the most impactful federal rule is the eviction moratorium recently created by the Centers for Disease Control and Prevention (CDC) in response to the global health crisis caused by COVID-19. On September 4, 2020, the CDC issued an order temporarily preventing evictions. The moratorium has been extended at least through March 31, 2021. The CDC’s order prevents residential landlords from evicting certain individuals, including those who have suffered substantial income loss. Tenants must provide a signed declaration to their landlord before the restrictions are imposed. Importantly, landlords who violate the order are subject to criminal penalties. To learn more about the moratorium, visit the CDC’s answers to frequently asked questions.

Federal environmental law administered by the Environmental Protection Agency (EPA) requires landlords renting most buildings built before 1978 to provide lead paint disclosures. The landlord must provide the tenant an EPA-approved brochure, any known information about the building’s lead paint status, and a ‘lead warning statement’ as an attachment to the lease.

State Regulations

In Pennsylvania, the Landlord and Tenant Act of 1951 serves as the statutory basis for the landlord-tenant relationship. The Act covers many landlord obligations and rights, including rules regarding security deposits, notice and entry, licensing (when applicable), subleasing, and the prohibition of retaliation and recovery of possession. For a summary of Pennsylvania’s landlord and tenant law, read a Housing Equality Center (HEC) of Pennsylvania’s publication here.

In addition to statutory landlord-tenant law, there are judge-created laws that can apply to landlords. The most relevant of these judge-created laws appear below:

        • The implied warranty of habitability imposes a burden on landlords to provide every tenant with a safe, sanitary, and reasonably comfortable living space. This requires that the property be fit to live in, not aesthetically pleasing. Significantly, parties cannot modify this by contract.
            • A landlord’s failure to comply with this minimum standard gives the tenant several options: terminate the lease and leave, reduce monthly rent, or remain in the property and sue the landlord for damages. For more on tenant remedies, read HEC’s report.
        • The implied covenant of quiet enjoyment restricts the landlord’s ability to use or access the tenant’s property. Landlords cannot unreasonably or excessively intrude on the tenant’s right to possess the property. Usually, this requires the landlord to give advance notice and to enter during reasonable hours, but parties can modify this obligation by contract. Breach of this rule can act as a breach of the lease agreement.
        • Landlords must also refrain from using ‘self-help’ to effectuate evictions. Self-help is when a landlord takes certain steps outside the court system to get a tenant to move out, like changing locks, turning off utilities, or removing the tenant’s personal property. A landlord engaging in this type of illegal eviction can expose himself or herself to significant liability.

Landlords should also be mindful of state tort laws. Generally, tort laws give relief to people harmed by intentionally bad conduct or negligent conduct – when an individual does not exercise ‘reasonable care’ in actions, meaning they fall short of doing what a reasonably prudent person would do.

Local Regulations

Most significant at the local level are zoning rules and ordinances covering rent, noise, and other health and safety standards.

Zoning: While getting zoning ‘right’ during the rental purchase may seem straightforward, landlords must continually ensure that tenants do not violate the zoned purpose. A home business run by a tenant could easily contravene zoning ordinances, which could cause big headaches for the landlord. Read this blog post by Movoto Real Estate for more.

Other ordinances: There are many other regulations local governments can pass that would impact landlords. Rules like rent control, noise limitations, and health and safety standards can affect a landlord’s ability to operate.

A landlord may already have a lot on their plate with property management on top of a full-time job. It is likely not worth the trouble to learn each rule’s ins and outs. It would be sufficient for the landlord to know how to spot issues, research further when necessary, and know when to use legal counsel.

This post has been reproduced with the author’s permission. It was originally authored on February 11, 2021, and can be found here.

Jacob Ryder, at the time of this post, is a 2021 graduate of Penn State Dickinson School of Law. Prior to moving to Carlisle, Pennsylvania to attend Dickinson Law, he was a resident of Olney, Maryland. He attended Towson University in Baltimore, Maryland where he earned his bachelor’s degree and played four years of Division 1AA football. Jacob was a comment editor for Dickinson Law Review and a research assistant for the professors who work in the Law Library. Following graduation, he will be pursuing his interest in business law as an associate at Morris, Nichols, Arsht & Tunnell in Wilmington, Delaware.

 

Sources

Pugh v. Holmes, 384 A.2d 897 (Pa. Super. 1979).

Weighley v. Muller, 51 Pa Super. 125 (1912).

Minnich v. Kauffman, 108 A. 597 (Pa. 1919).

Lenair v. Campbell, 31 Pa. D. & C.3d 237 (Phila Comwth. Ct. 1984).

Smith v. Wells, 212 A.3d 554, 557 (Pa. Super. 2019).

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