Real estate investors want to avoid unnecessary taxation, and while there are many clever ways to reduce your effective tax rate, it can be difficult to simultaneously achieve robust asset protection. That’s because accountants and attorneys each have knowledge gaps that prevent them from seeing the full picture, according to Riley Neilson, real estate investment manager and founder of Flying ‘N’ Group. His business brings together lawyers and CPAs to help his clients achieve the delicate balance between minimal taxation and maximum asset protection.
Liability lawsuits against businesses are increasing in number and severity year-over-year, with businesses now spending an average of $1.2 million each year to counter litigation. Mom-and-pop real estate businesses are not immune, even those that do everything by the book, work to reduce risks and never cause intentional harm.
Before committing to a tax strategy, it’s important to consider how a lawsuit might impact your business and take precautionary measures to ensure your portfolio won’t be swiftly seized in the event of an accident. “The overall goal is to not own your assets and only control them. You want to make it so that the paperwork of your assets cannot lead to you,” says Neilson.
Can Real Estate Investors Avoid Lawsuits?
With the right asset protection strategy, it’s possible to prevent most lawsuits—more on that later. But you can’t avoid lawsuits simply by doing the right thing. “There’s a misconception that the only people who find themselves in lawsuits are people… who have wronged other people, and that’s absolutely not true,” says Neilson. If there’s money to be made from your business, victims of accidents may allege negligence—and not just to cover their losses.
There are several reasons why the digital age is conducive to an increasingly litigious culture. One is that personal injury attorneys are advertising to consumers directly, and their efforts have gotten even more sophisticated with the advent of targeted advertisements. Neilson says the marketing messaging often depicts personal injury lawsuits as “get rich quick” schemes. Aggregator businesses that sell plaintiff information to law firms also play a role, accounting for a large share of ad spending in 2021. The estimated $971.6 million in spending on legal services television advertising in 2021 represented an 11% increase from the year prior.
Another factor is that people are becoming increasingly aware of courts awarding plaintiffs high settlements and are expecting similar outcomes in their own cases, a concept known as “social inflation.” That’s causing claimants to file more frequent lawsuits and seek larger awards. Even if a claimant has a frivolous case, there’s little to deter them from hiring a contingency-based lawyer. That’s because most states follow the American Rule, where the loser isn’t responsible for paying the winner’s legal fees. Claimants’ expectations of high payouts are further reinforced by justice system abuse on the part of some attorneys.
Justice System Abuse and Insurance Policy Exclusions
Neilson explains that if personal injury attorneys become aware that defendants have significant assets, they may use tactics to artificially inflate damages. “Some of these personal injury attorneys will direct their clients to go to medical clinics that do lien-based treatment,” he says.
While there can be legitimate reasons to seek out-of-network care, some attorneys refer their clients to contingency-based healthcare providers that are able to bill up to 25X more than the in-network negotiated rate for the same treatment solely for the purpose of getting a bigger payout, according to Neilson. A 2018 appellate court case in California provides a precedent for the nefarious strategy to be tolerated.
That’s having an impact on insurance companies as well, says Neilson. “Insurance companies are catching on to this, and they’re having to either increase their premiums or, even worse, reduce their coverage.” Reduced coverage often takes the form of policy exclusions that may catch policyholders by surprise.
Neilson says real estate investors should ask insurance agents to review the exclusions in everyday language. It’s helpful to understand the gaps in the policy, and it may be possible to fill them. “A lot of times if you want coverage in a specific area and you ask for it, it’s not going to increase your premiums by very much,” he says.
One exclusion real estate investors should be aware of is that standard homeowners insurance policies won’t cover you if your insurance company detects “systemic rental activity,” so you should have a landlord policy if you intend to rent your property. You should also be aware that your business policy won’t protect against personal liabilities and vice versa. Other common exclusions in landlord policies include:
- Dog bites
- Claims of sickness related to mold or Covid
- Existing damage
How the Right Business Structure Can Protect You
If your only focus has been minimizing taxes, your business could be particularly vulnerable to litigation, says Neilson. “S-Corps, for example, are often used, but since the owner can only own S-Corp shares in their personal name, they offer very little asset protection, and in many cases, the owner would have been better off just keeping assets in their personal name.” Depending on your situation, the tax savings that an S-Corp may provide may not be worth the potential downsides, and an S-Corp election can be difficult to undo later on.
On the other hand, the right strategy may prevent lawsuits altogether. “We don’t want our clients to win lawsuits because they’re well-defended. We want them so well-defended that the lawsuit never finds them in the first place,” says Neilson, noting that keeping your assets in an offshore LLC on the Caribbean island of Nevis is one strategy that prevents someone from using a contingency-based attorney in a lawsuit against you. The goal of robust asset protection is for the cost of a lawsuit to exceed the value of your assets.
Of course, there are individual factors that will determine the best strategy for you, including the state you live in. “For example, Some people may recommend putting your primary residence into an LLC to protect it from lawsuits and gain some tax benefits, which would potentially be smart to do in a state like New Jersey, which has poor asset protection laws,” says Neilson. “However, if you live in Florida, which has an unlimited homestead exemption for your primary residence, and you placed it in an LLC, you would lose that protection completely.”
How to Prevent Courts from Piercing the Corporate Veil
Even if you structure your business as a corporation that provides limited liability, the directors or shareholders can be held personally liable if the court identifies misconduct. That would mean your personal assets would be fair game in a judgment against you. Most people know not to co-mingle their business and personal funds, but there’s more you need to do to prevent courts from piercing the corporate veil.
According to Neilson, “Following corporate formalities like having a board of directors that meets together annually and keeps a record of that meeting can also help legitimize your business in the eyes of a court.” This doesn’t have to be especially formal— you and a family member can have a meeting and take notes on what was discussed. But you want to make sure you’re not using your business as an alter-ego.
A lot of holding companies for real estate investors are undercapitalized and don’t have an operating agreement, and that can be problematic as well. “Asset protection laws for that setup are very weak in just about every state. And that’s because an LLC is designed to be run actively. It’s not supposed to be for passive income,” says Neilson. “So you have to change the way you’re running your business so it conforms better to what the court wants.”
Neilson has some general advice for real estate businesses: Don’t do business with the same LLC that owns your assets to avoid mixing your assets with your liabilities. And while you shouldn’t let potential lawsuits scare you into putting your assets in a trust that’s taxed at 37%, you should speak with an attorney to ensure your assets are protected rather than relying solely on tax guidance from your CPA. Neilson notes that it’ll cost you a fraction of what your assets are worth to keep them protected, and it’s well worth the cost to avoid losing everything you’ve worked to achieve.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.