One of your first concerns when becoming a landlord may be how to protect yourself from lawsuits. You know you need insurance, but what’s the best policy for your real estate investment? Let’s compare two popular options for liability protection — LLCs and umbrella insurance — so you can make the best decision for you and your rental property.
What Is an LLC?
An LLC, or Limited Liability Company, is a type of business structure allowed by state statute. Every state has different regulations, but basically the members (or owners) of the LLC are provided with limited liability. This means, in most cases, that you can’t be held personally liable for any debts incurred by your business. You also aren’t personally liable for most lawsuits brought against your LLC since it is considered a separate entity from you, like a corporation.
But just because you have an LLC, you’re not automatically protected from all lawsuits. An LLC structure is complicated and there are limits to its legal protections. For example, if you neglected to maintain your property (swimming pool maintenance, for example) and that resulted in an injury to your tenant, you might still be held personally liable. If you broke a law or deceived your tenant in some way, these instances might not be covered by your LLC.
The owner of a single-member LLC pays a tax on their net earnings, in the same manner as a sole proprietorship. Many find the costs, restrictions, and taxes involved prohibitive. LLCs cost money to create and some states charge an annual fee to have one. Be sure to review the relevant tax forms with your accountant or attorney and know your state laws pertaining to LLCs.
What Does an LLC Cost?
The amount of money you’ll spend on your LLC depends on where your property is located. Every state has different fees associated with LLCs, but the average cost to file is about $132. In addition to a filing fee, most states have an annual or biennial fee (a mandatory fee assessed every one or two years). If you pay this fee after the due date, you’ll incur late fees on top of this fee. The amount of the annual or biennial fee ranges depending on your state. A few states, like South Carolina and New Mexico, don’t have an annual fee. Some, like New York, have a very low fee (for example, New York’s fee is $9 every two years). In other states, you can pay much more. An LLC in California costs $800 a year with an additional $20 every two years.
No matter where you live, you’ll want to talk to your tax advisor to make an informed decision about your situation. You’ll incur more costs if you set your LLC up with an attorney. Many landlords form LLCs for each of their properties for further protection, so costs can add up quickly depending on where you live and your individual needs.
What Is an Umbrella Insurance Policy?
An umbrella insurance policy is a supplemental insurance policy that kicks in when costs exceed what your standard policy will cover. Umbrella insurance policies protect landlords from personal fiscal responsibility in the event of an injury or a lawsuit. Umbrella insurance policies also cover claims typically not covered from standard insurance policies, such as slander, libel, false arrest, malicious prosecution, or mental anguish lawsuits.
In addition to covering your rental properties, umbrella insurance policies cover personal circumstances, as well, and it travels with you. For example, if you dog bites someone at the park, your umbrella insurance can cover the medical costs.
Keep in mind that your umbrella policy won’t cover anything that isn’t already covered by your standard coverage. An umbrella policy doesn’t provide additional coverage for areas of risk, it merely adds more to your existing coverage.
What isn’t covered by umbrella insurance?
Unlike an LLC, which is limited to the state in which it is registered, an umbrella policy can cover multiple properties across several states. But while you may have more flexibility with an umbrella policy than an LLC, umbrella policies tend to have more caveats and loopholes, so work with your insurance company to make sure you understand the coverage. Often, since it is in their best interest to win lawsuits, insurance companies provide their own legal team to fight any lawsuits lodged against you. Ask if your insurance company will help you fight a lawsuit.
In some situations, your tenant’s renters insurance will cover damage to the property and claims from accidents, so consider requiring renters insurance in your lease in your lease. Be aware that your umbrella policy won’t cover everything your standard policy covers — it only covers liability.
There are some loopholes to umbrella policies. For example, some personal umbrella policies won’t cover any liabilities incurred during business or professional activities — this would require a business liability policy. Most umbrella policies don’t cover your own injuries, intentional or criminal acts, damage to your personal belongings, or injuries or damage that your business is liable for.
How Much Does an Umbrella Insurance Policy Cost?
The amount you’ll pay for your umbrella insurance policy depends on where you live. On average, for a $1 million policy, you can expect to pay about $383 annually. Policies can go up to $10 million in coverage, which costs roughly $1,578 a year. Speak with several insurance providers to get a variety of quotes and learn what is included to make sure you find a policy that best works for you. If you package all your insurance needs with one company, you might be able to get a discount.
While an umbrella policy picks up where your standard policy leaves off, keep in mind that you’ll still have a deductible to consider. You’ll have to pay the deductible before the umbrella policy pays the remaining amount. This amount varies depending on the cost of the premium. A lower annual premium, for example, will likely have a higher deductible.
The cost of LLCs and umbrella insurance are both tax deductible, which can help offset the costs.
LLC vs. Umbrella Insurance
Deciding whether you want an LLC, an umbrella insurance policy, or both will depend on several factors, including the type of property you own and in how many states. Here are a couple of scenarios to consider:
Scenario 1: umbrella insurance
A landlord owns a triplex worth $700,000. A tenant breaks their leg on the property and sues the landlord for $300,000.
LLC: The LLC has assets of $700,000. The LLC pays the full amount of $300,000.
Umbrella insurance policy ($10,000 deductible/$1,000,000 coverage): The dwelling insurance picks up the liability max. After that, the landlord pays $10,000 out of pocket for the deductible. The umbrella policy would pick up the remaining balance plus legal costs.
Result: The landlord would be better off with the umbrella insurance policy. With the LLC, the landlord would lose $300,000. However, with the umbrella policy, the landlord only loses $10,000.
Scenario 2: LLC
A landlord owns a warehouse and rents it out as an event and residential space. A fire ignites in the warehouse and kills several people. Prosecutors sue the owner for negligence due to safety hazards. The insurance pays the $3 million to the owner for the fire. However, several families sue the landlord over the fire. The families win a $20 million lawsuit.
LLC: The judgement is $20 million. The value of the warehouse is $3 million. The landlord loses the warehouse and insurance payout. The total monetary loss is $6 million.
Umbrella insurance policy ($10,000 deductible/$3,000,000 coverage): The landlord goes bankrupt, losing $20 million.
Result: The landlord in this case is better off with an LLC, which shields them from personal bankruptcy.
Which Is Best for You?
What works best for you depends on your real estate portfolio. An umbrella insurance policy is often the better financial choice for landlords with small portfolios, but everyone’s situation is different. Some landlords choose both an LLC and an umbrella insurance policy. The extent of coverage you choose will depend on your assets, your incomes, and the types of buildings you have. Stay organized by tracking your expenses with Apartments.com. Whether it's repairs, new investments, or even insurance costs, tracking your finances can be a headache. With our expense tracking platform, you can summarize rental expenses by property and tax category. From there, you can easily export them to CSV or PDF formats to make evaluating your finances a breeze.
Review your personal financial situation along with your real estate portfolio, and make a decision that won’t erode your profits but will still lessen your risk for bankruptcy. Consult with your lawyer to consider your options and choose what works best for you.
