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This article is presented by LegalZoom.
Perhaps you’re just dipping your toes into real estate investing with your first property, or you might have a bit more experience and are currently renovating a couple of units.
Wherever you are on your investing journey, if you’re a small-scale real estate investor, it may seem like the whole “setting up an LLC” aspect of it doesn’t apply to you. It may seem excessive and too time-consuming for what it’s worth. Surely putting a fresh coat of paint and improving a couple of things in an older unit before renting it out isn’t that big a deal, legally speaking?
The truth is that many small real estate investors underestimate how much legal exposure comes from renovation work. It’s not the scale of your investment that should get you thinking about setting up an LLC—it’s the type of investment.
If you’re investing in a turnkey property via a company, you may well be off the hook because someone else owns that liability (more on that later). But if you are managing the renovation work yourself, even on a single investment property, the potential benefits are substantial.
Here’s how LLCs protect you from liability claims on renovation.
Common Legal Disputes During Renovations
First, you might be wondering, “How bad can it really be?” Well, here’s a taste of what can go wrong on a renovation site that could lead to a liability claim:
- A contractor gets injured on-site and sues the owner.
- A subcontractor files a mechanics lien.
- A renovation causes damage to a neighboring property.
- A flip buyer claims undisclosed defects.
- A vendor contract dispute escalates.
- Poorly drafted rehab agreements lead to overruns or nonperformance.
- Unlicensed work creates liability after resale.
As you can see, there are a ton of legal “unknowns” that come with a renovation project. Your biggest risk is often not the property itself, but the vendors and subcontractors performing the work. They can sue you if something happens to the builders on the premises, but they can also cause litigation much further down the line if the renovation work isn’t completed up to standard.
By far the riskiest aspect of any renovation work is that the legal side of things (who owns responsibility for what) is often vague and complicated. The more subcontractors who are involved in your project, the greater the risk that someone working on site is not properly qualified/unlicensed, which can have huge consequences. It could be just a single plumber/installer.
Not all states require contractors to have a specific warranty; instead, they stipulate vague requirements along the lines of “fitness for intended use and habitability” (a Michigan example). If a structural defect is discovered after a sale and you’re sued by the new owner, and the contractor warranty will not cover you, you are liable.
Lien filings can be disastrous for a real estate investment. When a contractor orders renovation materials, the supplier has a lien on part of your home equal to the cost of the materials. If a contractor, for whatever reason, ends up not paying the supplier, the supplier can sue you for the cost, or, in the worst-case scenario, force the sale of the property to cover their costs.
Investors in multifamily units should be prepared for costly lawsuits from residents who, at some point, discover that they live in a building that is insufficiently or improperly renovated. If you own a condo, for example, you can be sued for a flooded communal parking garage (a real case in Florida) or an under-renovated lobby. Again, depending on your local legislature and the exact building, either the building developer, or you, the owner, can be filed against.
The right question isn’t, “How likely am I to get sued?” but “How much complexity is involved in my renovation?” The more complex the renovation project, the more trouble you can land in if something does go wrong.
How Personal-Name Ownership Amplifies Liability
Quite simply, if you own a renovation property in your own name, you are personally responsible for any legal claims filed against you. You can then stand to lose anything you own, including your savings, any other investment properties you own, or even your home.
Your premises liability insurance does not cover any contractors working on renovating your investment property. You may have heard about taking out a “Builder’s Risk”-type policy, and it’s true that it will cover personal injury or accident—to you or your tenant/a visitor, but again, not a contractor or subcontractor working on the property. Contractors need to be covered by their own insurance.
You also cannot use personal liability insurance to pay for investment-related claims; you must take out premises liability for anything investment-related.
As an investor, you’re not left with many options if you own your investment property under your own name. You are legally responsible, and there’s not much recourse if something goes wrong during or after a renovation because insurance won’t cover workers on your premises.
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Why an LLC Creates a Legal Boundary Between Rehab Risk and Personal Assets
When you form an LLC for your investment properties, if the renovation contracts are between the contractors and the LLC, not you personally, then any legal claims in connection with the property can only be filed against the LLC, not you personally. That means that your personal assets (your own home, personal savings, car) are protected; only your company assets (say, another investment property held under your LLC) are open to claims. Even if a liability claim results in you having to pay the claimant, if you don’t have enough in your business assets, the claimant cannot go after your personal assets.
Considering how easy it is to set up an LLC, it’s a no-brainer for any real estate investor. However, you have to run them diligently and conscientiously.
If you start mixing personal and business expenses, for example, by using your business bank account for your personal bills, you are breaching that legal LLC shield, potentially opening up your personal assets to litigation after all. But, so long as your LLC is run correctly, it does protect you. You also don’t have to run a company to form an LLC—you can be a single-member LLC.
How LLCs Work With Insurance
Despite all of its benefits, setting up an LLC does not mean that you don’t need to take out insurance on your investment properties. There are many scenarios where having an LLC will not protect you from a claim. For example, you still need home insurance to protect you from natural disasters and hazards like fires.
Or let’s imagine another, far more common renovation-related scenario: Someone visits the premises while you are also there during the renovation and slips and falls. They could still sue you personally, and if the court found that the accident was the result of your own personal negligence, you could still lose personal assets. That’s why a premises insurance with a Builder’s Risk policy is still essential.
Why Investors Doing Value-Add Projects Should Always Have Entity Protection
Value-add investments are by their nature more complex than turnkey investments. There is more that can go wrong both during and, crucially, after the renovation—in some cases, even after you’ve sold the property.
Think of an LLC as that vital shield against “unknown unknowns”: You simply can’t predict or avoid every eventuality because of the multiple parties involved, so it is essential to protect your personal assets against any claims that you are potentially being exposed to.
