One of the best and most stable ways to increase your wealth over time is to have rental properties. By investing in a property that gives you good rental returns you will attain financial security and long term growth because you have an asset that not only provides you with a steady income but also appreciates in value over time. Once you have understood what it takes to make money through rental properties you can build a real estate empire from by starting from a single rental property.
The idea of buying a good property, getting it ready for rental and finding tenants may seem like an uphill task at the beginning. But if you take it one step at a time you can make the entire process a smooth experience. You will initially need to surround yourself with professionals who can help you find the right property and also update you with legal issues surrounding the rental process. Let us start with some guidance:
Protect Your Assets
The first and foremost rule of real estate investing is to NEVER buy property in your own name! I know this thinking may run counter to what most people think and do when they buy property. There are some good reasons for this advice though. The most important aspect of this rule is that it ensures protection of your assets ensuring that lawsuits cannot touch what you own whether it be a house, car or bank accounts. There are other reasons to buy a property under a separate entity such as:
- Special tax benefits
- Easier Accounting
- Easier Transfer to Heirs
Another way you can protect your assets is to go for maximum insurance on your property. There are number of things that can go wrong with residential properties and when expensive problems start happening to your property, insurance coverage can take care of it. As mentioned, the double combination of buying your properties under a separate holding company and buying ample insurance coverage can offer strong protection against liabilities such as tenant slip-ups, weather and environmental damage etc. Let us discuss in more detail about how to go about forming a holding company to protect your assets and also how to insure your properties to protect against environmental or man-made disasters.
The Holding Company
Seasoned property investors know that one of the strongest tools in their arsenal is the holding company which is a special legal structure that protects your personal asset such as your house, your car, bank accounts etc. from any legal problems pertaining to your investment properties. There are two types of commonly used business entities for this purpose – Limited Liability Companies (LLC) and Limited Liability Partnerships (LLP). Both these forms of entities can offer you maximum flexibility and pass-through taxation which means that the company does not pay income taxes – the income “passes through” to the owners’ personal income tax returns. Depending on your circumstances, you can decide what works best for you – LLC or LLP. But both can offer you legal liability protection when administered properly.
If you want this strategy to work for you then you have to keep your personal and business finances totally separate. That means you cannot make a loan payment for your property from your personal savings account and you cannot receive rent payments into your own personal savings bank accounts. If you want to transfer money between your savings and current accounts you have to do it officially – like making a formal payment to the company so that it can pay the mortgage amount. Similarly you have to write yourself a cheque from the company when it comes to rent. You will also be required to run the business professionally, keeping up-to-date records and following all the local and national regulations stipulated by the government from time to time to lock in the liability protection.
LLC (Limited Liability Companies)
LLCs are special business entities that can protect the members’ personal assets from company-related lawsuits and they are used quite frequently by real estate investors in the US. You can form an LLC either alone as a single-member LLC or have partners with you. The company is formed according to the state laws and is governed by a legal agreement which is absolutely important for LLCs with many members. Any LLC member can take part in the day-to-day running of the company unless the agreement forbids it. The LLC agreement also states how the income is distributed among members. Although there is some paperwork to be done, LLCs require far less time commitments, money and paperwork than corporations but still offer their members protection against liabilities.
LLP (Limited Liability Partnership)
Unlike an LLC, an LP requires at least two participants – one general partner and one limited partner. The general partner can also be a limited partner if there is one more person involved. In this case, only the general partners can run the company on a day-to-day basis whereas limited partners are not permitted from taking part in day-to-day activities which is why the are called “Silent partners”. Generally, limited partners invest the money and general partners run the company. General partners are liable whole and sole for business obligations which is why many LLPs are set up in conjunction with another LLC as the general partner. Limited partners cannot lose more than they money that they invested in the company. This works well for a group of real estate investors who decide to contribute their money to purchase properties without dealing with property management issues. The LLP is formed according to the laws of the land and is governed by a partnership agreement which lays out specifics and details such as the responsibilities of the general partners, ownership percentages and how the income will be distributed.
The Negatives of Holding Companies
There are solid legal benefits attached to forming a holding company for your real estate investments but there are some drawbacks. Firstly it costs a lot of money to set up and maintain a LLC and even more if you have an experienced real estate lawyer or CA handle the paperwork. And to ensure that your protection is as strong as possible you need to ensure that a good legal eagle is also by your side. Apart from that there are taxes to contend with. It can also be difficult to get financing in the name of your company when you are just getting started. That means you have to personally guarantee or co-sign for loans which makes you solely responsible for loan repayments. A word of advice – as soon as you form the company apply for a company pan card, open a company bank account etc. Even though you will have to personally guarantee credit to avail of a loan in the initial stages it will help the company to build it’s own credit rating for loans in the future.
As we have discussed so far, having a separate holding company is to protect your assets in the unforseeable future is a good idea and it will protect your assets from being taken over or attacked but even that may not shield your properties from loss. The best way to deal with that is by picking up the right insurance policies and coverage that will ensure that your company and your properties are safe and protected from natural and man made disasters. As we have seen during the Coronavirus Pandemic, unpredictability is the very nature of living life on our fragile planet. If you think the Coronavirus Pandemic is bad, wait till the effects of global warming strikes a few decades later whereby severe storms and hurricanes, flooding, drought and rising sea levels can threaten the very existence of homes, buildings and properties! Coastal cities are more exposed to the might of nature and particularly if you own or are planning to own beachfront properties situated near the edge of the sea you should definitely think about insuring your properties against environmental disasters. It is not just the environment; even man made disasters can destroy the value of your property investments. Case in point – Wars (Europe, Japan & US in WW II), severe pollution (Delhi), nuclear radiation exposure (Chernobyl), gas leaks (Bhopal / Vizag), Fires, (everywhere!) bio-terrorism (waiting to happen!) are just a few of the potential risks that human beings can bring upon through their actions (whether intentional or through accidents) in a particular geographical area or a country.
When it comes to insuring property the idea is to strike the right balance between the premiums that you are paying and the corresponding benefits. Excess coverage will deplete your profit margins and leave you with little cash on hand whereas too little coverage will serve no purpose and leave you financially destroyed if an environmental or man made disaster strikes. You should also be careful that you have the right kind of insurance to protect your investments. Every property is different and the unique features and it’s location will dictate the kind of coverage that you need. For example a villa at the foothills of the Himalayas will need a different insurance than a beachfront property in Mumbai. Having said that, there are some basic insurance coverages that all landlords must have. You should ideally ensure that you have both property and liability coverage. If you own or are planning to own rental property you should purchase the below policies either individually or in combination:
- Liability insurance (for both the property and the holding company)
- Fire and hazard insurance
- Sewer / septic backup insurance
- Personal property coverage (for any contents, such as furniture or appliances, owned by the landlord)
- Loss-of-income insurance (to cover lost rental income if the home becomes uninhabitable)
- Workers compensation insurance (if there are employees such as a building supervisor or maintenance workers on-site)
- Umbrella insurance (to cover anything else)
Some insurance companies may club the above policies together in one big landlord policy but whatever be the case you must ensure that your insurance covers all the above points. Depending on the location of your property you should consider flood insurance. Technically you will only require that insurance if your property is situated in a designated flood zone but even if the property is situated at the bottom of a hill / mountain or in an area that gets battered by heavy rainfall consider adding this coverage for sure. Do remember that man made flooding like burst pipes or a leaking water heater are not covered by standard hazard insurance policies. Of course you will need to work with an insurance advisor who will walk you through the entire process. Feel free to contact any of the well known home insurance providers such as HDFC Ergo, Bajaj Allianz and SBI General.
As we have seen, if you are willing to become a seasoned real estate investor you must consider creating a holding company to house all your property investments and also make them future-proof by buying adequate insurance coverages for long term peace of mind!