Reduce Lawsuit Risks and Minimize Tax Liabilities of Owning Real Estate
Maximizing the protection of your valuable personal and practice assets and minimizing unnecessary tax liabilities are essential if you own real estate.
Real estate is a common investment among neurologists and neurosurgeons. However, very few have implemented the proper legal structures to get the most out of this investment. As a result, many become exposed to unnecessary lawsuit risks and pay far too much in unnecessary taxes on their real estate investments. In this article, we will show you how to own real estate so that you can protect yourself from real estate-related lawsuits. Perhaps most importantly, the proper structure could more than pay for itself through the tax savings you may realize.
The types of real estate we are referring to include rental residential or commercial properties, the practice building, or even raw land. The merits of real estate as an asset class are beyond the scope of this article, but the structure to most efficiently benefit from all of these holdings is universal.
As all doctors learn in medical school, “first, do no harm.” The same concept is true in real estate investing. The last thing you want to do is invest in an asset that generates a lawsuit that threatens all of your other wealth. Each year, millions of lawsuits are filed against the owners of real estate throughout the US. They are brought by lenders, tenants, guests, lessees, and even trespassers.
Rob the Real Estate Owner is Victimized
Let’s look at an example of a real estate lawsuit risk.
Rob owns a number of apartment buildings. He owns some in his own name and some in his wife’s name. The total value of the real estate is $4,000,000 and there is about $2,000,000 of debt on the properties. The rental income more than covers the debt service and Rob and his wife make a nice little profit every month. Rob also has a beautiful home worth approximately $1,500,000 with a mortgage of about $500,000.
After an unfortunate event at one of the properties, Rob was named in the lawsuit. Though Rob wasn’t even on the property at the time of the event, Rob still ultimately lost a judgment for $3,000,000. His liability insurance covered $1,000,000 of the loss, but he had to come up with $2,000,000 himself.
This left Rob with a dilemma: Sell all of his real estate properties as part of a fire sale and mortgage his house for the remainder of the settlement, or sell his house and further mortgage his real estate at relatively unattractive loan rates. In either case, Rob was very unhappy about the consequences, since both options result in a loss of the equity he had built over the last 20 years. In the end, Rob lost his rental properties and his home. Though he didn’t lose his ability to spot a good real estate opportunity, Rob was very uncomfortable going back into real estate after this terrible experience.
What Could Rob Have Done Differently?
If Rob had gotten the right advice, he could have done a few things to protect himself. Here are a few options worth considering:
Review Property and Casualty (P&C) Insurance. In this case, Rob did not have adequate insurance protection. Had he had the right coverages and limits—either through a “slip and fall” type policy, landlord insurance, business umbrella or other coverages—his personal liability might have been severely reduced… if he had any at all. Also, such coverages can be extremely inexpensive, given their high coverage limits. This is one reason we make a P&C insurance review part of every asset protection planning engagement.
Separate Properties into LLCs. A limited liability company (LLC) is a legal entity that affords both inside-out and outside-in protection. In other words, if you had one LLC for each piece of property, a lawsuit arising from one property could only threaten the equity in the property inside that LLC. The judgment would not extend to the assets in other LLCs. Further, if Rob had been sued personally for an accident, for malpractice (if he were a doctor), or for any other personal claim, the LLC would provide a high level of protection from that lawsuit, even though Rob and his family own all the shares of the LLC. This is a very popular strategy for real estate owners in the US.
Separate LLCs with Management Company. To take the above strategy to the next level, many savvy real estate owners use a management company to manage all of the various LLCs that own properties. This technique can provide significant tax and retirement advantages, as the management company can be structured as a different type of tax entity from the LLCs. This allows the owner to get the “best of all worlds” in terms of the taxation of the entities involved. One benefit the management company can provide the doctor investor is to sponsor qualified or non-qualified retirement plans. These plans can often be layered on top of existing retirement plans at the practice level, may not require contributions for practice employees, can reduce the taxes on real estate generated income, and can ultimately increase retirement income for the owners.
Captive Insurance Company (CIC). A highly successful real estate developer or owner could create a captive insurance company to insure the properties from various risks. This strategy allows the business to ultimately create a multi-million dollar tax-efficient reserve fund to cover future losses. The same CIC can be used to protect the medical practice from various risks of employee lawsuits, HIPAA and Medicare audits, and other significant risks. A key fact about the CIC is that it can be structured for a superior level of protection as well—against risks like the lawsuit that Rob endured.
If you now own significant real estate or plan to in the future, you will want to maximize the protection of your valuable personal and practice assets (not just the real estate) and minimize unnecessary tax liabilities. n
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David B. Mandell, JD, MBA, is an attorney and author of ten books for doctors, including For Doctors Only: A Guide to Working Less & Building More, as well a number of state books. He is a principal of the financial consulting firm OJM Group www.ojmgroup.com, where Carole C. Foos, CPA is a principal and lead tax consultant. They can be reached at 877-656-4362 or firstname.lastname@example.org
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.