It's hard to build and manage a rental property business. I know this for a fact – I own nine properties and self-manage them while holding down a full-time job. If you are a landlord too, I am sure you can relate.
So it only makes sense to preserve what you have built with adequate liability protection.
A tenant or guest may be injured (or worse) in one of your properties and may sue you. If they win big, it can unravel everything you have worked so hard to create (including personal assets that have nothing to do with your rental property business).
Fortunately, there are some very effective landlord liability protections you can put in place. LLCs and umbrella policies are the two most common forms of liability protection used by landlords.
Now, real estate investors have been debating the merits of these two strategies for a long time. Each has its pros and cons (which we will get into) and what works for you may not work for someone else, but here's my overall take on which one is better for landlord liability protection:
A properly structured and maintained LLC offers better liability protection for a landlord because you can fully insulate assets outside the LLC without any coverage limits. But an umbrella policy can still offer robust protection to a landlord without the administrative hassles associated with LLCs.
This article will cover the basics around LLCs and umbrella policies, examine the pros and cons of each type of protection, and discuss factors that might help you determine which option is best for you. If you want to skip ahead to my final analysis, click here.
Let's dive into it!
The information contained in this post is for informational purposes only. It is not a recommendation to buy or invest, and it is not financial, investment, legal, or tax advice. You should seek the advice of a qualified professional before making any investment or other decisions relating to the topics covered by this article.
What is Umbrella Insurance?
Umbrella insurance is extra insurance coverage above the coverage you receive through other insurance policies like auto, homeowners, and landlord insurance (in the case of rental property owners).
So you should first obtain landlord insurance for each property (in many cases, your lenders may require this anyway). Then you can buy umbrella insurance that will cover claims that are in excess of the liability limits under your landlord insurance.
Here’s a simple example of how it works.
You own a rental property. You buy landlord insurance for that property that includes liability coverage up to $300,000. The tenant in that property is injured on the premises and sues you for damages. She prevails and the judge awards her $500,000.
Your landlord insurance only covers the first $300,000. If you have an umbrella policy for $1 million, then the remaining $200,000 could be picked up through the umbrella coverage.
What Is Not Covered By Umbrella Insurance?
An umbrella policy generally does not provide coverage for:
- your injuries or damage to your personal property
- a criminal or intentional action causing damage to someone else
- liability you assume under a contract
How Much Does Umbrella Insurance Cost?
According to Kiplinger, umbrella insurance costs around $150 to $350 a year for the first $1 million of coverage and about $100 for each additional million dollars of coverage above that.
You should definitely shop around.
I would highlight that not all insurance companies offer this type of coverage to landlords. If they do, some of them will limit the number of rental properties covered by the umbrella policy or will require that you use their company for the underlying landlord insurance.
Should Landlords Have Umbrella Insurance?
A landlord should have umbrella insurance if they believe claims arising from their rental property business (or even their personal activities) may expose them to liability in excess of their existing insurance coverages.
Of course, if a landlord has other forms of liability protection, such as LLCs (which we will cover later), umbrella insurance may be somewhat redundant (or at least not as important).
We will cover later on what situations would be better suited for using an umbrella policy over an LLC and vice versa.
How Much Liability Insurance Does a Landlord Need?
As a general rule, a landlord should have enough liability insurance to cover reasonably anticipated claims.
Part of that calculation is looking at the riskiness of your rental portfolio.
If you own a single rental property with a single tenant living in it, your potential liability exposure is much less than if you own an apartment building with 100 tenants. If the rental burns down and causes the demise of a single tenant and you are deemed at fault, your exposure will be meaningful.
But if the same thing happens to your apartment building with those 100 tenants, your exposure is exponentially greater.
Of course, you also should take into account how much you stand to lose if a big claim is brought against you. If you don’t own much to begin with, it may not be worth it to spend a ton of money to get a huge liability policy in place.
Pros and Cons of Umbrella Insurance for Landlords
Pros of Umbrella Insurance for Landlords
Cons of Umbrella Insurance for Landlords
Easy and simple to set up and maintain
Coverage limit increases may be needed
You can become a litigation target
Meaningful coverage available
Must pay deductible
Finance properties in your name
Loss of coverage possible
Pros of Umbrella Insurance for Landlords
Umbrella Policies Are Easy and Simple
The biggest pros of using an umbrella policy are its ease and simplicity. You just buy one and you immediately reap the benefit of meaningful liability protection. You can get started obtaining millions of dollars of coverage with a simple click or call.
It doesn’t get much easier or simpler than that.
And unlike LLCs, there are no ongoing maintenance obligations that you need to observe to keep your protection in place.
Umbrella Policies Are Affordable
Umbrella policies are also affordable – as we covered already, you can expect to pay between $150 to $350 per year for $1 million in coverage. In my view, that’s a bargain.
Umbrella Policies Provide Meaningful Coverage
You can get meaningful coverage through umbrella policies. There are companies offering well in excess of $5 million (or even $10 million) in umbrella coverage. You also get coverage for other areas of your life that are not related to your landlording activities.
For example, umbrella policies can provide extra protection for liability that exceeds your auto and home owners policy limits, and can protect you against claims like false arrest, libel, and slander.
You Can Finance Rental Properties in Your Name
Another big benefit of using umbrella insurance instead of LLCs is that you can finance rental properties in your name. This comes with a host of benefits, the most important being that you can actually obtain financing.
Many lenders won’t offer financing to LLCs who want to purchase rental properties.
In fact, if you want a conforming loan under Fannie Mae/Freddie Mac standards (which offers favorable rates and other financing terms), the financing must be made to an individual.
You can certainly search out lenders willing to do a non-conforming loan or find a direct lender that will offer financing to LLCs, but the terms will probably not be as attractive.
You may be thinking that you could get around the financing issue by transferring ownership of the property from your name to the name of the LLC after you buy it. But that comes with its own risks too.
There is usually a due-on-sale clause in most loan agreements that will trigger if you do this. That means that the lender could make the entire amount of the loan due and payable when the transfer happens.
Now, the lender may never find out about this. Or they may be fine with the transfer. But you are rolling the dice if you do this without getting the lender’s approval first.
Cons of Umbrella Insurance for Landlords
Coverage Limit Increases
One of the primary drawbacks of using an umbrella policy as a landlord is that you may need to raise your coverage limits on your underlying landlord policies (and possibly your auto and homeowner's policies too).
So if your current landlord insurance policy has only $100,000 in liability protection, your umbrella insurance provider may insist on raising that to $300,000 or even $500,000 before they will issue umbrella coverage.
Obviously, this will increase your landlord policy premiums.
You Can Become a Target
You also may become a more appealing target to lawyers who take on personal injury cases if they discover that you have a large umbrella policy.
After all, most personal injury lawyers take cases on a continency basis (i.e., they get paid out of the proceeds of a judgment or settlement). For that reason, they will be less likely likely to sue someone that they think has no money or insurance.
But if they discover that you have a large umbrella policy, you become a much more attractive target.
Of course, as with most insurance policies, you will have a deductible and will need to pay that before your umbrella coverage kicks in, but that should be pretty small when compared to the size of the claim.
Loss of Coverage
This applies to all insurance policies, but you are at the mercy of the insurance company once a claim has been paid out. If they no longer think you are a good risk, they may drop your coverage.
Ok, so that covers the pros and cons of using an umbrella policy for liability protection. Let's now turn our focus to the other popular option for landlord liability protection: LLCs.
What Is an LLC?
An LLC is a limited liability company and, as its name implies, is a legal entity that protects the personal assets of a business owner from the LLC’s liabilities.
Each state has different rules regarding LLC formation and maintenance, so you will need to follow those rules to establish and operate an LLC in that state.
How Much Does an LLC Cost?
On average, an LLC will cost you a few hundred dollars to set up. The exact costs will vary by state. You may also need to pay ongoing filing fees and related fees depending on your state. These can run as high as $800 per year in a state like California if your LLC makes less than $250,000.
Source: State of California
If you want a state-by-state breakdown of LLC fees, Nolo has a chart that provides this info.
How Does an LLC Protect Landlords?
An LLC provides the landlord with limited liability. This means that the landlord is generally not personally liable for any debts incurred by the LLC (including most business-related lawsuits).
Because the landlord is not personally liable, people who file lawsuits against the LLC can’t collect against the landlord’s personal assets (e.g., their personal residence, cars, cash, investments, etc.)
Instead, they are limited to collecting from the LLC’s assets, like the rental properties in that LLC and the LLC’s bank accounts.
Does an LLC Really Protect You?
An LLC can effectively protect assets that are held outside the LLC, but you need to make sure you are structuring and maintaining it correctly.
That's because of this legal concept called piercing the corporate veil. Piercing the corporate veil refers to a situation in which courts ignore limited liability and hold a business owner personally liable for the LLC's liabilities.
Source: Legal Information Institution
The biggest factor in whether a court will pierce the corporate veil is the existence of fraud, wrongdoing, or injustice.
This goes without saying, but don't use your LLC as a vehicle for this type of activity.
You should also be careful to treat the LLC as a separate entity and honor the corporate formalities required, such as having a solid operating agreement in place, holding annual meetings (although most states do not require this), good bookkeeping (documenting decisions of the LLC through minutes, etc.) and maintaining good financial records.
Don't forget to establish a separate business account and do not commingle your personal funds with the LLC’s funds. Pay bills out of that business account, deposit rent into that account, and make sure that the entity is adequately capitalized (i.e., make sure there is enough money in the bank account to handle your operating expenses).
Finally, you want to make sure all of your leases and contracts are in the LLC’s name.
Single-member LLCs are particularly vulnerable to piercing the corporate veil, so you need to be even more attuned to these factors if you are the sole owner of your rental business.
Pros and Cons of Using LLCs for Landlords
Pros of LLCs for Landlords
Cons of LLCs for Landlords
Unlimited asset protection
Relatively easy and cheap to set up
Tax prep costs
Less financing options
Pros of Using LLC for Landords
Unlimited Asset Protection
If structured correctly (as we just covered) an LLC can provide unlimited protection for assets held outside the LLC. Contrast that with an umbrella policy that has very clear coverage limits. If your liability exceeds your umbrella coverage limits you will need to tap into your assets to pay for such excess liability.
Let’s take an example to illustrate the point.
Let’s assume you own a rental property worth $250,000 and have landlord liability coverage of $300,000 and umbrella coverage of $1 million. So your total coverage is $1.3 million.
If your tenant files a claim against you and wins a judgment of $5 million, you will owe $3.7 million, which will need to be satisfied out of your remaining assets.
However, if you own that rental property in an LLC then the $5 million judgment would need to be satisfied from the assets in your LLC (which, in our example, is just the one rental property). Your remaining assets, whether they are valued at $100 or $100 million, will be completely protected.
LLCs Are Relatively Easy and Cheap to Set Up
You can set up an LLC through a lawyer or through the many online companies offering this service. Prices vary, but the online options can be pretty affordable. Of course, we already reviewed the costs of setting up the LLC with the state.
While in some isolated cases like California, the costs can be high, for the most part, the set-up costs for an LLC are not going to break the bank.
LLCs Afford Some Level of Anonymity
You can name your LLC in a way that does not identify you (and you should do that), so it can offer you some level of anonymity. This will be helpful when trying to protect against personal liability.
But I would not rely on this anonymity too much: a determined and competent lawyer or investigator may be able to track down your identity without much trouble.
Cons of Using an LLC for Landlords
One of the biggest drawbacks to using LLCs as a landlord is the administrative hassle associated with this approach. It can become extremely burdensome as you acquire more properties, especially if you create a separate LLC for each property.
You must maintain complete separation between yourself and each LLC (and between each of your LLCs). So you must use separate bank accounts, track expenses separately, enter into contracts and agreements separately, etc.
And, as we discussed before, if you want to preserve the liability protections afforded by an LLC, you should observe corporate formalities, which just adds to the hassle factor.
Tax Prep Costs
You must also file taxes for each LLC. That can add up to a lot of money if you have multiple LLCs. Don't underestimate this cost. Writing that tax prep check for thousands of dollar to your accountant each year can be really painful.
Fewer Financing Options
We touched on this already when we discussed the benefits of using umbrella insurance, so I won’t cover this in detail again.
Bottom line: LLCs make it harder and more expensive to obtain financing for your rentals.
When Should Landlords Use an LLC vs. an Umbrella Policy?
Ok, so we covered both liability protection strategies, including what they are, how they work, their costs, and their pros and cons. But armed with that knowledge, the question still remains. Which strategy is right for me?
I think it boils down to this. The biggest benefit of using an LLC over an Umbrella Policy is the unlimited liability protection an LLC can provide for assets held outside the LLC.
So if you are a high net worth individual then you may want to consider an LLC approach, especially if your rental portfolio is high risk (see the apartment example from before). You may also want to consider choosing an LLC over an umbrella policy if you are concerned about loss of coverage after a claim. It’s a legitimate concern and hard to mitigate.
On the other hand, if your rental portfolio is not particularly high risk (you own just a handful of single-family houses scattered across an area) and you don’t want to deal with the administrative hassle of LLCs, then an umbrella policy may be a more attractive option for you.
Of course, no one knows the exact scope of risk involved in any rental business, so you should consult with qualified legal and financial professionals before making any decisions relating to this topic.
Hope this has been helpful and good luck on your landlording journey.
If you want to see other helpful tips and strategies for landlords, check out my articles on how to automate rental property management and how to reduce vacancies. In those articles, I share my real life tips on how to dramatically improve your landlording experience.