Don’t Make Critical Mistakes With Short-Term Rental LLCs: Learn the RIGHT Way to Protect Your Properties!
Are you making critical mistakes with short-term rental LLCs? Let’s learn how to protect your properties right now.
Hi, I’m Jeff Hampton with Str law guys. Welcome to our YouTube channel. Today, I’m going to talk to you a little bit about LLCs, real estate LLC’s specifically for short-term rentals. Are you using them the right way? Are they actually protecting you? By the way, if you wait around till the end of this video, I’ll also provide you with a free eBook: “Five Strategies to Protect Your Short-Term Rentals and Give You Peace of Mind.”
Okay, so Point number one, we have to even ask the question, why do we need an LLC anyway? Some people don’t think they need an LLC; they think they have insurance. I think they have plenty of protection. Well, let’s just talk about this. I’m a big believer in layered asset protection Strategies, but before we discuss why an LLC is important to protect your real estate, let’s first examine a layer that you really need. And I’m a big believer in layered asset protection. This is a layer you absolutely need when you’re looking to invest in a short-term rental. And that layer is, you need to make sure you have good, whether it’s long-term rental or short-term rental, you need to have good insurance. And it’s critical when you look at this, when you’re talking about a short-term rental. And I have a different video series covering specifically short-term rental insurance. Okay, but this is really critical. You need to make sure you have good commercial insurance coverage for your short-term rental because if you don’t, a lot of times people come to me with second home policies. They tell me, “Hey, look, this should cover it. I’m not seeing any concerns.” Well, you know your Insurance, your insurance is actually what, 70-80 pages long if you actually look at what you have. And if you go through the entire insurance policy, you’re going to find, and most of the time, there’s a section, always a section at the very bottom that talks about exclusions. And in that exclusion section, it’s really important to make sure that you don’t have a second home renters’ policy or a second home residential policy because the reason why that is, you have to understand, short-term rentals are not only inherently high-risk activities, but they are always labeled commercial activity.
So, look in your residential policy or your commercial policy, whichever that’s labeled, go in there and look at the very bottom and look at the exclusion section. Do you see something called commercial exclusions? Do you see something called business activity exclusions? If you see anything specific along those lines, I can promise you right now, every single time, an insurance company is going to be labeling a short-term rental as commercial or business activity. If it’s in there, you’re excluded.
Also, be careful. Very often, they’ll only give you $250,000-$300,000 worth of insurance protection. You need to try, as far as premises liability goes, you need to have at least a million dollars coverage, generally speaking. And you need to make sure you have enough dwelling coverage to replace the entire property in case of fire or some sort of loss. So, it’s a really in-depth analysis you need to do to make sure you have good insurance because that is layer number one anytime, you’re talking about protecting your short-term rental.
Now, why do we need an LLC? Let’s get into that.
Back to what we were talking about originally when you look at an LLC, it’s really important. I’m going to give you a true story. Somebody who essentially, somebody that came to us and decided, “Look, I don’t really think I need any sort of short-term rental protection. I don’t need an LLC at all.” Well, they end up getting into a pretty serious situation at their short-term rental. And as a result of someone being injured there, they get sued.
Well, after their suit, it appeared, here’s the problem. They had multiple short-term rentals. They look like a big target, right? Why were they a big target? Because they had multiple short-term rentals. They were all in their personal name. Personal injury attorneys start doing pretty serious research as to what type of assets this person has, what’s their net worth look like. And now they look like a pretty juicy target for a personal injury attorney coming at them for a premises liability lawsuit.
So, this is really important. Your goal is to not be an easy target. Truly, your goal is to own nothing but control everything, which is really the entire clarion call for all asset protection. That’s really what you’re trying to go after anytime you’re trying to set up asset protection. Now, you can structure your assets in a manner where the attorney will have a very difficult time finding it or it’ll be completely in total pro, totally private so that you become a much smaller target in the event of a lawsuit.
Okay, now let us talk about this. The first thing I want to talk about is base layer LLCs. And what do I mean by that? Well, LLCs as a general rule, when you are putting property, particularly real estate in them, they are much better to use than setting up a corporation as an entity.
Corporations create a higher tax burden as a general rule. If you move around assets in a corporation, that is often labeled a taxable event by the IRS. You end up having to pay way more taxes than is necessary. So, LLCs provide much more flexibility. Many times, you can move those assets around, you can take distributions, and really you don’t end up talking about multiple taxable events.
Now, LLCs provide, generally speaking, what is the purpose? It is a limited liability company. They help you provide a separation from a business asset and a personal asset. You want to keep business assets separate from personal assets so that in the event of a lawsuit, you do not want a business lawsuit coming up taking your personal assets.
So, what if a short-term rental, what if you have a short-term rental and you place it in an LLC? What if someone slips and falls on your property during their stay and they end up bringing a lawsuit against you? What happens? Well, here is the worst-case scenario. Let us say they were to sue you and bring a lawsuit against you, end up having a judgment against you, lose in court. This judgment against you, if it’s in your personal name, guess what they can do? That judgment can be placed on every one of your personal assets, other than your exempt assets. I’ll have a separate video series about what exempt assets are, but essentially, as a short example, if you live in Florida, Texas, you have an unlimited homestead exemption, and there are some exemptions under federal law for your 401(k)s, IRAs, different things like that for your retirement plans.
Okay, so the problem is what they’re going to do outside of those exempt assets if it’s in your personal. They can actually take that judgment and allow them to get access to your personal funds in order to exercise that judgment. Now, what if it’s in an LLC? And when I say exercise that judgment, I mean force a sale. They could force you to sell your property in order to pay it off. But what if you place those assets into an LLC rather than in your personal name?
Well, here, they will receive what’s called a charging order against you, an attempt to force a sale in order to gain access to the equity that might be in that property. Can they do this? Well, here’s the reality. It depends on what state you set up your LLC. Now, some states like California will allow forced sales to take place. So, if you set up a California LLC, you’re really not getting quite the protection you might think you are, and many times they can force a sale and you can lose the equity in your assets.
Other states like Wyoming, Nevada, Texas, there are some state laws that are very specific that provide this will not allow this to happen, and this is known as charging order protection. So, let’s talk about this. What is a charging order? It means if you try to sell your assets from your LLC or distribute cash from your LLC to yourself, you’re required to pay the creditor first. Essentially, charging order protection means they may not be able to force a sale. However, if you do try to pay out on it, then you can end up having to pay the creditor.
So many times, this is something that personal injury attorneys are looking at. They’re looking to see; can I get a forced sale? If I can force a sale, this is a juicier target. If I can’t force a sale, and all this person can do is sit back…
And continue to collect. And if they don’t pay themselves and I don’t get paid anything for my client, then it’s not quite as attractive of a lawsuit target. Okay, so that is known as charging order protection. How is it protected? Well, a personal injury lawyer knows if they set these up, if someone else sets up these LLCs the right way, they’re not really going to get paid. And so, what does it do? It actually helps encourage an insurance settlement in many ways.
Now, the next question is, where should we set up an LLC? So, when you’re looking at where to set up the LLC, there’s so much confusion on this issue. People talk about these things all the time, and they say, “Well, I’ve heard that Wyoming and Nevada have favorable laws for business, so I’m going to go set up my Colorado property. I’m going to go set up a Wyoming LLC or a Nevada LLC.” Now, does that make sense? I mean, we’ve heard that Wyoming has great laws, right? Why don’t I just put my Colorado property into a Wyoming LLC?
Unfortunately, it does not work that way. You’re not going to get the protection you think you need. For example, if you have a Colorado property that you decide to set up a Wyoming LLC, the first thing you have to ask yourself is, “Isn’t the property located in Colorado?” Well, of course it is. It’s not located in Wyoming. So, what do you think is going to happen if there’s a lawsuit? If there’s a lawsuit, Colorado law is going to control. A Colorado judge is not going to care one bit about what Wyoming law says. They are only going to apply Colorado law.
So, you say, “But I don’t understand. If I get hauled before a Colorado court, can I stand in front of the judge and say, ‘Judge, look, Wyoming law is beneficial. That’s why I set it up this way?'” The judge is not going to care. And in fact, home state law Rules always apply when it comes to being brought jurisdictionally into a particular courtroom. So, wherever your property is, that state is what’s going to control the law in that situation. Now, for example, if you set up a Wyoming LLC for a Colorado property, here’s another problem you can have. What if you set that up and maybe it’s a long-term rental and you want to evict them? In this situation, you will not be allowed to do so many times in court because you are not registered to do business in Colorado. Because you have a Wyoming LLC, now sometimes people try to get around that by saying, “Well, that’s fine. I’ll set up a foreign agent to do business for me.” So, I can set up a Wyoming LLC and set up a foreign agent. Here’s the problem: when you do that, you lose your privacy. You lose the benefit of why you would have set up a Wyoming LLC to begin with. So, the moment you do that when a Wyoming LLC is not doing business in Colorado, this doesn’t work this way. You lose the protection you think you’re getting when you set up that foreign agent.
So, it’s really important. By the way, you can also end up paying double filing fees, registered agent fees, and other expenses all for nothing. You’ve basically wasted your money. You’re not getting any extra protection. So, what state do we set up the LLC in? In this example, it would be Colorado. As a general rule, it makes sense to set up the LLC in the state where the property resides. Why? Because you cannot chase charging order protection. This is exactly what I talked about before. You cannot go and borrow another state’s beneficial laws and bring them into your state and claim that they’re going to protect you. It does not work that way in practice, okay? But what if the state we are looking at does not provide decent protection? What if you’re in many of these states like New York, maybe from California? Some of these states don’t have very strong LLC laws. What if you’re not getting a lot of protection? Well, as a result of that, you need a holding company strategy. In fact, most states don’t have very strong protection when it comes to their LLC laws. So, we use a holding company strategy in order to help strengthen that relationship so that you will have more protection.
So, what is a holding company? A holding company structure, what is that? Well, when you use a holding company, a holding company acts as a buffer between your state LLC and personal assets to secure asset protection. So, what I mean here is we would use, let’s say, a state LLC. You’re talking about Colorado, right? You would use a Colorado LLC for your Breckenridge property hypothetically. And now, we would use either two different types of possible holding company strategies. You could use a Wyoming LLC holding company, or you could use an Arizona limited partnership holding company. Essentially, these holding companies allow you to create this barrier where you’re now able to have a Wyoming LLC or an Arizona limited partnership owning as a single member your LLC for your property. And now, you do get the benefit of that state’s laws for your holding company.
So, how do we set this up? It is critical that your holding company owns all of those base layer LLCs. So, if you’ve got three properties, your holding company has to make sure and own each and every one of those. And each of those base layer LLCs for each property needs to be a single-member LLC that is owned by your holding company. And so, the reason why we do that is that any LLC can be set up in one of two ways: it can be set up as member-owned or manager-owned. It is critical that all of your base layer properties, let’s say your Colorado property, are put in their own LLC and are member-owned rather than manager-owned when you use a holding company strategy. The reason why is that if it’s manager-owned, your name will be available for other people to see, and you will lose the privacy that you would like to obtain when you set up that holding company strategy.
Now, how should you have your LLCs taxed? I’m jumping all over the place here. There’s all kinds of information that you need to know about LLCs and how many people make so many mistakes when they set them up. Well, first of all, there are a couple of ways to do this. You can always set up an LLC as a disregarded entity, number one. You can also set up an LLC to be taxed as a partnership, number two. Or you can have it set up to be taxed as an S Corp or a C Corp. You can have it taxed as a corporation. Now, this is confusing, and many people make the mistake of setting up an LLC on their own, and they miss all of this. They don’t even set it up the correct way, and it can create serious confusion if it’s not done right at the front end.
Now, let’s talk about option number one, a disregarded entity. This essentially means that you don’t have to file a tax return for that LLC, and that disregarded status flows through to your personal tax return. Now, what’s the negative? The biggest negative is that when you set it up this way, if you do not use that LLC in a holding company, let’s say you set up that Colorado LLC, if it’s a disregarded entity and you do not use it A holding company above it. Now, that disregarded entity is not going to receive much asset protection at all. There’s kind of an old saying that if the IRS disregards it, the courts are going to disregard it. So having a single-member LLC as a disregarded entity provides you with very little asset protection strategy without a holding company strategy to go along with it.
Now, the good thing about it is it’s good for tax purposes. Accountants love to set up disregarded entity LLCs, and I can understand that. But you’re getting virtually no protection from an asset protection perspective.
Now, let’s talk about partnership status here. It’s very simple. Any LLC that’s not a single member, if it’s a multi-member LLC, it’s a partnership. That’s the de facto setup here. So, if you’ve got a couple of people in this partnership, two people within that, then that particular LLC will be taxed as a partnership. You will have to file a K-1 tax filing with the government, and there’ll be that expense that you have to pay your accountant.
Now, I want you to be aware, though, one of the biggest mistakes I see happen is that people set up their own LLC and they do not choose a tax status that matches up with their operating agreement. If you do this, you’re setting yourself up for a mess. So, make sure that you’re matching up with your operating agreement whenever you set up your tax status.
Now, let’s talk about a holding company strategy setup. When you are using a holding company strategy, I usually recommend that a client set up their property as a single-member LLC in the state that the property is located and then designate it as a disregarded entity. By doing this, we allow the flow-through Of those taxes to move up through the holding company and then ultimately up to that person’s individual return. Why? Because if you’re setting up LLCs for short-term rentals, you want to not only get some asset protection, but you want to maintain the integrity of your tax benefits: passive losses, passive income, cost segregation studies, bonus depreciation. You want to be able to maintain all of that.
So, the holding company can then be set up as a partnership. And you want to set it up that way. When you set up the holding company as a partnership, you’re receiving that asset protection portion. Now, all of your properties below are set up as single-member LLCs. It simplifies your tax filings, it helps eliminate some of those K-1 tax filings below for each individual property, but yet you still receive asset protection.
Now, here’s the real question people ask: How many LLCs do I need? There’s a lot of people that have a lack of understanding when it comes to this. They get confused. They say, “Well, I’ve got five short-term rentals. Can I put all those short-term rentals into one LLC? I mean, why does it matter? At least I’m being protected.” Be very careful. It does matter. If you choose to put all of your five properties into one LLC, you are creating an unnecessary risk. What happens if one of your short-term rentals gets sued? Now, all five of them are subject to a potential lawsuit. Now, you could lose all five of them in a lawsuit.
So, it’s very important, generally speaking, it’s advisable to place a single property into its own single LLC. By placing each property into its own LLC, you are segregating them and diversifying your assets.
Risk. You’re making sure if your Colorado property gets sued, that you’re separating it from your Tennessee property, your Texas property, and your California property. That way, they’re not all brought into the same lawsuit together. Because if you don’t separate your LLCs, you could lose everything if you’re attacked. So, I think it kind of goes without saying, I think it’s pretty simple here: put them all in their own individual LLCs. Okay, that’s what makes sense. Each LLC for each property.
Now, what rules do I need to follow for an LLC? This is really important. If you only use LLCs and you don’t use a holding company strategy, this is critical. Every state has certain rules you must follow in order to maintain compliance and keep your charter for an LLC. See, one of the things you have to do is you need to set up, really important, after you set up an LLC, you need to set up each LLC with its own EIN number. You need to set up your own individual bank account for each, and you need to make sure that the money from Airbnb and VRBO or your direct booking sites flows through directly to those particular accounts and segregate the funds between properties. Because here’s what will happen if you co-mingle funds. It’s one of the quickest ways for a personal injury attorney to attack that LLC and do what’s called piercing the veil.
Piercing the veil essentially means attacking the LLC structure, allowing the entire entity to be pulled apart and become vulnerable to gaining access to the assets that are inside of it. So, a couple of things that you can do on that. Number one do not co-mingle funds. Number two, have an annual meeting and really keep your annual meeting minutes. You need to keep those corporate formalities That are required by your state in order to maintain and retain your LLC, or you may not have the protection you think you do.
How can you move properties into an LLC? Okay, now finally we’re almost done here. How do I move properties into an LLC? Well, there are really two ways to do it. One, you can do what they call a quitclaim deed, the property from your personal name into an LLC. There are a couple of risks with this. Some of the risks that you will run into is there’s something called the due-on-sale clause for your mortgage company. Some people do get concerned about this because if you’re not careful, you can end up having your mortgage company coming to you, saying that you breached your contract, and as a result of that, they could call the note due. There is a way around that. We’ll talk about that in a minute. There’s also something called transfer taxes that can take place in certain states. There’s the “funds tax” that can take place in Tennessee. Every state has its own nuances on that. And one of the ways to get around that is you can use something called a land trust. And I want to encourage you to watch some of my other videos. I’m going to have an additional video series coming out about the land trust, specifically for short-term rental properties. And there’s going to be some videos coming out about the “funds tax” in Tennessee if you happen to have properties in the Smokies in the Tennessee area. We’ll cover some of that.
Okay, so the land trust helps avoid these risks, and it actually takes your name off the transaction. And watch the videos that I have coming up about those issues, all right? So, we’re at 20 minutes. I’m cutting this out right here. Summary, what are some of the things that we’ve Covered so far, number one, why we covered why we need an LLC, the importance of what an LLC does for you. We discussed the importance of a holding company strategy when you’re considering putting your short-term rentals in an LLC, and you must be careful the tax election that you make for each one of your LLCs as you go through it. We also talked about the rules you must follow when you set up an LLC and to maintain that LLC so that you receive the protection that you believe you have, and you must be careful not to move a property from your personal name into an LLC unless it’s done the right way, so that you avoid the taxes and avoid a mortgage mess or meltdown on a due-on-sale clause. Okay, we covered a lot. I tried to give you a lot here in a brief period of time. I also promised you a free eBook, “Five Strategies to Protect Your Short-Term Rentals and Give You Peace of Mind.” If you click down into the link below into the YouTube description, I’ll be happy to send that over to you. I want to thank you for joining us here today. I’m Jeff Hampton. Thank you for joining our Str Law Guys YouTube channel. I look forward to seeing you on our next video.
