Can Rental Property Create A Planning Problem
Owning rental property can be a great way to build wealth, but rental property creates a planning problem that your home, checking account, and investment accounts usually don’t. You aren’t just owning an asset. You’re also operating a business, dealing with tenants, maintaining property, collecting rent, signing contracts, and creating situations where someone could potentially make a claim against you.
That means there are two very different planning questions. The first is what happens to the rental property if you become incapacitated or pass on. The second is what happens if something goes wrong while you own and operate the property and someone files a lawsuit. A revocable living trust can help with the first problem, but doesn’t solve the second.
If you own rental property and already have a revocable living trust, here are five things you should know.
1. Your Real Estate Should Be Connected to Your Trust One Way or Another
As a general estate planning rule, real estate should usually be connected to your revocable living trust one way or another. I’m using those words deliberately because that doesn’t necessarily mean every piece of real estate should have your trust listed directly on the deed.
With your personal residence, it’s often relatively straightforward to deed the property directly into your revocable living trust. If you become incapacitated, your successor trustee can manage the property. If you pass on, the property can continue to be administered under the trust instead of having to pass through probate.
Rental property can be different because there are additional liability considerations. You may ultimately decide that the best owner of the rental property isn’t you personally and not even your trust directly. It may make more sense for a limited liability company, or LLC, to own the property.
If that happens, the rental property is still connected to your trust, but it happens indirectly because your trust can own your interest in the LLC. That’s what I mean when I say your real estate should be titled in your trust “one way or another.”
Unless there are Medicaid Planning reasons otherwise, real estate should be owned directly by the trust or by a business entity that’s then owned by the trust. Either way, the goal is to prevent the property or the ownership interest from becoming an unnecessary probate asset.
2. A Revocable Living Trust Doesn’t Automatically Protect You From Rental Property Liability
This is where estate planning and liability planning have to be kept separate. A revocable living trust can be an excellent probate avoidance and incapacity planning tool, but a standard revocable living trust isn’t designed to protect your assets from your own creditors.
If you personally own a rental property and someone is injured on the property, you can potentially face personal liability arising from that ownership and operation. Moving that same rental property into your revocable living trust doesn’t make that personal liability disappear because you still control the trust and its assets.
The major estate planning improvement is that property titled in the trust will avoid probate at your death. That can make administration much easier for your family and your successor trustee, but it shouldn’t be confused with lawsuit protection.
In other words, moving rental property from your individual name into your revocable living trust can solve one problem while leaving another problem largely unchanged. You may have improved the probate situation considerably without materially changing the liability exposure associated with operating the rental property.
3. Review Your Insurance and Consider Umbrella Coverage
Before creating additional companies, partnerships, or more complicated legal structures, start with one of the simplest forms of protection available: insurance. Your rental property should have appropriate insurance coverage, and you should understand what that policy actually covers, what the exclusions are, and how much liability protection you’re buying.
You should also consider whether umbrella liability insurance makes sense. An umbrella policy can potentially provide an additional layer of liability coverage above the limits of your underlying policies. That can become extremely important when a serious claim exceeds the liability limits on the primary policy.
You should also make sure the ownership structure you’re using is properly reflected in the insurance coverage. If your revocable living trust owns the property, discuss with your insurance professional whether the trust should be listed as an additional insured or otherwise properly identified under the policy.
If an LLC owns the property, that entity should also be addressed appropriately in the insurance structure.
The same analysis should be done with umbrella coverage. You don’t want to spend time creating a trust or LLC structure and then discover after a claim occurs that the insurance policies were never updated to match the legal ownership of the property. Your estate planning attorney and insurance professional should be looking at the same ownership structure rather than working from two completely different versions of who owns what.
4. An LLC Can Add a Layer Between Your Rental Property and Your Personal Assets
For many rental property owners, the next step is creating an LLC and transferring the rental property into that LLC. The basic idea is to create a legal entity that owns and operates the rental property rather than having you conduct the rental business directly in your own individual name.
If you use an LLC, the structure should be real and consistent. The deed to the property should reflect the LLC as the owner. Rental agreements should be entered into in the name of the LLC. Rent payments should be made to the LLC. Ideally, the LLC should maintain its own bank account, records, insurance, and business documentation. The reason for doing this isn’t simply to have three letters after the name of the property owner.
The goal is to create a meaningful separation between the rental operation and your personal finances. When properly established and maintained, the LLC can potentially provide a layer of liability protection between claims arising from that rental property and your other personal assets.
That doesn’t mean an LLC is a magical shield against every possible lawsuit. Personal conduct, guarantees, improper business practices, failure to maintain the entity properly, and many other facts can affect liability. However, for a person operating rental property as a business, an LLC can be an important part of a larger liability protection strategy.
5. If an LLC Owns the Property, Your Trust Should Own the LLC Interest
This is where the estate planning side of the equation comes back into the picture. Suppose you create an LLC and transfer your rental property into that LLC. The property itself is no longer owned by you individually. The LLC owns the real estate.
But you now own something different: your ownership interest in the LLC.
If that LLC interest remains in your individual name when you pass on, you may have solved the real estate liability planning problem while accidentally creating a probate problem with the LLC ownership interest itself. Your family may then have to probate your ownership interest in the company before the successor owners can fully control the business.
That’s why the next step is often to transfer the LLC ownership interest into your revocable living trust. The LLC owns the rental property, and the trust owns your interest in the LLC. You have now created a structure where the property is separated from your personal ownership through the LLC while your ownership interest in the LLC is integrated into your estate plan through the trust. This is the clearest example of what I meant earlier by saying rental real estate should be connected to your trust “one way or another.” The trust doesn’t necessarily need to own the building directly. It may instead own the company that owns the building.
Bonus: Multiple Properties May Require Multiple Entities
If you own several rental properties, putting every property into one LLC may create another problem. If one property produces a large liability claim and all of your rental properties are sitting inside the same LLC, those other properties may also be exposed to claims against that company.
For that reason, rental property owners with multiple properties may want to consider spreading the properties among different LLCs. The idea is to avoid putting every rental asset into the same liability bucket. One LLC might own one property, another LLC might own another property, and so forth depending on the value of the properties, the cost of maintaining the entities, the amount of liability exposure, and the overall financial situation.
For larger portfolios, another structure worth discussing is a Family Limited Partnership. A Family Limited Partnership may serve as an ownership and management structure above multiple LLCs, with the partnership owning interests in the individual property-owning companies. The general partnership and limited partnership interests then need to be coordinated carefully with the revocable living trust so the estate planning and asset ownership structure continue to work together.
I discussed Family Limited Partnerships in more detail in a previous video, which you can watch here: https://youtu.be/uTCnGaGpVxM?si=0JRZafFVKAZkhIbm
The larger point is that estate planning and liability planning shouldn’t be treated as two completely separate projects. Your trust, LLCs, insurance policies, leases, bank accounts, and any partnership interests should all reflect the same overall plan.
The Bottom Line
The mistake is thinking there is one universal answer to the question, “Should I put my rental property into my revocable living trust?” Sometimes the answer is that the trust should own the property directly. In other situations, the better structure may be for an LLC to own the property while the revocable living trust owns the LLC interest.
The important thing is that rental property should always be incorporated into your estate plan one way or another. At the same time, you should recognize that probate avoidance and liability protection are two different goals. Your revocable living trust can address probate and incapacity planning, while insurance, umbrella coverage, LLCs, and potentially more advanced business structures can address liability exposure.
When those pieces are coordinated correctly, you aren’t simply asking, “Whose name is on the deed?” You’re building a structure designed to manage the property while you’re alive, protect against unnecessary exposure, provide continuity if you become incapacitated, and avoid unnecessary probate when you pass on.
For more information about how revocable living trusts work and how to properly coordinate assets with your estate plan, visit FreeTrustCourse.com.