Liability Protection: Considerations Regarding The Transfer of Rental Property To a Legal Entity
Q: I recently purchased a rental property and title is held in my individual name. I put 20% of the purchase price down and financed the remaining 80% of the purchase with a loan secured by a deed of trust on the property. I am concerned about my liability exposure relating to the rental property and am considering transferring the legal title to the property to a limited liability company. What should I consider when making such a transfer?
A. The foregoing scenario is one that I am frequently asked about. Individuals who own one or more rental properties are often concerned about liability exposure relating to their ownership of the rental property and would like to protect their other personal assets (e.g. equity in their principal residence, bank accounts, stock accounts, and other assets) from such liability. The transfer of a rental property to a limited liability company (“LLC”), when properly executed, can achieve a measure of the desired liability protection. Below is a list of 5 general considerations to be mindful of when contemplating and/or performing a transfer of legal title for rental property from one’s individual name to an LLC:
1) Limited Liability Company. The most common type of legal entity used for holding ownership of a rental property is an LLC. Once the LLC becomes the legal owner of the property, it becomes liable for the rental activities relating to the property, thereby protecting the assets of the LLC’s owners from liabilities relating to the rental activities. The liability protection provided by an LLC is not perfect, and instances may arise where the LLC’s owners remain liable for the LLC’s activities. Prior to transferring your rental property, you will need to establish your LLC and the ownership structure of the LLC. You should speak with legal counsel to understand the benefits and limitations of transferring your property to an LLC, and how best to establish and operate the LLC once the property has been transferred.
2) Property Insurance. Prior to commencing a transfer of your rental property to an LLC, you should evaluate and discuss the current scope and structure of your insurance coverage for the property. Questions to focus on are: (1) do you currently have sufficient insurance coverage; (2) does your insurance policy cover your rental activities; (3) can you obtain an umbrella insurance policy to provide you with additional coverage; and (4) if you transfer title to an LLC will your insurance rates go up? In many instances, your insurance coverage will be the first line of defense for liability issues that arise regarding rental activities with the property. Accordingly, prior to commencing a transfer of title for the property you should understand the scope of your insurance coverage and how it may change if the LLC becomes the legal owner of the rental property.
3) Deed of Trust Issues. In a majority of purchase transactions, buyers will finance a portion of the property purchase with a loan from a lending institution. In Colorado, the borrower’s repayment obligations are secured by a deed of trust which is recorded against the property. Most deeds of trust contain some type of “due on sale” clause which provides that when a sale, or transfer of title, of the property occurs, then all amounts secured by the deed of trust become immediately due. An example such a clause is below:
- “The following events shall be referred to herein as a “Transfer”: (i) a transfer or conveyance of title (or any portion thereof, legal or equitable) of the Property (or any part thereof or interest therein); (ii) the execution of a contract or agreement creating a right to title (or any portion thereof, legal or equitable) in the Property (or any part thereof or interest therein); (iii) or an agreement granting a possessory right in the Property (or any portion thereof), in excess of 3 years; (iv) a sale or transfer of, or the execution of a contract or agreement creating a right to acquire or receive, more than fifty percent (50%) of the controlling interest or more than fifty percent (50%) of the beneficial interest in Borrower and (v) the reorganization, liquidation or dissolution of Borrower. . . All sums secured by this Deed of Trust shall become immediately due and payable (Acceleration).”
To the extent your property is encumbered by a deed of trust, you should understand if your contemplated transfer could potentially trigger the due on sales clause, and the associated risks with such a transfer.
4) The Deed. The instrument that is used to transfer the legal title from an individual to an LLC is called a deed. When transferring title to property in Colorado, there are three primary types of deeds that may be used to complete the transfer: (1) a warranty deed; (2) a special warranty deed; or (3) a quit claim deed. Each of the foregoing deeds have different warranties and implications when used. As part of your transfer you will need to determine the appropriate deed to use. A commonly used deed is the “special warranty deed”, but ultimately the appropriate deed will depend upon the circumstances surrounding your transfer. Legal counsel can assist you with the selection, preparation, and recordation of the deed to complete the transfer of the property.
5) Title Insurance Endorsement. A commonly overlooked component to completing the transfer of rental property from an individual to an LLC is a title insurance endorsement. Title insurance is the insurance that you obtained when you purchased the property to insure your title to the property. As part of your transfer to an LLC, you will want to confirm that the LLC (as the new owner of the property) will be covered under your title insurance policy. This can be confirmed by reviewing your policy and, if necessary, working with your title company to obtain the appropriate endorsement. If you are thinking of establishing an LLC and transferring title of your rental property to the LLC, you should consult with a real estate attorney who is knowledgeable in this area. This article is not intended to be exhaustive and only outlines general considerations to think about when contemplating a transfer of your rental property to an LLC. Please contact me to discuss the specifics of your situation.