Asset Protection for Short Term Rentals: The Role of LLCs and Insurance

While an LLC can certainly be a valuable asset protection tool, it’s important to understand that it has its limits. In this blog post, we’ll delve into the role of LLCs in asset protection, how they work, and what else you can do to ensure that your assets are fully protected.

First, let’s define what an LLC is and how it works. An LLC is a type of legal entity that allows business owners to separate their personal assets from their business assets. This means that if your business is sued or incurs debt, your personal assets (such as your home, car, and savings account) are generally safe from being seized to pay those debts. In other words, the most any creditor can collect is the total assets of the LLC.

So, let’s say you buy a short term rental property and put it on Airbnb. Conventional wisdom says that you should put it in an LLC to protect your assets. But what happens if one of your guests slips and falls due to a loose stair banister, breaks both arms, and hires a personal injury attorney? Let’s assume that the total medical bills and lost wages come to $500,000, and the guest also claims $1 million in pain/suffering/emotional distress damages for a total claim of $1.5 million.

If you have appropriate short term rental specific insurance, like Proper Insurance, the insurance company may pay out the policy’s maximum limit of $1 million (assuming you’ve purchased a bone-fide short term rental homeowner’s insurance policy). However, the insurance company will say that you’re on your own for the remaining $500,000. On the other hand, if you’re using a primary residence homeowners insurance policy without a short term rental endorsement, the insurance company may pay out nothing at all and you’ll be on the hook for the full $1.5 million claim.

Now, let’s say that the guest’s lawyer sues both you and your LLC, and ultimately gets a judgment for $1.5 million. However, you may be able to convince the court that only the LLC is liable because the LLC owned and operated the property. In this case, the LLC’s only assets are the property and any cash in the LLC’s bank account. The LLC would then have to sell the property to pay the judgment.

This is where an LLC can be helpful: it keeps that excess liability of $1 million from affecting any assets held outside the LLC. In this scenario, anything in the LLC bank account would go to the tenant, but your personal assets would be safe. However, your LLC would be bankrupt and the property would be gone.

Now, let’s consider a slightly different scenario. What if you, as a short term rental investor, have a single umbrella liability policy that covers all of your activities and assets up to $5 million? In this case, the insurance company would cover the entire liability claim and it wouldn’t matter whether the property was held in an LLC or not.

This brings us to an important point: insurance is what protects your assets, not the LLC. The LLC’s role is to limit liability, not eliminate it. LLCs do not protect any of the assets held by the LLC. This means that if you want to truly protect your assets as a short term rental investor, you’ll need to do more than just set up an LLC.

So, what’s the best asset protection strategy for most short term rental investors? Here are a few key steps you can take:

Hold your short term rentals in an LLC: As we’ve discussed, an LLC can provide a layer of protection between your personal assets and any business-related debts or lawsuits.

Get appropriate short-term rental-specific insurance: As mentioned above, a short term rental specific insurance policy can help protect you against liability claims from guests. Make sure to shop around and compare policies to find the one that best fits your needs.

Get a liability umbrella policy for all of your business operations: An umbrella policy provides additional liability coverage above and beyond what’s included in your other insurance policies. For example, if you have a $1 million umbrella policy and a $1 million short term rental insurance policy, you’ll have a total of $2 million in coverage.

Don’t commingle funds: It’s important to keep your personal and business finances separate. This means having separate bank accounts and credit cards for your business and not mixing personal and business expenses.

Make distributions often and don’t leave a lot of cash in the LLC’s bank account: If you have a lot of cash in your LLC’s bank account, it could be seen as a tempting target for creditors. By making distributions to yourself and not leaving a lot of cash in the account, you’ll reduce the risk of your LLC’s assets being seized.

It’s worth noting that the protective powers of LLCs are not absolute. To truly protect your assets, you’ll need to follow good corporate governance practices, such as keeping thorough documentation and maintaining separate financial records for your business. Otherwise, it may be possible for a creditor or lawyer to “pierce the corporate veil” and access your personal assets.

Piercing the corporate veil is a legal concept that refers to the process of holding the owners of a business personally liable for the debts of the business. This is often done when the owners have not properly maintained the separation between their personal and business finances or have not followed good corporate governance practices.

For short term rental investors, it can be very easy to pierce the corporate veil. For example, if you use your personal credit card to buy furniture for your rental property, that could be seen as commingling funds. Similarly, if you take out a mortgage or make purchases in your own name instead of the LLC’s name, that could also be seen as a lack of separation between your personal and business finances.

To avoid having your corporate veil pierced, it’s important to maintain good corporate governance documentation, such as operating agreements, and to avoid comingling funds and using the same bank accounts for both personal and business expenses. In short, don’t give a lawyer a thread to pull in order to pierce the veil.

In conclusion, while setting up an LLC can be a valuable asset protection tool for short term rental investors, it’s important to understand that it has its limits. To truly protect your assets, you’ll need to get appropriate insurance, maintain good corporate governance practices, and follow best practices for separating your personal and business finances. By following these steps, you’ll be well on your way to protecting your assets and ensuring a successful short term rental business.