Investing in real estate in California, or anywhere, really, is risky, with potential liabilities extending beyond sunken costs. A business entity, such as a corporation or a limited liability company (LLC), can protect investors from liabilities associated with their investment. They can also protect the investment properties from unrelated issues in an investor’s personal life. A California real estate investor does not need to form a business entity in order to make an investment, but it can be useful. Understanding how, and when, forming a business can help is an important part of planning an investment.
Limited Liability of Investors
One of the primary purposes of business entities like corporations is the protection they offer owners against liability for business debts. It is such a central feature that it is part of the name of business forms like the LLC. An individual engaged in a business activity on their own, including real estate investment, is known as a sole proprietor. A group of individuals doing business together form a general partnership by default. In either case, the individuals are liable for any debts or other obligations arising from their business activities. Partners in a general partnership are jointly and severally liable for one another’s business activities.
California law governs the formation and operation of business entities within the state, and determines their limitations on liability. Shareholders in corporations, members of LLC’s, limited partners in limited partnerships, and owners of other business entities are not individually liable for anything arising from ordinary business activities undertaken through the business entity. This requires a strict separation of personal and business assets and activities. For example, if an investor sets up an LLC to manage their real estate investments, the LLC should have a separate bank account.
If a tenant at an investment property is injured, and the lease is in the name of the business entity that owns the property, individual investors are not personally liable for damages to the tenant. In certain situations, however, injured parties can hold individual owners liable. This is known as “piercing the corporate veil.” If, for example, the injury suffered by the tenant was the result of criminal activity by an investor, or the investor was grossly negligent in managing the property, the tenant might be able to pierce the corporate veil.
Protection of Business Assets
The liability protections offered by business entities also protect investment assets from outside liabilities. If an investor is involved in a car accident in their own vehicle, while doing anything other than investment-related business, assets held by a corporation or other business entity are likely to be shielded from anyone asserting a claim against the investor.
When Does a Business Entity Not Help?
Forming a business entity is not always helpful. Liability protection only occurs when distinct business activity exists. A person cannot create a corporation to avoid liability for the ordinary activities of their everyday lives. Another version of piercing the corporate veil occurs when someone is using a business entity solely as an alter ego for themselves.
For the California real estate investor, a brand new business entity can also be ineffective or detrimental to some aspects of real estate investing. Banks will not loan money to a newly formed corporation or LLC that has no established track record. The investor will have to sign the loan documents in their own name. It might be possible to transfer title to the property into a business entity at a later time, but the loan obligation will remain with the individual or individuals who signed the note.