When getting started in real estate investing one common question asked by new investors is the difference between setting up a corporate entity to hold your properties vs. purchasing liability insurance. There are significant differences between the two. Your individual specific financial situation needs to be considered when making this decision. This is why the advice of a competent attorney and/or tax professional is extremely important when making this decision.
With that said, here are some general rules of thumb that will help you when deciding the best strategy for protecting yourself and your properties.
When you incorporate what you are in effect doing is creating a separate business entity from you personally. Corporations were used as early as the 1400's and 1500's when voyages were made from Europe to the American continents, which were known as "The New World." There was a tremendous amount of risk for these voyages. Therefore the wealthy owners of the ships set up corporations. This way if a ship was lost, the losses would be restricted to the corporation and the personal assets of the owner couldn't be seized.
This is exactly one of the main purposes of setting up a corporation. It is designed to protect your personal liability. Typically any challenges that occur when operating under a corporation will not affect your personal assets and vice versa. For instance, if you are sued personally and you lose the lawsuit, the winning party can come after your personal assets. However, if your property is owned by a corporation, they will not be able to take the property away from you. If someone sues your corporation and they win, they will be able to go after the corporation. However, they won't be able to go after your personal assets.
The second benefit towards incorporating is the tax benefits. There are a number of tax benefits that are available to you though a corporation that are not available if you run your real estate business as a sole proprietorship with liability insurance for your property.
For example, as a corporation you are able to offer "fringe benefits" to employees that are considered expenses to the corporation but are not considered income to the employees. You can offer to pay all health related expenses as a benefit that are not covered by insurance. You can offer to pay for all educational pursuits as long as the education benefits the company. This works well particularly if your real estate company has no employees other than family members as these benefits have to be made available to all employees.
Liability insurance is just that, insurance against liability that occurs as the result of a lawsuit. Therefore if you have 3 million dollars of liability insurance and you lose a 2 million dollar lawsuit, the insurance will pay the judgment of the lawsuit for you. This way you can continue to run your business and you are not forced to shut down as a result of a lawsuit.
So which one is better for you? Many investors prefer not to incorporate. The reason why is because they can acquire more attractive financing for certain types of properties operating under their own name than they could if they operated under a corporation. Therefore, they would rather operate under a sole proprietorship and purchase liability insurance for protection.
The problem with that is if you are sued personally and you lose, they can come after all of your properties as well because you have no protection.
Also keep in mind a corporation is no guarantee that you can't be sued personally. Many attorneys will simply sue both the corporation and the owners personally and if you lose, you will still need liability insurance.
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