Real estate investors (correctly) worry about potential liability. In other words, no investor wants to be sued by a tenant, contractor, or anyone else. Fortunately, strategies like establishing single purpose entities exist to minimize your liability. But this begs the question: Ryan, what is single purpose entity?
A single purpose entity is a legal entity—often an LLC—used for a single deal. Frequently, house flippers establish a single purpose entity to purchase, rehab, and sell a property. After the deal, they dissolve this entity, reducing the likelihood of legal action in case something bad happens.
I’ll discuss more of the details of single purpose entities in this article. Specifically, I’ll cover the following topics:
- What’s Single Purpose Entity?
- Using a Single Purpose Entity for Fix & Flip Deals
- Using a Single Purpose Entity for BRRR Deals
- Keys to Successfully Using a Single Purpose Entity
- Final Thoughts
What is a Single Purpose Entity?
As the name suggests, investors use a single purpose entity for a single purpose. But, what does that mean?
In real estate, investors typically establish a single purpose entity as a limited liability company, or LLC. They establish this LLC for a single real estate transaction. Rather than A) conduct a transaction in your own name, or B) in the name of your regular business, investors conduct the entire transaction within this one-time LLC. Then, once they’ve completed the deal, investors dissolve this single purpose entity.
The reasons for this are two-fold, but they both boil down to asset protection. When you operate an LLC, you limit your personal liability. In other words, if someone sues you, they can generally just go after the assets within the LLC—not your personal ones. In real estate, this typically means that someone can go after the property held in the LLC in a lawsuit, not your primary residence, retirement accounts, other rental properties, etc.
Additionally, single purpose entities can help you in the future. Say someone tries to sue you after you’ve completed a deal. When an attorney looks up the associated LLCs and sees that it has been dissolved, he or she will likely not pursue a legal action. It’s simply too much trouble trying to sue a company that no longer exists.
Critics frequently argue against single purpose entities due to their additional cost and administrative burden. Yes, you will have additional costs in terms of legal fees, registration fees, and administrative compliance. However, the benefits generally more than outweigh the potential risk of a lawsuit that could go after all of your personal assets and other investment properties.
Using a Single Purpose Entity for Fix & Flip Deals
In residential real estate, fix & flip investors frequently use single purpose entities. Here’s how it works: assume you want to purchase a distressed property to rehab and sell. You could A) purchase and sell it in your own name, or B) establish an LLC and purchase and sell the property under this company’s name.
Now, let’s say that this property happened to have mold behind the walls, but you didn’t identify it during the rehab period. You then sell the property and move on with your life. Two years down the line, the new resident becomes extremely ill with mold-related sickness. If you executed the fix & flip in your own name, that’ll be clearly reflected in public records. And, an attorney would have no difficulty finding and suing you. When it comes to lawsuits, even if you win, you lose. Regardless of the outcome of a lawsuit, you’ll need to pay attorney fees, take a ton of time out of your day-to-day activities, and just add unnecessary stress to your life. And worst case scenario, you lose and they go after your other assets.
Now, assume you’d set this fix & flip deal up with a single purpose entity. Before purchasing the home, you established Flip Deal #1, LLC. You then used this LLC to buy the property, sign all the rehab contracts, and sell it. Once you’ve sold the property, you then dissolve the LLC, so the company no longer exists. As a result, all the public records reflect Flip Deal #1, LLC—not your name. If an attorney tries to sue the company after the deal, he or she will see in the state records that Flip Deal #1, LLC no longer exists, likely deciding not to pursue a suit.
Additionally, establishing that LLC can protect you during the rehab process. What if a contractor gets hurt with lapsed insurance? Or, say someone slips and falls on the front step during the rehab process. In these cases, the LLC would help shield your personal assets, meaning that only the property would be at risk.
NOTE: An LLC will not protect you from negligence. If someone gets hurt due to your own negligence, a decent attorney will find a way to “pierce the corporate veil” of your LLC’s liability protection and go after your personal assets. As such, establishing a single purpose entity does not give you a blank check to act in a negligent fashion.
Using a Single Purpose Entity for BRRR Deals
Many BRRR investors also use single purpose entities for their BRRR deals. This stands for buy, rehab, rent, and refinance, meaning that these investors do all the rehab work of a fix & flip investor but instead hold and rent the property following the rehab period.
Accordingly, the major difference with this strategy is that BRRR investors don’t dissolve their LLCs. Unlike a fix & flip deal, BRRR deals do not have a hard end date. Rather, BRRR investors often establish a single purpose LLC and conduct the entire deal under this company, ultimately renting and refinancing the property under the LLC—not their personal names.
Once again, this LLC employment serves as an asset protection strategy. If a contractor, tenant, or anyone else decides to sue the BRRR investor, they’ll go after the LLC—not the investor. While this means the real estate within this purpose entity remains at risk, it shields the rest of your assets.
Keys to Successfully Using a Single Purpose Entity
To successfully use a single purpose entity, investors need to comply with some key guidelines. If not, a good attorney will find a way to pierce the veil of liability protection, arguing that the LLC didn’t actually represent a separate entity. While not all-inclusive, here are some of the important compliance guidelines to follow:
- Maintain a separate bank account for the LLC.
- Maintain a separate set of accounting records, or books, for the LLC.
- Do not commingle personal and LLC funds.
No liability protection is 100% guaranteed. But, following these guidelines when using, it will put you in a good position.
Final Thoughts
At the end of the day, a single purpose entity functions like an insurance policy. You need to pay for it—with money, time, and compliance—and you may never see the benefits. But, as the saying goes, it’s better to have and not need than need and not have when it comes to liability protection.
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