Asset protection for landlords

Rent it Right

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Luxury Connect | Oct. 16-18 | Beverly Hills

Q: My husband and I are going to rent out my parents’ home, which I have inherited. How can we best protect our personal assets from lawsuits or other claims that might arise during our landlording business? –Fred and Delia J.

A: The best way to avoid trouble is not to invite it. If you learn the rules surrounding the business of being a landlord — and there are many, on the federal, state and local level — your chances of being sued or having to deal with unexpected expenses go down.

Similarly, if you use written contracts with vendors and tradesmen, the chance that you’ll have a dispute concerning the relationship that boils over into litigation will be lessened. Combined with adequate insurance, this offense is your best defense.

But sometimes, despite your best efforts, things go awry. Many landlords in your position want to shield their personal assets from judgments or settlements, and many people automatically think of forming a corporation. True, a corporation will protect your personal assets (as long as you segregate your personal assets from the business assets), but forming and running one is time-consuming and expensive; and you’ll have to file a corporate tax return.

Alternately, you could form a limited liability company (LLC), which will give you the same protection as a corporation, but not require regular board meetings and minutes. You can also pay taxes through your individual tax return, an option not available to regular corporations.

Don’t assume that once you form an LLC for your business, your personal assets will never be at risk, however. Lenders and creditors (vendors) understand that people form LLCs precisely to protect their personal assets — and to limit the creditor’s ability to collect — should the LLC fail to pay a bill or a loan.

And why should the bank or vendor agree to such a limitation? The short answer is that they won’t. Instead, they will probably ask you to personally guarantee loans or the extension of credit to your LLC. This guarantee means your personal assets are at risk despite the LLC structure. In other words, it destroys the limited liability the LLC would otherwise provide.

On the other hand, with an LLC your personal assets will still be protected from claims for personal injuries and violations of the fair housing laws. This protection holds only if you’ve run your LLC as a business entity that’s truly separate from your personal business, however.

If you are sloppy, commingling funds, failing to keep separate books and otherwise disregarding the legal rules concerning LLCs, you may lose the protection you sought.

Q: I rent an efficiency unit for $399 per month. Written into my lease is a late-fee clause stating any late rent is subject to a $75 late fee with additional charges per day of $5, capping off at $100.

I work at a company that has recently significantly cut my hours, and this has made it impossible to pay my entire rent on the due date. So I have been paying half and waiting two weeks to pay the other half. But then I get hit with an additional $100 late fee.

I know I have to pay my rent on time, but $100 seems exorbitant on my small unit. Can I ask a judge to rule that it’s not legal or fair? –Yolanda S.

A: You’re looking at a 25 percent late fee! You certainly do have some arrows in your quiver. But before turning directly to your question, let’s review the rules. …CONTINUED

Late fees are legitimate when they compensate the landlord for the actual loss suffered as a result of a tenant’s tardy payment. Such losses include the cost of reminding the tenant to pay (by sending a pay-or-quit notice, for example), the staff time spent trying to collect, and the interest lost on that money for the days it doesn’t spend in the landlord’s bank account. Late fees that exceed actual damages are legally considered penalties, which are not valid in consumer contracts (including leases and rental agreements).

Many states recognize that it’s not easy for landlords to accurately measure the losses they will incur. These states allow landlords to include a set late fee in the lease, but the fee must still follow the universal rule explained above, by being a close approximation of what the landlord will in fact lose if the rent is late.

For example, in Delaware, Maryland and Oregon, the fee cannot exceed 5 percent of rent; in Iowa, late fees cannot exceed $10 per day or $40 per month; North Carolina will invalidate a fee that is higher than $15 or 5 percent of the rental payment, whichever is greater; and New Mexico and Tennessee, at the high end of the list, cap the fee at 10 percent.

Some states, like Texas, require a late fee to be "reasonable," but that is simply another way of saying that the fee must closely approximate the landlord’s damages.

Now, let’s look at the late fee in your situation. Let’s suppose that you live in a state that specifies how high the fee may go, as do the states mentioned above. To my knowledge, no states surpass New Mexico and Tennessee in letting landlords charge more than 10 percent of the rent.

If you live in those two states, your fee should have been no more than $40; and if you live in a state with a lower cap, the maximum fee would be lower still.

But suppose you live in a state whose rule is simply that the fee must be "reasonable." Here things get sticky, because a landlord is likely to argue that it requires just as much time and effort to collect $400 in rent as it would be to collect $2,000.

The only difference is the amount of interest the landlord loses on the rent for each day it remains unpaid. But with passbook interest rates at record lows these days, the interest component won’t amount to much, so the difference in lost interest between low and high rents won’t be significant.

In short, a requirement that fees be "reasonable" makes it possible for the landlord to apply more or less the same late fee to small rents and high rents alike, as long as the fee approximates the landlord’s losses. It may not be unreasonable to say that late rent payments cost the landlord $100 in time and effort.

It would be a mistake to stop here, however. The real issue for you is that you can’t pay the full rent when it’s due; instead, tough economic times have made it necessary to pay in two installments. Approach your landlord and explain your situation — you are hardly alone these days.

Unless you live in one of the very few rental markets that’s hot these days, your landlord would be foolish to continue to impose high fees that may drive you away. He may end up not only with a vacancy, but with a risk that the next tenant will not be a keeper. While you’re at it, point out that the late fee amounts to 25 percent of the rent.

Even in a state with a "reasonable" requirement, that percentage is still shocking. I can imagine that some judges will be simply unwilling to stick it to an otherwise stable tenant, especially in these hard economic times.

If you get nowhere with your landlord, consider moving. To contest this fee, you’d have to refuse to pay it, refuse to move when you get a pay-or-quit notice, and use your argument as your defense in an eviction lawsuit. It’s better to just move: An eviction lawsuit would involve too much time and effort, and you don’t want an eviction case, even one you win, in your background.

It would be great if you could, instead, go to small claims court and ask the judge to declare the policy invalid (that way, you wouldn’t be risking an eviction lawsuit), but your state’s small claims courts may not be set up to deal with lawsuits that ask for "declaratory judgments" on people’s rights.

Janet Portman is an attorney and managing editor at Nolo. She specializes in landlord/tenant law and is co-author of "Every Landlord’s Legal Guide" and "Every Tenant’s Legal Guide." She can be reached at janet@inman.com.

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