How to get sued, without really trying.
By William May
Published: 10/11/04 Topics: Comments: -
It is easy to become wildly enthusiastic about the money-making aspects of buying and renting your own vacation rental home, what with the many factors contributing to the rapid growth of private vacation rentals: internet advertising, low interest rates, an emphasis on leisure and the post-911 "Live for today" attitude. Perhaps the biggest factor is simply that renting a large and comfortable, fully stocked home is simply a far better bargain and far more enjoyable for guests than staying in a hotel.
After new owners get past the thrill of setting up their units, running some ads, booking guests and watching the money roll in, I hope each and every one will take the time to do a "gut check" - realize that they are in a business, and like all enterprises, it carries risks and legal exposure.
Luckily, like the thousands of other industries in the world, the financial exposure of vacation rentals can be researched, evaluated, planned for and - with care and caution - usually avoided. But you have to know what you are doing. If you don't you'll find yourself in court answering questions, you may not be prepared to answer. Your response may cause judge and jury to find you were prudent and reasonable and without fault. Or they can just as easily find you failed to exercise due caution, did not conform to written rules and regulations and are one sorry excuse of a landlord, from whom they will extract large sums of money.
So how do you go about making yourself open for legal and financial exposure? Here are some (tongue in cheek) suggestions:
- Advertise and promise the moon. Doctor photos to remove you view of the condo dumpster. And, for goodness sake, never tell them the off-putting aspects of the house, resort or neighborhood, they'll find that out after it's too late to get their money back!
- Do everything verbally. Don't bother with written leases. You are the boss and your guests will do as you say (Just like your children!)
- Let anyone with the money rent your house. And let them bring as many guests as they want. Parties? No problem, as long as they have the rent. It doesn't matter if the neighbors are disturbed, you probably won't even know them anyway.
- Take credit cards, even when you have time to get paid by check. The more the better. Sure the guest can create a Chargeback, but hey, the bank's on my side right?
- Hire the cheapest housekeepers and maintenance people you can find. While paying good wages on time may give you reliability, guests won't know the difference if the place isn't perfectly clean and well maintained.
- Don't worry about safety, fire and other regulations. If the house starts to burn, what good is a fire extinguisher anyway? Who would even notice? And how can anyone expect little old you to know about all those big bad governmental regulations?
- Don't have a 24 hour, 7 day a week emergency phone number. Hey, they rented the house and they should now enough not to lock themselves out. I'm in it for the money, not the work.
- Don't have a local representative to help with problems. Sure you live a scant, 4 hour plane ride away, but what could go so wrong as to require someone to visit the home on short notice?
- Never use a manager. They are all thieves, actually charging you $8 to drive to a house 15 miles away to install a light bulb. Sure some owners don't have the time or experience to properly manage their homes, but who is going to pay a manager when everyone says it's so easy to do-it-yourself?
- Don't join the industry association. What could hundreds of other owners who have been renting for up to 40 years and some of whom own multiple homes - know that I can't figure out myself in just a few minutes? (Sorry for the shameful VRIA plug).
The silly examples above reflect the kind of thinking detected when speaking with new or inexperienced vacation home owners. I sound like a broken record (do they still make records?) when I say the following, "The only safe way to offer a vacation home for rental is to operate it like a business." No messing around. Learn what you don't know, follow the rules and get better everyday.
Remember: "Free advice is worth what you pay for it" so be careful listening to other owners who are often less skilled and experienced than they let on. Instead, smart investors dig deeply, study thoroughly and then act in responsible and reasonable ways.
There isn't time in this edition to provide instructions as to why the examples above are nothing short of stupidity. Some of these have been covered in prior newsletters and time will be devoted to many of them in future articles. Instead, let me just focus on one very important tactic all smart rental owners should employ.
GET THEE TO A LIMITED LIABILITY COMPANY:
To leave you with a taste of legal sanity, I want to give you a full and proper answer on legal entities and why you must immediately form a "Limited Liability Company" and have it (and not yourself personally) own your vacation rental home.
This is a frequent topic of discussion among owners who ask "Should I incorporate" to protect myself from the legal exposure of renting my home? When other owners answer they usually find a need to say, "I am not a lawyer, but ..." Maybe they have learned that insufficient disclaimer by listening to lawyers who have been trained, not to give you clear and concise answers, but to be able to argue either side of any issue. That may serve the lawyers well in court, but it's a terrible disservice to clients, especially those with a risky small business like a vacation rental home. Clients who need useable suggestions and efficient answers.
Well I'm not a lawyer either, but I may as well be after 30 years running over a dozen companies. In one firm, I had the distinct pleasure (sometimes pleasurable, but always distinct) of representing the buyers and sellers of companies as a broker or intermediary. In those negotiations every party had a lawyer and usually an accountant, appraiser, corporate board members, company officers and others who influenced their decisions (right on down to their priest, rabbi and brother-in-law). Well, you can imagine the cacophony of opinions that flooded the decision maker's ears. I found that the lawyers were usually the least sure of the decision maker's opinions while those with no training were usually the most sure.
After being a fly on the wall in hundreds of meetings with hundreds of attorneys, here is the only thing I know for sure: one must utilize the 80/20 rule. Eighty percent of the attorneys had no idea what they were talking about, couldn't explain what they did want to say, were not very persuasive and were usually terrible negotiators. Worst of all, eighty percent simply didn't know what they were talking about. They were worse than no-nothings because they insisted they had answers when they clearly did not.
THE QUESTION:That brings us back to the question of, "Should I incorporate my vacation rental home to protect myself from the liability of owner it?" The answers is - Yes, you should form a legal entity to protect yourself. Let me repeat that - yes, you should. In fact, yes, you must.
A TRAGIC TALE:The details of forming legal entities may come in other forms in different counties. Formation of legal companies is by statute (by law) in all jurisdictions and is not just some kind of ages old universal process that governments must accept. They all differ in terminology. That means, if you are not in the US, be sure to find similar mechanisms in your country.
Over two decades ago I remember reading the local business paper which had the sadistic practice (like many publications) of publishing the names, addresses and information of people and companies who had gone bankrupt. Like vultures circling a carcasses, I was struck by one particular entry. It was for a company named "Joan's Hair Cutting and Curling" who had filed for chapter 7 (permanent) bankruptcy. The company listed assets of $7,000 and Debts of $12,000 and Joan was having her debts dismissed by filing. Unfortunately Joan's little business had never been incorporated and that meant that for a negative equity of $5,000 Joan was not only going to lose her business, but all her personal assets as well. Maybe even her childrens' college education savings and (I extrapolate here) their opportunity to go to college and make a better life for themselves.
I also read about large companies that go bankrupt but it's hard to muster sympathy for them. We all make mistakes, some businesses are winners and some are losers. Sometimes it's the fault of the owners who are inexperienced or not careful, and other times because the economy has changed, competitors have prevailed or the managers made mistakes. The last may be true for Joan, but the large company officers generally do not screw up their personal lives and lose their life savings when they lose their companies. All because they have been big enough or smart enough to set up those businesses as distinct legal entities.
So for the lack of (in those days) a $100 filing fee and some forms, Joan was consigned to financial hell: a terrible personal credit report for 10 years.
Luckily, you don't have to make Joan's mistake. Today, you can use online services or buy simple software and form a legal entity to own your home. Or, if you like spending money, you can hire a lawyer to do it. I think Joan would tell you the $100 would have been money well spent. Today, you can spend about $200 to $400 to do the job, plus a small yearly renewal fee and a dozen pieces of copy paper. That's it.
Remember as well that Joan didn't take near the risk that any vacation rental home owner takes. Not only could you lose money and lose the house, you could have an accident (like a fire) that maims or kills someone and you could become personally responsible far beyond the limits of your insurance policy. Even a stove accident, or a slip in the driveway could cost you hundreds of thousands of dollars in legal fees.
For many years the legal form of choice was to become incorporated. Doing so was a matter of having Bylaws and Articles of incorporation written and then filed (in the US, anyway) with your state government. Each year after that, you have to take 5 minutes to fill in a renewal form, and send them a fee (usually in the $50 price range.) Oh, and you have to have a meeting of the shareholders and Board of Directors which, will take two more pieces of paper with three more paragraphs on them.
Along the way, the federal government came up with the option of "electing" to become an "S" corporation and have the corporate profits taxed at the personal level, thereby avoiding (in most cases) a double taxation situation - certainly a desirable option. As well as some other decisions - and hoops to jump through - that shareholders could make to remain a corporation in good standing.
If you formed a corporation, invested your capital into the corporation, had it buy your vacation rental home and followed the rules listed above, it's simple to distance your personal assets from any problem that arose in the home. Every lawyer will tell you that the system is not perfect, and that an opposing lawyer would attempt to "Pierce the corporate veil" to get at your personal assets. But realize, lawyers are taught to always find the opposing argument. In actuality, piercing the veil is a very difficult and highly unlikely thing for a judge to grant. So, that leaves us with this - incorporating is the best way (albeit, not the perfect way) to protect your assets.
USING AN L-L-C:
In the last few decades, however, a new legal form has arisen and been approved in virtually all US states called the Limited Liability Company or "LLC." It is a far better vehicle for owning real estate and separating that risk from your personal life. LLCs (like corporations) are, in the eyes of the law, autonomous legal entities. They can do everything a person can do; buy and sell things, borrow and loan money, hire and fire employees, enter into agreements, file taxes, sue and be sued. Just like a person, if they become insolvent or make mistakes, the LLC is liable for them. After all, the word "Limited" means limited to the company and not its owners.
LLCs are usually able to decide how they want to be taxed: as a partnership or sole proprietorship. You can't avoid the taxes, but you can only get taxed once, and you decide where the money comes from: the LLC or your pocket.
In the worst case scenario, death due to fire in your home, there could be financial liability greater than your insurance or the LLC has to pay. If the LLC doesn't have enough assets, it can declare bankruptcy leaving the creditor with all the assets of the LLC. But here is the good part - only the assets of the LLC. Your other personal assets (Cash, stock, savings, other real estate) not owned by the LLC, are outside the reach of the creditor.
What does all this mean to you? First, no one wants to have problems or become personally liable, and you certainly don't want to lose the equity you have invested in your vacation home. However, you must also understand that nothing else can limit the exposure you have when you buy and rent out your home. An LLC won't protect your equity, but it will "Limit" your exposure to the money you've invested.
There is one significant wrinkle - your bank may be unwilling to lend money to what is a very small company (your vacation home). But in many cases they will be willing to lend the money to the LLC if someone (you) co-signs the loan. You don't want to do that for some legal reasons, in particular, co-signing may cause an "unintentional" partnership to be formed, from which a court could construe you are liable for the debts of your partner - the LLC.
Instead, when purchasing your house, ask your bank if you can simply "Guarantee" the loan in the same way you might for a (very good) friend. If he (LLC) doesn't pay, you have to. Of course this means (sadly) that there is really no way to avoid responsibility for the mortgage on the home. But that is not your intention anyway, and this way you'll get the loan, the bank will be secure, and you will still have your risky (vacation home) asset separate from the rest of your financial future.
Next time someone asks if they should incorporate their vacation home or any business you will know the answer: ABSOLUTELY. You must form a legal entity to own and operate your business. In most cases, an LLC is the best legal form for small businesses. It will cost a few dollars to setup, and a few more each year to renew, but it will be the cheapest insurance you will ever buy and the most likely to protect you. Don't accept any other answer.
As they say in the game Monopoly - do not pass go, do not collect $200. But do form an LLC immediately. Or lay awake at night worrying about losing everything you own because a guest made a mistake.
As always, I seek your input. Please share your tips, techniques, compliments and complaints on this or any other subject by writing me at Director@VRIA.orgDirector@VRIA.org.
HOME OF THE WEEK:
This week's home is nestled up in the Vail mountains and comes complete with all amenities you'd ever need. 5,000 square feet of luxury for you and your family. Take a peek at (triangleriver.com)triangleriver.com
(If you want your place considered for Home of the Week, please drop me an e-mail.)
FEEDBACK:I've found your newsletters very informative and well written. I can't be sure, but I think since your advice to call, (besides writing emails), has secured me two bookings, and maybe, before, I've lost some.
- Katerina, Greece
Glad to hear it's working. Now I just have to find a way to visit you in Greece?
- Wm. May
ONLINE:Read and download samples of terms and conditions, booking confirmations and so forth on the members-only Web site: (VRIA.org)VRIA.org.
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Author: William May – Volunteer, Vacation Rental Association
Blog #: 0052 – 10/11/04
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