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Investor Insights Blog|4 Costly Consequences of Having the Wrong Rental Property Insurance

Real Estate

4 Costly Consequences of Having the Wrong Rental Property Insurance

house for rent

The following was written by guest blogger Bill Mecklenburg, President, SES Risk Solutions.

If you’re a real estate investor with a rental property, your insurance policy might be putting you at risk without you realizing it. If you hold that property in your retirement account, there are additional risks to consider.

Based on general conversations with IRA account holders, over 50 percent of rental properties held in these account holders’ self-directed IRAs could be deemed invalid by the insurance carrier or create a significant taxable event to the holder of the IRA.

The largest infraction we discovered is that the majority of properties are written as homeowner’s policies rather than rental dwelling policies. Why does this matter?

A homeowner’s policy (HO3 or HO6) is designed to insure an owner-occupied space. Insurance carriers consider owner-occupied and tenant-occupied homes to carry two different levels of risk.

 

If you have a rental property insured under a homeowner’s policy, you run the risk of having claims denied because you misrepresented the property in applying for insurance.

Bill Mecklenburg – President, SES Risk Solutions

If a house is owner-occupied, there is likely more upkeep and less deferred maintenance. Think of it this way: how many times have you washed a rental car? If you’re a homeowner living in your house with your family, it’s a 30-year investment for you.

From an insurance perspective, a leased house is viewed as a temporary residence, which carries a different risk. Because of this, there is a higher likelihood of loss, so the insurance costs more; however, a rental dwelling policy also covers risks associated with a tenant-occupied home that are not available in a homeowner’s policy.

This blog is written to ensure that you are properly insured. I will identify four costly outcomes you could potentially face if your IRA properties do not have the proper policy.

Ultimate Real Estate Investors Resource Guide

Your claim could be denied

If you have a rental property insured under a homeowner’s policy, you run the risk of having claims denied because you misrepresented the property in applying for insurance.

For example, say a tenant had a space heater that catches on fire and burns the house down. If you have homeowner’s insurance and your insurance carrier figures out the house was not owner-occupied but actually tenant-occupied, the carrier has the right to deny that claim which could result in you not having insurance to cover that damage.

At best, you could spend thousands of dollars in litigation fees. At worst, you could lose the entire value of the home in the fire.

[Related: Common Rental Property Risks and How to Minimize Them]

Your insurance provider won’t come to your defense

The wrong kind of insurance could hurt you from a liability perspective as well.

For example, say a tenant’s dog attacks the mailman. Your insurance carrier will not provide a defense for you if a tenant was living in the house instead of you.

Covering the cost of missed rent payments

Typically, if your rental property is significantly damaged and needs extensive repairs, the tenant will move out and you lose the ability to generate income on that house for several months. Meanwhile, you’re still paying taxes, your mortgage, and other property expenses without collecting any rental income. Given the time it takes to repair a significantly damaged home, you could lose over $20,000 in rental income for your self-directed IRA.

Conversely, a homeowner’s insurance policy typically pays for temporary residence for you and your family while repairs are taking place in your own home. However, if the claim is made on a property that’s not your residence, the policy will not provide a temporary residence for someone else, nor are they going to reimburse you for your loss of rent during that time.

If you properly purchase a rental dwelling policy, you will be reimbursed for any lost rent during the time of repairs under business interruption insurance.

With a homeowner’s policy, you’re not going to have loss of rent or business interruption coverage.

One more consideration: rental properties in an IRA could inadvertently create a taxable event

Now that you’re aware of the coverage needed for a rental property, there’s one more consideration: If your rental property is held in an IRA, you need to make sure the insurer understands the unique requirements involved.

All premium payments need to come from the IRA and any claim payments need to be made to the IRA. If you personally receive a check from an insurance company that should have been paid to the IRA, the IRS could consider that a taxable distribution from your IRA, which can also involve early withdrawal penalties. In our conversations with account holders, over 35 percent of the policies were in the IRA holder’s name rather than the name of the IRA.

[Related: Real Estate IRA Rules]

About Bill Mecklenburg

Bill Mecklenburg is President of SES Risk Solutions, a subsidiary of Alliant Insurance Services. Bill was previously the CEO of Redwoods Managers, Inc. and the COO of The Redwoods Group, a specialty insurance organization that The Wall Street Journal and the nonprofit organization Winning Workplaces selected as one of 15 winners of the 2008 Top Small Workplaces. Bill also served as a Managing Director of reinsurance broker Guy Carpenter and he was an SVP and the leader of the Property & Casualty Division of KEMPES, Inc. Bill has an Economics degree from the University of California, Berkeley.

About SES Risk Solutions

SES Risk Solutions is a leading provider of insurance services for real estate portfolios. SES currently services over 50,000 properties for fiduciaries, owners, and managers through master policies on a nationwide basis. SES has a 30-year history of offering competitive and comprehensive insurance products complemented by unparalleled service and technology platforms for properties (residential, commercial, farm, and land) held in trust by financial institutions or owned by real estate investors.

1

I plan to purchase a rental property with my IRA. Does the rental income have to go back into my IRA?

Yes, all income generated by an IRA-owned property must return to your IRA. This ensures that you retain the tax-deferred or tax-free status of the investment.

 

Bill Mecklenburg is not an employee of Equity Trust Company. Opinions or ideas expressed are not necessarily those of Equity Trust Company nor do they reflect their views or endorsement. These materials are for informational purposes only. Equity Trust Company, and their affiliates, representatives and officers do not provide legal or tax advice. Investing involves risk, including possible loss of principal.

Equity Trust Company’s arrangement with this third party provider is solely for the convenience of clients of Equity Trust Company. Equity Trust Company makes no recommendation or representations as to this third party provider, any insurance products, or the insurance needs generally of any client or any client’s account. Clients are in no way obligated to purchase insurance products generally or to purchase insurance products from this third party provider or through Equity Trust Company’s arrangement with this third party provider. Clients are free to purchase or not purchase insurance products for client or client’s account from any insurance company or broker as they deem appropriate. No client may rely on any statement made by Equity Trust Company or any of its officers, directors, employees, or agents for any decisions regarding the purchase of insurance products. Clients should consult with their financial and legal advisors before purchasing any insurance product for client or client’s account.

 


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