Real Estate Investing Issues

  1. Tenancies in Common (TIC’s)

    1. Advantages. The primary advantage of a tenancy in common is that it’s easy to move investors in and out of the investment group while doing 1031 exchanges – and preserving 1031 exchanges for those leaving.

    2. Disadvantages. The key disadvantage is that each tenant-in-common is fully liable personally for all debts, lawsuits, etc. regarding the property, since tenancies in common are treated like general partnerships.

    3. Forming Investor Entities. One approach is for each person or couple to form his/her/their own entity, and that entity can then invest as a tenant in common.

      1. Of course, if the entity is involved in more than one TIC then, since the entity has full liability regarding each property, one problem property may eat up the positive impact of the other properties.

  2. Number of Properties in an Entity

    1. If you are using entities to hold your real property, how many properties should each entity hold? Since the purpose is to keep liability from one property from affecting another, at the very least each high-risk property should be in its own entity. Many people feel high-risk properties include:

      1. Condominium development or conversion projects.

      2. Projects that involve significant construction.

      3. Any type of rental property.

    2. Basically, you need to weigh the risk associated with properties (and the insurance coverage you have for each) with the cost of setting up and maintaining the entities. Also, the more valuable the property, the more it justifies a separate entity.

    3. One thing to note is that certain potential liabilities -- such as mold and exposure to lead-based paint -- may not be coverable by insurance.  

  3. Choosing the State Where the Entity is Formed

    1. Tax Considerations

      1. If you are a California resident and the property is in California, from a purely economic perspective it makes no sense to form an LLC in another state. (There is an exception if you own multiple properties that we’ll get to in a bit.)

      2. A California resident pays California tax on all of his/her income, even if that income comes from outside California. It is very difficult to establish residency outside of California if you are doing anything in the State. Generally, California takes the position that someone is not a California resident only if:

        1. His/her presence in California does not exceed 6 months within a taxable year; AND

        2. If he/she maintains a permanent home outside California; AND

        3. If he/she does not engage in any activity or conduct within the State other than as a seasonal visitor, tourist, or guest.

      3. If you set up an out-of-state limited liability company (LLC) or Subchapter S corporation, since the profits flow through to the owners, any owner who is a California resident will be taxed on all the profit (and compensation) that he/she receives.

      4. Finally, if you have an out-of-state corporation or LLC but that entity is "doing business" in California, you have to register that LLC or corporation as an out-of-state entity with the State of California – and the filing fees and annual franchise tax are the same as if you set up the entity in California. (Again, with multiple entities it can be different.) Given the additional costs of setting up an out-of-state entity, frequently going that route is more expensive that simply using a California entity in the first place.

        1. Under California law, an entity is doing business in California if it enters into repeated business transactions in California. The following, though, do not constitute "doing business" in California:

          1. Maintaining or defending any litigation, administrative or arbitration proceeding.

          2. Holding meetings of directors or shareholders or carrying on other activities concerning its internal affairs.

          3. Maintaining bank accounts.

          4. Making sales through independent contractors.

          5. Obtaining orders where the orders require acceptance outside California before becoming binding contracts.

          6. Creating promissory notes, deeds of trust, etc.

          7. Conducting an isolated transaction completed within a period of 180 days and not in the course of a number of repeated transactions of like nature.

      5. Many states (for example, California, New York and New Jersey) tax an out-of-state entity on all revenue it earns within the state anyway. As time passes, more and more states are expected to do this.

    2. Protection Issues

      1. In some states (California is not one of them), creditors cannot attach membership interests in an LLC on the theory that it unfairly harms the other members. At the moment, this list probably includes Arkansas, Illinois, Nevada, Connecticut, Louisiana, Oklahoma, Delaware, Maryland, Rhode Island, Idaho, Minnesota, Virginia.

        1. A bankruptcy court recently decided that a creditor of a single-member LLC can attach the member’s interest in the LLC on the basis that there were no other members to be harmed. As a result, you either want to have two members for the LLC.

      2. If this type of protection is important – if, for example, you are in a high-risk profession where you are likely to be sued – it may be worth the additional costs of creating an out-of-state entity and paying the additional costs required to register the entity where the property is located.

    3. Privacy Issues

      1. When you create an entity you have to file papers with the state indicating who the managers are. If you are concerned that people not be able to look up your assets, one approach is to use a trust (one that does NOT include the family name) to hold the ownership in an LLC, designate someone who is not the creator or a beneficiary of the trust to be the manager (and be listed as the manager for state filings), then have that manager sign a power of attorney giving you all management powers.

        1. This works because no information about trusts or powers of attorney are filed with the state.

        2. Obviously, you should only make the manager someone you trust.

        3. This can be done with a corporation too, using one or more non-owners as the officers, although obviously it can be more complicated.

      2. The more difficult privacy issue involves who is authorized to sign on the entity’s bank account. Although the account itself is in the name of the entity, U.S. banks are legally required to obtain the name and Social Security number of every signatory on the account signatory. Unfortunately, there are asset-location services that can obtain this information. (They have bank employees secretly on long-term retainers to do this.)

        1. One option is to have the manager you designated be the sole signatory on the bank account but have that person give you a power of attorney to sign his/her signature on the entity’s checks. (You keep all the checks, of course.)

        2. Another option is to use an off-shore bank account, though that may make it difficult for your checks to be cashed.

  4. "C" Corporations.

    If you can set salaries and bonuses so that there is no profit, a "C" corporation may be the best choice of entity, since certain fringe benefits are tax deductible but are not counted as income for employees.

    1. Deductions. Employer payment for health insurance premiums and other medical expenses is deducted as a business expense, but isn't included in employees' gross income.

      1. Employer payments for the following employee benefits are treated the same way:

        1. life insurance;

        2. accident and disability insurance;

        3. supplementary unemployment payments;

        4. parking expenses and transit passes (up to certain limits);

        5. child care;

        6. meals, travel and lodging.

    2. Passive Investors. On the other hand, if there are passive investors, they may insist on a share of profits.

    3. Double Taxation. If the entity is going to have profits, a "C" corporation is a bad idea because there is effectively double taxation of profits: the corporation pays taxes on its profits and the employees and owners pay taxes on their salaries and dividends.

    4. "Pass-through" Entities". To avoid the double taxation of a "C" corporation, a limited liability company ("LLC"), limited partnership or Subchapter S corporation must be used, since (with some relatively minor exceptions) there is no income tax on the entity’s profits; instead, the profits "pass through" to the owners. Often the best entity for real estate is an LLC.

  5. Subchapter S Corporations

    1. Passive Income. There can be problems if the Subchapter S corporation will be receiving more than 25% of its income from passive investments. (Passive income is income from dividends, interest, royalties, rent payments, annuities, etc. – as opposed to income directly generated by your labor.) The IRS can terminate a corporation’s "S" status if its income from passive investments is more than 25% of its total income for more than three years in a row. If this happens, the S corporation is taxed as a "C" corporation. This frequently makes a Subchapter S corporation unattractive for real-estate investments – at least if there are going to be rents coming in from the property.

    2. Individuals Only. The owners of a Subchapter S corporation must all be individuals – no entities (corporations, LLC’s, etc.) are allowed.

    3. Losses. With a Subchapter S, you can only deduct losses up to the amount of your investment; with LLC's you can deduct all losses, even if they are in excess of your investment.

    4. Attachment of Stock. Generally, creditors of a shareholder can attach that shareholder’s stock.

    5. Identical Percentages of Ownership, Voting and Profits. With a Subchapter S corporation, each owner must have the same percentage of ownership, voting power, and profits and losses.

      1. With an LLC someone can have, for example, 25% of the ownership (meaning 25% of the proceeds if the LLC is sold), 10% of the voting power and 5% of the profits and losses.

      2. It is possible to control voting in a corporation with a voting trust, though it can be complicated.

    6. Non-Resident Aliens. Non-resident aliens may not be owners of a Subchapter S corporation unless they meet the "substantial presence" test.

      1. For this purpose, the IRS definition (not the immigration definition) is used: basically, a non-resident alien is any non-citizen or legal permanent resident who has not been physically present in the United States on at least:

        1. 31 days during the current year, and

        2. 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:

          1. All the days he/she was present in the current year, and

          2. 1/3 of the days he/she was present in the first year before the current year, and

          3. 1/6 of the days he/she was present in the second year before the current year.

        Persons who meet the substantial presence test will be taxed primarily the same as legal permanent residents and citizens, which may include withholding of FICA from employment compensation.

    7. Self-Employment Tax. One advantage of a Subchapter S Corporation is that, although you must set a "reasonable" salary for any owner who is doing any work on behalf of the corporation, no self-employment tax has to be paid on any profit pass-throughs.

      1. The self-employment tax is equivalent to withholding for employees for Social Security and MediCare, but includes both the employer and employee portions; currently this is currently 15.3%. This is in addition to income tax.

  6. Limited Liability Companies

    1. Self-Employment Tax. With an LLC, each owner who a) is empowered to sign contracts on behalf of an LLC (which includes managing members and members of LLC’s that are member-managed) or b) spends more than 500 hours in a year on the LLC’s business probably has to pay the self-employment tax on ALL money that he/she receives that is in addition to his/her compensation as an employee (where withholding is already being done).

      1. While it is possible to try to avoid this by designating someone as the manager who is not a member (e.g., an affiliated corporation), that still does not help members who work more than 500 hours in a year on the LLC’s business.

      2. There is an exception if the income arises from real estate rentals. For example, if your business is solely involved in real estate leasing, the rental income generated estate would not be subject to the self-employment tax in an LLC.

    2. Tax on Revenues. One disadvantage to a California LLC is that it must pay a California tax based on the amount of revenues if the revenues exceed $250,000:

      California Tax on LLC Total Income

      (this is in addition to the $800/year annual franchise tax)

      $250,000 up to $500,000


      0.36% at $250,000; 0.24% at $375,000

      $500,000 up to $1 million


      0.5% at $500,000; 0.333% at $750,000

      $1 million up to $5 million


      0.6% at $1 million; 0.2% at $3 million

      $5 million or more


      0.2358% at $5 million

      1. Note that this tax applies only if the LLC’s annual revenues exceed $250,000.

      2. Assuming the revenues exceed $250,000, then based on this chart, the average LLC tax percentage is approximately 1/4 of one percent of revenues. (In contrast, the maximum rate that California taxes a C corporation is 8.84% of profits -- and there are federal taxes as well on a C corporation.)

  7. Limited Partnerships

    1. Two Entities Needed. The problem with a limited partnership is that you need to form two entities: the limited partnership and the entity for the general partner.

    2. Use in California. Still, assuming you need a California entity and expect it to have annual income in excess of $500,000, it may well be worth it to create a limited partnership with an LLC (or corporation) as the general partner holding a 1% interest.

      1. You want an entity as the general partner because the general partner has unlimited liability for the partnership.

      2. Only the general partner has any management rights. (As a result, each owner often owns a piece of both entities, but it does not have to be that way.)

      3. Since a limited partnership is not subject to the LLC income tax, the savings may outweigh the cost of setting up a second entity, filing two tax returns each year and paying the annual $800 franchise tax for both entities.

    3. Self-Employment Tax. Any self-employment tax is minimal, even if an LLC is used as the general partner, since the LLC has only a 1% interest in the limited partnership.

  8. Family Limited Partnerships and Family LLC’s

    1. A family limited partnership is simply a limited partnership where all the owners are family members. Similarly, a family LLC is simply an LLC where all the owners are family members. The purpose of these is to transfer business interests or real property to the next generation.

    2. A transfer of ownership to a child in excess of the $11,000 per person annual gift exclusion per person will reduce a parent’s lifetime gift tax exemption (currently $1.5 million) that is permitted under federal estate tax laws. For this reason, the value of the ownership transferred to a child is often discounted from a proportional share of the fair market value. There are at least two reasons to justify this.

      1. There is a substantial value in being able to control a business. If, as is usually the case, the ownership transferred at any one time is relatively small and therefore does not carry the ability to control the business, the value of the interest being transferred is less.

      2. Because there generally is no public market for the interests in the business, it is often difficult to sell the interests later.

      3. Discounts frequently range from 10% to 50%.

      4. It is important that these types of discounts be documented by an appraisal, in case the IRS challenges the discounted values.

  9. Series LLC’s

    1. Series Are Similar to Subsidiaries. A Series LLC is (so far) unlike anything else. At the moment, Delaware, Illinois, Nevada and Oklahoma allow the formation of a Series LLC.  There is a single LLC with one or more "series". Each "series" is treated much like a separate subsidiary – except there are not the same formation and administration expenses.

      1. Each series operates as its own profit/loss center.

      2. Each series may have different owners.

      3. Each series may have different management.

      4. Voting may be different for each series.

      5. There may be tax-free transfers within the LLC (though apparently this has not been tested).

      6. The assets of one series are, in theory, protected from the losses and liabilities of the other series.

    2. Adding and Dissolving Series. Additional series can be added by simply amending the "limited liability company agreement" (equivalent to an operating agreement for other LLC’s). A series may be dissolved by the vote of 2/3 of the ownership interests.

    3. Savings. For investors owning more than one piece of property, a Series LLC may offer significant savings over multiple regular LLC’s. Please note that the legal and accounting fees in the following chart may vary substantially from these figures.


      10 California LLC’s

      Single Del. Series LLC (with 10 series)


      Filing Fees in Delaware




      Filing Fees in California




      Legal Fees




      Accounting Fees




      Franchise Tax








      Also, the California franchise tax of $800 per year per entity in California is going to continue year after year.

    4. Liability Among Series. Delaware clearly intends its Series LLC law to prevent someone suing one series from pursuing assets held by other the other series. The question is whether California (and other states) will honor this approach. There are no cases on this point. Probably California will honor Delaware’s intent, given that California law requires it to respect another state’s determination of liability of its entities’ owners. Still, there is no guarantee. To minimize the chances of one series being held liable for another’s liabilities, the owners of a Series LLC should do the following:

      1. Keep the assets and operations of each series separate from the other series. Each asset should be owned solely by one series. In other words, two or more series should not be co-owners of the same property.

      2. Make sure each series is adequately capitalized.

      3. Have each series files a fictitious business name statement in each county where it owns property. Each series should have its own name and the filing should emphasized the ownership of that series, for example, "Abracadabra LLC, Blackacre Series only". This is to put creditors on notice.

      4. All contracts, deeds, notes, etc. should be signed in the name of the series. Again, use something like "Abracadabra LLC, Blackacre Series only".

      5. A separate bank account should be maintained for each series.

      6. Any loans between series should be properly documented.

      7. Any transactions between series should be conducted in an arms’-length manner at fair market prices using appraisals.

    5. IRS Tax Issues. Although this is not definite, some commentators believe that a Series LLC will be taxed as one entity for federal tax purposes (which is usually desirable) IF there is not too much disparity in the assets, members and managers among the series. To maximize the chances of this:

      1. Every member should own a least a minimum amount (perhaps at least 10%) in each series.

      2. The managers should be the same for each series.

      The reason is that, since there is then commonality of ownership and management, the IRS should find it difficult to find that each series is a different entity.

    6. California Income Tax Issues. Although there is nothing official on this point, commentators believe that California will tax only the income from series that are conducting business in California, rather than taxing all income of the LLC.

    7. California Franchise Tax on LLC’s. Although California does not appear to have any official position on this matter, California’s $800/year LLC franchise tax should apply only once, since the series are part of one LLC. In a recent phone call the Franchise Tax Board indicated this is the case. Still, there is nothing official.

  10. Trusts

    1. A "land trust" is basically a trust that holds title to land on behalf of the real owners, who are the beneficiaries of the trust. It is primarily a privacy-protection device: it allows buyers or owners of real estate to hold title in the name of the trust (or a numbered trust account) rather than in their own names.

    2. Regardless of whether it is a land trust or not, a trust by itself does NOT provide protection of assets held by the trust unless you make it a "spendthrift" trust and you make it irrevocable as well.

      1. In other words, the standard revocable ("living") trust often used for estate planning does NOT provide any protection of assets by itself: creditors of the person(s) who set up the trust can still get at the trust assets. (See "Protection Issues" under the heading "Choosing the State Where the Entity is Formed" above.)

      2. Also, if a trust owns several properties, liabilities regarding one may affect the others. (See "Number of Properties in an Entity" above.)

      3. Still, a revocable trust may own multiple LLC’s or corporations, each possibly holding its own single piece of real property.

    3. A problem until relatively recently is that you could not set up a spendthrift trust for yourself. Sensing a business opportunity, a handful of states – Alaska, Delaware, Nevada, Rhode Island and Utah – have passed laws since 1997 that permit this. For this to work, the trust must:

      1. Be irrevocable.

      2. Have an independent trustee.

      3. Not provide for mandatory distributions of income or principal (i.e., such distributions must always be subject to the discretion of the trustee).

      4. Have a spendthrift clause.

    4. Drawbacks.

      1. Many people don’t like the loss of control that comes with an irrevocable trust.

      2. Asset protection trusts are expensive. They can cost from $10,000 to $20,000 to establish, plus administrative and asset management fees that can add up to several thousand dollars a year.

      3. A big concern for many advisors is that domestic asset protection trusts have yet to be tested in court.

  11. Warning Regarding Transferring Property

    1. Transfers of property can affect 1031 exchanges, trigger transfer taxes and generate property-tax reassessments. Be careful.

    2. With 1031 exchanges, generally you cannot change the owners between the two legs of the exchange. In other words, the owners who sold the first property will need to be the same owners of the new property – and have the same ownership percentages.

    3. Transfers of some or all of an interest in a property can also trigger transfer taxes (at least to the extent of the value of the property transferred). Transfers, even partial ones, may also generate property-tax reassessments, and not just in California.

    4. Still, because a single-owner LLC (and probably an LLC owned by spouses) is considered "transparent" by the IRS, a sole owner of property (or spouses who own property) probably can sell a property in the first leg of 1031 exchange as an individual (or as a couple) and have the LLC take title to the new property. BUT check with your tax advisor first! In addition, this type of transfer probably will not be subject to transfer taxes or trigger a property-tax reassessment, but check with the county where the property is located before doing it.

    5. Also, in general, transfers of some or all of a property from one spouse to another generally do not lead to the imposition of transfer taxes or cause property-tax reassessments. Again, though, be sure to check with the county first.

    6. Once property is in an LLC, transferring some of the ownership interests in the LLC may cause transfer taxes or property-tax reappraisals (unless 2% or less is transferred in a given year).

  12. Using Self-Directed IRA’s to Invest in Real Estate

    1. Regular and Roth IRA’s – and 401(k) plans – can be converted to self-directed IRA’s that can invest in real estate.

    2. You cannot do this yourself; an IRA "administrator" is needed.

    3. Some companies that can do this (in no particular order) are:




    4. Be sure to first check that the company handles the type of real estate transactions that you are interested in – and is able to hold title to real estate in the state(s) in which you want to invest your IRA. (Many have a list of the states.)

    5. You also want an actual "custodian", not merely an "advisor".

    6. To protect other assets in the retirement account, you will want the retirement account to invest in an entity rather than be a direct owner of the real estate.

  13. Securities Laws

    1. Ownership interests in corporations, limited partnerships, and LLC’s are securities (except in some circumstances where all owners are actively involved in management of the LLC) and you must comply with securities laws – or the exemptions to them. If you sell interests in an entity without complying, you are in violation of the securities laws. What this means is that if you ever have an unhappy investor for whatever reason, you are in deep trouble.

    2. Generally, any kind of public advertising is strictly forbidden.

    3. For investors within California, often the 25102(f) exemption is used.

      1. There can be no more than 35 ultimate purchasers for the offering. (Husbands and wives count as one person; officers/directors/managers of the offering company who are also buying stock do not count towards the total; and certain sophisticated investors do not count against the total.)

      2. All purchasers must either:

        1. Have a pre-existing personal or business relationship with the company or any of its officers/directors/managers of such a nature and duration as would enable a reasonably prudent purchaser to be aware of that person’s/entity’s character, business acumen and general business and financial circumstances; or

        2. Have the capacity to protect their own interests in connection with the transaction, by reason of their business or financial experience or that of their professional advisors.

      3. Each purchaser must sign a document representing that the purchaser is purchasing for his/her/its own account and not with a view to sale of the interest.

      4. There can be no advertising or general (public) solicitation with respect to the sale of the interests. Communication of the opportunity may only be made to persons reasonably believed to meet the 25102(f) qualifications.

        1. As a result, print ads, television ads, and web site advertising are prohibited.

        2. Seminars in theory could be done, but one would have to have an extremely exacting pre-screening method.

    4. When non-California investors are involved, federal law and the laws of the other states where there are investors must be considered. Although it is limited to sophisticated investors (accredited investors are deemed to be sophisticated), federal Rule 506 is often used because it exempts the offering from all state regulation, which is a big advantage (although notices have to be filed in some states).

      1. Sophisticated investors are those who, either alone or with a purchaser representative, have such knowledge and experience in financial and business matters that they are capable of evaluating the merits and risks of the prospective investment.

      2. Basically, accredited investors are:

        1. Any organization not formed for the specific purpose of acquiring the securities offered and having total assets in excess of $5,000,000;

        2. Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;

        3. Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of the purchase exceeds $1,000,000; note that as of summer of 2010 the personal residence is not counted as part of net worth;

        4. Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income in the current year.

      3. You can only communicate the offer to those whom you know qualify as sophisticated or accredited; as with 25102(f) offerings, public advertising is forbidden. Some brokers maintain lists of investors that they have pre-qualified as accredited.

      4. If you can limit the offering to accredited investors only (no merely sophisticated investors), the amount of information that must be provided to the investors can be substantially reduced (although reasonable information still must be provided).

  14. Replacement Insurance Warning."Replacement" insurance may well not cover replacement of the building! See the attached August 31, 2004, articles from the New York Times – "Homeowners Come Up Short on Insurance" and "When Buffers Replace 'Replacement'" – for information on the problem and what to do about it.

Homeowners Come Up Short on Insurance

August 31, 2004


New York Times

EL CAJON, Calif. - Karla and Bruce Carroll remember the sheriff on his bullhorn ordering residents to evacuate and, minutes later, hearing the roar of monstrous flames arcing toward their modest home here in the hills above San Diego.

Mrs. Carroll grabbed a family photo album as they ran to safety; Mr. Carroll started to gather his fishing rods. But she hustled him along. "Don't worry about those things,'' she recalls saying at the time. "We've got insurance."

But, the Carrolls say, the insurance they bought from State Farm, the nation's largest property insurer, has left them at least $100,000 short of the cost of rebuilding their home. Today, nearly a year later, they are still wrangling with their insurer and living in a 29-foot-long house trailer on the land where their three-bedroom home once stood, overlooking a spectacular sweep of ridges and canyons.

Their woeful shortfall in insurance coverage, experts say, is a plight shared unknowingly by millions of American homeowners. It has been fed largely by a shift in the way property insurance has been sold in recent years.

In a move to cut costs from claims, insurance companies began in the late 1990's to phase out coverage that guaranteed the replacement of a destroyed home, regardless of the expense to the insurer. In place of that unlimited coverage, which had become nearly universal, insurers substituted a similar-sounding policy with a crucial difference: it pays only the amount stated on the policy plus, typically, an additional 20 percent to 25 percent.

For their part, insurers insist that it is the consumer's responsibility to acquire adequate coverage.

The old policy was called a guaranteed replacement policy. The new one, which most Americans now have, is called an extended replacement policy.

"People look at this and it says 'replacement' and they think, 'That's good, I get my house replaced,' " said John Garamendi, the insurance commissioner in California. "But they don't get their house replaced. They get money up to the set limits plus the extended 20 percent or 25 percent."

Marshall & Swift/Boeckh, a Los Angeles company that most insurers rely on for help in calculating the value of houses, estimates that 64 percent of American homes are underinsured by an average of 27 percent, with some homes underinsured by 60 percent or more.

Another insurance industry company, AIR Worldwide in Boston, estimates that many upper-income homes in New England are underinsured by 30 percent to 40 percent.

"The underinsurance problem lies just beneath the surface all across the country,'' said Robert P. Hartwig, the chief economist for the Insurance Information Institute, a trade group in New York.

The insurance gap has been worsened by the nationwide housing boom that has been rapidly driving up the cost of lumber, bricks, cement and other construction materials, industry executives say. And in Southern California, rebuilding costs soared even higher as the demand for contractors and building supplies suddenly jumped after the Carrolls' home and several thousand others were destroyed in wildfires over a few days last October.

But such explanations do not satisfy the industry's critics, who say insurers have shifted the burden of such mistakes onto homeowners.

"Most people go to their insurance agent to buy coverage and figure they're fully covered," said J. Robert Hunter, the director for insurance at the Consumer Federation of America. "But often they're not."

The issue of underinsurance has not attracted much attention because, of the millions of insurance claims every year, fewer than 2 percent are for the total loss of a house. But the wildfires here last fall came as a jolt. They quickly incinerated more than 3,700 homes and, Mr. Garamendi said, "a very large proportion" of them were underinsured.

Consumer advocates and industry executives expect similar problems for the victims of Hurricane Charley in Florida as they begin working through their claims.

"The problem is everywhere,'' Mr. Hartwig said. "The disasters simply expose it.''

George Kehrer, a lawyer and building contractor who founded Community Assisting Recovery in Los Angeles more than a decade ago to help people with insurance claims after disasters, said he had spoken to 1,200 people who lost homes in the California fires.

"About a dozen of them,'' he said, "were adequately insured."

No single factor is entirely to blame for the underinsurance, consumer advocates and industry executives say. Homeowners, they say, need to recognize their own responsibility.

But under pressure to make sales, Mr. Garamendi and consumer advocates explain, insurance companies and their agents often aim low in valuing houses. The goal, they say, is to keep premiums down to keep customers from going to competitors, and sometimes even a few dollars can make a difference.

"If they quote a realistic replacement cost, the price of the policy goes up," Mr. Garamendi said, "so they are motivated to keep the replacement cost down."

Insurance industry executives argue that it would make no sense to undervalue homes intentionally. The higher the insurance coverage, the higher the premium, they point out.

But Mr. Garamendi disagrees. "You want the sale first," he said. "O.K., you can get a little more premium if you give full coverage. But you lose the sale."

Mr. Hunter, the consumer advocate, said agents often lacked the training to assess accurately the value of a home, usually done these days with the help of a computer program. Rarely do the agents leave their offices to assess a house personally, agents and industry executives said.

Mr. Garamendi said some agents inadvertently undervalued homes by using a computer shortcut to obtain what is known as a "quick quote." Then, when a customer decides to buy coverage, the agent fails to add details like designer cabinets and fixtures that tend to increase the replacement estimate and the cost of the insurance.

While most insurance policies include a built-in escalator to keep pace with general inflation, the costs of building supplies and paying for construction crews have been rising at a faster pace, in many cases widening the gap between the amount a house is insured for and what it will cost to rebuild it.

Another factor in the insurance gap has been a failure by some homeowners to increase coverage after the spurt in home improvements, from new kitchens to extra bedrooms, as millions of Americans have used cheap money from mortgage refinancings in recent years to upgrade their homes.

Still, in dozens of interviews over several days this month, owners of the homes in Southern California that were destroyed said repeatedly that they had been led to believe they had bought enough coverage to rebuild their homes and were stunned to find out they were wrong.

Mrs. Carroll said she first bought her insurance from State Farm in 1998 shortly after she and her husband acquired their home for $172,500.

"I told them I wanted full coverage for my house," she said. "I've lived in this area most of my life, and I knew there was a huge fire risk here. I had been evacuated for fires three times as a child."

Two years later, she said, she checked back with the agent to make sure she had enough coverage and increased the coverage for possible additional costs as a result of changes in building codes.

"I said, 'Are you sure this is enough to replace the house?' and she said, 'Oh, that's plenty of coverage,' " Mrs. Carroll recalled. "She had me convinced my house could burn or fall down in the canyon under heavy rains and, yeah, it's covered."

At the time of the fire, the Carrolls' house was insured by State Farm for $126,000, which, following standard practice, did not reflect the value of the land. Their annual premium was $730.

With 20 percent in extended replacement coverage and other standard features including a built-in adjustment for inflation and coverage on their two-car garage, fences and driveway as well as an additional 25 percent for anticipated building code changes - upgraded by Mrs. Carroll from the usual 10 percent - the Carrolls estimate their policy will pay them about $222,000. But Mrs. Carroll said a contractor hired by State Farm estimated that replacing their losses, not including their clothing and other personal things, would cost nearly $400,000.

Bill Sirola, a spokesman for State Farm, said it was not clear whether the Carrolls were underinsured. "We are working with that family," Mr. Sirola said. "We are working with other builders on their behalf to get other estimates of their rebuilding costs."

As the insurance companies see it, if people are underinsured it is primarily their own fault.

"It's the homeowner's responsibility to see that his home is properly insured," said Mr. Hartwig of the Insurance Information Institute.

Insurers say the terms of coverage are clearly spelled out in their policies. In California, insurers are also required to mail a statement annually specifying the terms of coverage along with renewal notices.

But many homeowners burned out by last year's fires say they made clear they wanted to be able to replace their homes. In interviews, they said they had no way of knowing how much insurance they needed and relied on the agent to set the proper value and charge the appropriate price. Many say they would have been willing to pay more to assure themselves that their losses would be fully covered.

"They're the experts," said Donald McCormick, a high school math teacher, who lost his home in the Scripps Ranch section of San Diego. "I don't go to the doctor and tell him how to do surgery."

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When Buffers Replace 'Replacement'


New York Times

Published: August 31, 2004

In the event of the total loss of a home, most insurance policies these days provide for the payment of the amount stated on the policy plus, typically, an additional 20 percent to 25 percent.

This is often referred to as extended replacement coverage. Sometimes the term itself is not used, but an additional amount equal to, say, 20 percent of the stated value is shown on the policy.

Policies that pay to replace a home regardless of the cost to the insurer are called guaranteed replacement cost policies. Premiums on this coverage are generally 20 percent to 25 percent higher than for the other policies, but only a few companies sell them and they are usually available only for homes with a replacement value of $500,000 or more.

The policies with coverage limits are intended to pay for the replacement of a home. But they will do so only if the house is accurately valued and insured for that amount.

The additional 20 percent or so is intended as a buffer in case the insured amount proves too low. But the buffer can be easily nullified if a policy is not regularly updated.

To reduce the chances of getting the insured value of a house wrong, consumer advocates and insurance industry officials recommend that homeowners get a second opinion when buying coverage. Independent contractors and public claims adjusters, whose business is negotiating claims settlements with insurance companies, will estimate the cost of rebuilding a house for a fee of a few hundred dollars, depending on the size and construction of the house.

Once a house is insured, the owner should review the coverage with the agent each year and specifically consider the rise in costs of building materials, not just the general rate of inflation.

Coverage should be increased whenever a house is remodeled. Prices for coverage vary widely across the country and according to the type of house. But State Farm, which is the largest home insurer and like most others in the business sells extended replacement coverage, says that its average coverage is for $160,000 at a premium of $700 a year. To increase that coverage by $20,000, to $180,000, costs an average of about $80 a year. It costs another $60, or a total of about $840 annually, to raise the coverage to $200,000. The additional insurance also increases the coverage for personal property and other buildings like garages.

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