Throughout ancient history, the most powerful monarchs in the world built grandiose cities that were the epicenter of trade, commerce, art and civilization.
Rome, Athens, Babylon, Constantinople just to name a few, all had a similar configuration. The center of the city was a reflection of the monarchs own power and wealth with its royal palaces, buzzing markets, amphitheaters and temples. But in the outskirts, there were always strong walls to protect the city from possible attacks from those who were after the riches that the center offered.
In my opinion, that is an excellent metaphor for the crucial importance of a solid asset protection strategy for your long term real estate investing. When you execute our Blueprint real estate investing strategy, the goal is to build something beautiful that allows you to accomplish extremely important goals. A net worth that’s large enough to produce an income that gives you freedom. Which in turn removes most obstacles so you can pursue the life you want, whatever that entails. Follow the time tested principles we outline and you will build your beautiful “city center”.
But that beautiful thing you built, requires a strong, impenetrable wall around it to protect it from outside threats. Neglect asset protection and all your disciplined efforts and sacrifices expended over a decade of investing could all have been for naught.
Liability exposure for real estate investors
Real estate investors face two major types of liability that a solid asset protection strategy can help combat. The first is liability associated with the asset(s) owned by the investor. Namely, one of your tenants can slip and fall on some unstable steps, hurt themselves and sue the investor for damages. Or one of the tenants’ kids has a friend in the neighborhood whom he likes to wrestle in the backyard of your property. If the friend gets hurt, their parents can sue the owner of the property for damages. And so on. The second type is liability associated with the investors themselves or their dependents. For instance, if the investor gets into an automobile accident and hurts another person, attorneys for that person could pursue assets owned by the investor to collect damages in the case. Similarly, if a dependent of the investor (i.e. son or daughter) causes harm to another person, the same thing could happen.
In either type of liability, if the investor owns property in their own name, the liability exposure could wipe out everything the investor has worked so hard to build including his primary residence and personal assets since there’s no separation between those assets and the investment properties. Since they’re owned by the same entity (the investor), everything is fair game.
Liability insurance
But what about liability insurance – Doesn’t liability coverage in your home insurance policy or in an umbrella liability policy dispel that exposure completely? No and for two reasons. First, I don’t know if you’ve heard but insurance companies aren’t in the business of paying claims. They’re in the business of collecting endless premiums while only paying a small portion of them out to claims. They achieve this by including several varieties of exemptions in their policies. More specifically, these are cases in which your policy wouldn’t cover you. And they’ve gotten so good at this premium collection business that they exempt themselves from liabilities that tend to occur most often. Second, are you sure you want to be involved in a lawsuit even if the liability policy ends up covering part of the damages? A side of lawsuit wasn’t exactly what you had in mind when you made this investment in the first place. So, while ample insurance coverage can sometimes treat the problem, a proper asset protection strategy prevents it from happening in the first place or from spreading further once it happens.
Enter the mighty LLC
The consensus amount asset protection specialists is that a Limited Liability Company (LLC) is the best vehicle in which to hold long term investment real estate. An LLC is a standalone legal entity so it offers adequate separation between the investors personal assets and her investment portfolio. But unlike some corporation structures it doesn’t come with the burden of double taxation. When you hold investment assets under the umbrella of an LLC, your liability exposure is limited to the assets owned by that LLC. For instance, if someone slips and hurts themselves on a property owned by an LLC, only the assets held within that same LLC are subject to being pursued for liquidation of damages but not the investor’s personal assets or assets held in different LLCs.
Okay then – You’re sold on this LLC idea. Let’s buy all your assets in the name of your LLC or transfer ownership of your existing assets into an LLC. Two major problems with that plan:
- No Lender will allow you to buy properties in the LLC from the start because they want you to be personally liable for the mortgage loan.
- If you transfer the ownership of your assets into an LLC after closing, your Lender will view that transfer as a sale. And in your mortgage note there’s a “due on sale” clause that gives your Lender the right to accelerate your mortgage (read: require you to pay full amount right away). This transfer triggers that due on sale clause which you really don’t want to do.
So you must purchase the property in your own name to satisfy Lender requirements, then transfer ownership to the LLC without triggering the DOS clause. But how?
The Land Trust Workaround
The vehicle that allows the long term real estate investor to enjoy the protection offered by the LLC without getting on their Lender’s bad side is the land trust. They’ve been around since the Roman empire with widespread use during the reign of Henry the VIII with the primary purpose to conceal the ownership of property. So if you were an aristocrat in the fourteenth century and didn’t want people to know you owned a piece of property, you would hold it in a land trust of which you were the beneficiary. If someone were to look up the property records they’d see the property was owned by the trust and they would be unable to know who was the true owner of the property.
Land trusts are the best antidote to triggering the due on sale clause. For this to happen, the investor hires an attorney to set up a land trust of which she is the beneficiary – then deeds the property to that land trust. This transfer is not viewed as a sale by the Lender and as such does not trigger the due on sale clause. Afterwards the investor assigns the beneficiary rights of the land trust to the LLC through an attorney drafted document. So the investor owns 100% of the LLC which is the beneficiary of the land trust in which the property is held. Asset protection plus no due on sale trigger.
—
One important note to consider is that I’m not an attorney (nor do I play one on TV) so always consult an attorney before you execute an asset protection strategy.
Erion, nice article. Is the land trust in place solely for the benefit of not triggering the due on sale clause? In other words, if purchasing a property outright would it be best to just use the LLC?
That’s correct, Glenn. If you are paying cash for the property then just take title in the LLCs name from the start. Unless you wish to make it hard on people to find out the true ownership of the property – in which case you would use the land trust to achieve that.
There are a few caveats that I think you should mention regarding the land trust.
1. The same person cannot serve as Trustor, Trustee, and Beneficiary. The Trustee must be an individual, not a LLC.
2. Trust law in Texas falls under the Property Code, whereas the law of business entities (such as LLC´s and corporations) falls under the Business Organizations Code “BOC”. Trusts can hold property, but there is no liability barrier against lawsuits as is the case with entities that are formed under the BOC.
Basically a land trust in Texas doesn’t help you at all. I came to this conclusion many years ago after consulting with lawyers.
The best solution if you want asset protection and to avoid triggering the due on sale clause is to put the properties into a Family Limited Partnership. See Garn–St. Germain Depository Institutions Act of 1982.
Hi Robert
You make some great points. As I was writing this last night, I hit the 1200 word mark and thought I should probably leave the details for an additional post.
“The same person cannot serve as Trustor, Trustee, and Beneficiary. The Trustee must be an individual, not a LLC.”
That’s absolutely correct. In fact, most investors that follow this strategy will have split such duties among themselves, their spouse and their attorney.
“Trust law in Texas falls under the Property Code, whereas the law of business entities (such as LLC´s and corporations) falls under the Business Organizations Code “BOC”. Trusts can hold property, but there is no liability barrier against lawsuits as is the case with entities that are formed under the BOC.
Basically a land trust in Texas doesn’t help you at all. I came to this conclusion many years ago after consulting with lawyers.”
Actually, the trust itself does not provide any sort of liability protection at all. As I mentioned, it was created as a vehicle to conceal the ownership of the asset. However, my understanding is that when an investor assigns the beneficiary rights to the land trust to the LLC that creates a liability firewall. In other words, someone who has a claim against the asset held in a trust, would pursue its beneficiary to recover damages and since the beneficiary is an LLC your exposure is limited to the equity of assets held within that LLC.
“The best solution if you want asset protection and to avoid triggering the due on sale clause is to put the properties into a Family Limited Partnership. See Garn–St. Germain Depository Institutions Act of 1982.”
I’m not familiar with the implications of holding a property in a FLP for liability protection purposes. But the Garn- St Germain Act is specifically the law that allows anyone to place real estate into a trust without triggering the due on sale clause. One concern I would have with holding the property in a limited partnership of any kind is that one of the partners typically has to be a general partner and therefore carry no liability protection whatsoever. Would love to hear if there’s a workaround for that.
Thanks for your comment. I appreciate it and keep them coming please.
There’s a very nasty potential problem with the Family Limited Partnership approach. Down the road you want to execute a tax deferred exchange. Not a problem whatsoever with the IRC. However, once sold, you then find the property(s) you’ll be acquiring. IF you require a loan(s), the lender will politely ask you to get the property out of the partnership. At that point, at least in the vast majority of cases, you’ve just blown up your 1031 exchange. Not always, but usually.
Erion’s take on land trusts is accurate. They’re meant to merely hide ownership, not provide further protection.
There are LLCs out there not required to file tax returns. This is a question you should absolutely pose to an asset protection attorney. Period — no exceptions.
And that’s one of those things you only know when you stop counting after a few hundred successfully executed tax deferred exchanges, folks. No substitute for experience.
I strongly second the course of seeking the advice of an attorney that specializes in asset protection. In many cases you get a general lawyer that doesn’t foresee problems that a short term solution can create in the long term.