Asset Protection

Note: Today I have the honor of welcoming Scott Smith as an expert guest contributor to Investing Architect. Scott is an Attorney that specializes in asset protection strategies for long-term real estate investors. He is a real estate investor himself and uses the same strategies he will share with us to protect himself and his portfolio. What I admire most about Scott’s writing is that it is all substance and no fluff. Enjoy!

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*** This information is not legal advice and I am not your attorney***

A proper asset protection strategy protects your net worth even if you are sued. Below, I will share with you the secrets that will have you sleeping easy at night and going about your business as usual even when you’re being threatened by a lawsuit. You won’t have to worry about what will have your friends aging overnight. After implementing a proper strategy, lawsuits will never even get filed and the problem is gone before it begins.

Asset Protection for real estate investors is premised on two parts:

1. Isolating the assets for liability purposes inside of a Holding Company and
2. Hiding the assets from being connected to you or the Holding Company

Additionally, this company structure is scalable at no additional costs or fees, streamlines your taxes, can be used in conjunction with traditional financing, and allows for the traditional recording keeping you are already using.

After it is set up, you won’t even notice it’s there in your normal course of business.

Which type of company should I use to hold my investment real estate?

The best holding company for real estate asset protection is the Series LLC. You can think about the Series LLC as a Parent – Child relationship. The Series LLC is the Parent, and it can have as many children as it wants. Each child is known as a ‘Series’.

Even though the Series LLC is technically one company with one filing with the state and one tax return, each child ‘Series’ is treated as if it were its own LLC for liability purposes.

Each Series is typically designated with its own letter, e.x. Series A (See the picture below). This means that if a lawsuit is filed against Series A, it cannot affect Series B, Series C, etc. A lawsuit against Series A can only affect the assets held in Series A.

In the diagram above, the REI Asset Holding LLC has three Series. Each Series has only one property held by it. REI Asset Holding LLC – Series A owns a single asset, a piece of Real Property located at 123 Main st. As such, since Series A only holds that single piece of real property, a lawsuit against Series A does not jeopardize the real property located at 456 Main st. or 789 Main st.

Moreover, if there was a lawsuit against the owner of the parent REI Asset Holding LLC, that lawsuit could only collect against the assets of the owner and not against the assets of REI Asset Holding LLC. In this way, a lawsuit against the owner of the LLC does not affect his or her assets. [1]

How to stop a lawsuit before it starts

The Series LLC limits our downside risk in the event of a lawsuit since it limits the maximum amount we can lose, the amount held in the Series. However, limiting the amount of the lawsuit is our last resort. What we want is a protection system is that stops the lawsuits before they are ever filed.

To stop a lawsuit before it is filed you have to take out one of the three essential pillars of a lawsuit – what you need as a litigator to make a case worthwhile:

1. The law
2. The facts
3. The recovery

The law and the facts are generally easy to fabricate, and any decent lawyer can find a basis for a lawsuit that will survive summary judgment. The asset protection system I put in my place for my clients attacks the third leg, the recovery. The recovery is the ability to seize assets and get paid after you win a judgment. A judgment is worthless on its own, it is only a piece of paper. It is only as good as the assets you can seize with it.

So, before a case is filed an attorney will always research whether there are assets which he can seize from the defendant in the case that he wins. If it appears that the defendant has very limited or no assets, then in all but the cases but personal self-righteous vindication will the lawsuit be foregone.

To show the opposing side that there will be no recovery from the lawsuit we hide the assets using Anonymous Trusts. These Anonymous Trusts can own the LLC itself as well as serve as Title Holding Trusts for the real estate asset.

The LLC typically must disclose the members of the LLC on the filing instruments called the Articles of Incorporation. However, the member listed on the filing can be an Anonymous Trust. Since the Anonymous Trust is a private document and it is not filed with the State, anybody researching the Owner or Beneficiary of the Trust will be unable to find that information in the public records.

Additionally, anyone researching the owner of the real estate asset by searching the County Clerk records will only find the name of the Anonymous Land Trust. Typically, the property owner’s name is listed on the County Clerk’s records, but in this case, the owner of the property would be listed as the 123 Main St. Trust. Since the Owner of Trust and the beneficiary is not registered with the state, they cannot find out that the Series LLC is the beneficiary of that Trust.

For the purposes of clarity, I refer to the Anonymous Trust used for the purposes of filing the LLC itself as the “Filing Agent Trust” and the Trust used for holding the real property as the “Anonymous Land Trust”. The Filing Agent Trust in the below example is the actual owner of the Series LLC.

What should I expect for tax planning

The taxation structure with the above entity is typically done in one of two ways depending on the number and type of owners. If the owner is a single individual or a married couple, then the entire structure is a pass-through entity and the investor owner(s) simply report the income on their personal income tax return under Schedule E. If the owner-investors are unmarried, then the LLC will need to file a partnership tax return.

Financing inside of a company structure should only be done once traditional personal financing is exhausted. Traditional financing is typical with better, cheaper terms than the commercial financing required if the property is purchased directly in the name of the LLC. Once the property is purchased in your personal name, the property will need to be deeded into the company structure. Deeding the property into the company structure will violate the Due On Sale clause located in the mortgage; however, we have not seen a bank foreclose based upon the Due On Sale clause since before 1960 as long as the payments are made. I hear of lots of threats, but I have not seen any banks actually do it.

How do I make sure my LLC is not “pierced”

There are several things you must do to keep an LLC from being pierced:

1. Filing franchise tax
2. Having an operating agreement
3. Managing the money correctly

Where I see most of my clients drop the ball is in money management and record keeping.

The recording keeping of the above structure is likely very similar to what you already do for your basic accounting of the investment. For any investment, you need to know the profitability of the particular asset purchased, so you need to have records which reflect the amount of capital invested in the asset, the amount earned by it, etc.

The Series LLC structure above will require you to maintain the records of each Series separately just as if they were separate companies. In many cases, all this requires is for you to “tag” the entries in your QuickBooks so that the entry is shown in correlation to the specific company. If you do not use QuickBooks and instead use an excel spreadsheet, then be sure to add a new entry any time you add or withdrawal money from the bank account for the company. If you forget to do this a few times it is not the end of the world. You can always go back after and “catch up” on the accounting. The Court will allow this as long as it is “reasonable”: nobody expects you to be perfect, but don’t abuse it.

***Note: This information is not legal advice and I am not your attorney***

[1] Please note that this is not true in all cases, but it is the case per the Business Organizations law for Texas companies.

A few weeks back I wrote about how long term real estate investors can protect themselves from liability exposure.

That article argued that a wise investor that builds a great long term real estate portfolio must also build a strong impenetrable “wall” around it for protection.

A properly constructed asset protection strategy protects you in two primary ways. First, it protects you and your other assets from liability that might arise from your ownership of investment real estate. In that sense, it creates separation between your “personal” assets (primary residence, cash, stocks etc) and your real estate portfolio. Second, it protects your real estate assets from liability that might arise from your ownership of other real estate assets. In other words, it should prevent “liability contamination” within your portfolio.

The proposed solution to these issues is the utilization of limited liability companies as a holding vehicles. And to avoid triggering the due on sale clause in their mortgage, investors should setup land trusts. So far so good.

But after several conversations with current clients on that very strategy, I realized that there were still many unanswered questions. For instance:

Should each property have its own dedicated LLC or should you hold your entire portfolio in one LLC?

If you setup dedicated LLCs will you need to file taxes for each LLC each year and is that practical?

Will you lose important tax benefits like depreciation and tax deferred exchanges if the property is held in an LLC?

Let’s address each of those questions individually.

From a purely asset protection standpoint, setting up dedicated LLC for each property is the optimal solution as it covers both bases. It creates a separation between your personal assets and real estate portfolio as well as insulates your real estate assets from each other.

But from a pragmatic or practical standpoint it may be a bit overkill. For instance, in investment blueprints that involve the acquisition of 9 or more properties, that means there are  at least nine LLCs, nine tax ID numbers and nine bank accounts to setup, pay for and maintain.

On the opposite end, you could put everything into one LLC and it would be practical and easy to setup. But while you would create a wall of separation between your personal assets and real estate holdings, a liability issue with one property could take down your entire portfolio. And your retirement plans with it.

So a good middle of the road solution is to hold about two to three properties in a single LLC. That way you protect from liability contamination within your holdings and keep it practical.

What about tax returns? Will you need to file taxes for each LLC each year and won’t that get cumbersome and pricey?

Actually, no. When you setup your LLC you are given an option to make an election for “disregarded status”. That means, the LLC will be disregarded for tax purposes and will not be required to file annual tax returns. The gains or losses from the properties held in these LLCs will just flow through to your personal tax return. It’s important for you to make this election otherwise you will question the necessity of your asset protection plan come April 15. You will save yourself a lot of headache and dollars.

Finally, for those who are concerned about losing tax benefits by holding properties in an LLC – there’s no need to worry. Whether you hold a property in your own name or in an LLC, depreciation and mortgage interest expenses are used to offset the rental income the property produces in a given year. Then, the resulting gain or loss simply flows through to your personal tax return and there its treated in accordance with your personal tax bracket and particular situation. One item of concern is that LLC aren’t allowed to perform a tax deferred exchange by the IRS. So if you are holding the properties in a trust whose beneficiary is the LLC, you should transfer those beneficiary rights and close the sale under your personal name. Then perform the 1031 exchange in your own name and transfer the new property into a trust yet again.

tropicaLiving – Jessy Eykendorp via Compfight

Note: I am not nor do I pretend to be an attorney. Which is why I direct all my clients to an attorney that specializes in asset protection. You should always consult an attorney prior to executing any asset protection strategy.

A few weeks back I wrote about how long term real estate investors can protect themselves from liability exposure.

That article argued that a wise investor that builds a great long term real estate portfolio must also build a strong impenetrable “wall” around it for protection.

A properly constructed asset protection strategy protects you in two primary ways. First, it protects you and your other assets from liability that might arise from your ownership of investment real estate. In that sense, it creates separation between your “personal” assets (primary residence, cash, stocks etc) and your real estate portfolio. Second, it protects your real estate assets from liability that might arise from your ownership of other real estate assets. In other words, it should prevent “liability contamination” within your portfolio.

The proposed solution to these issues is the utilization of limited liability companies as a holding vehicles. And to avoid triggering the due on sale clause in their mortgage, investors should setup land trusts. So far so good.

But after several conversations with current clients on that very strategy, I realized that there were still many unanswered questions. For instance:

Should each property have its own dedicated LLC or should you hold your entire portfolio in one LLC?

If you setup dedicated LLCs will you need to file taxes for each LLC each year and is that practical?

Will you lose important tax benefits like depreciation and tax deferred exchanges if the property is held in an LLC?

Let’s address each of those questions individually.

From a purely asset protection standpoint, setting up dedicated LLC for each property is the optimal solution as it covers both bases. It creates a separation between your personal assets and real estate portfolio as well as insulates your real estate assets from each other.

But from a pragmatic or practical standpoint it may be a bit overkill. For instance, in investment blueprints that involve the acquisition of 9 or more properties, that means there are  at least nine LLCs, nine tax ID numbers and nine bank accounts to setup, pay for and maintain.

On the opposite end, you could put everything into one LLC and it would be practical and easy to setup. But while you would create a wall of separation between your personal assets and real estate holdings, a liability issue with one property could take down your entire portfolio. And your retirement plans with it.

So a good middle of the road solution is to hold about two to three properties in a single LLC. That way you protect from liability contamination within your holdings and keep it practical.

What about tax returns? Will you need to file taxes for each LLC each year and won’t that get cumbersome and pricey?

Actually, no. When you setup your LLC you are given an option to make an election for “disregarded status”. That means, the LLC will be disregarded for tax purposes and will not be required to file annual tax returns. The gains or losses from the properties held in these LLCs will just flow through to your personal tax return. It’s important for you to make this election otherwise you will question the necessity of your asset protection plan come April 15. You will save yourself a lot of headache and dollars.

Finally, for those who are concerned about losing tax benefits by holding properties in an LLC – there’s no need to worry. Whether you hold a property in your own name or in an LLC, depreciation and mortgage interest expenses are used to offset the rental income the property produces in a given year. Then, the resulting gain or loss simply flows through to your personal tax return and there its treated in accordance with your personal tax bracket and particular situation. One item of concern is that LLC aren’t allowed to perform a tax deferred exchange by the IRS. So if you are holding the properties in a trust whose beneficiary is the LLC, you should transfer those beneficiary rights and close the sale under your personal name. Then perform the 1031 exchange in your own name and transfer the new property into a trust yet again.

tropicaLiving – Jessy Eykendorp via Compfight

Note: I am not nor do I pretend to be an attorney. Which is why I direct all my clients to an attorney that specializes in asset protection. You should always consult an attorney prior to executing any asset protection strategy.

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:

1. 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.
2. 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.

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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.

Phillip Capper via Compfight