The Nevada State Legislature recently passed the mortgage mediation law great fanfare. The law was expected to save as many as 17,000 Nevada homeowners from foreclosure. The law, which went into effect July 1^st, allows homeowners in default to request a mediation hearing with the lender.

To be eligible a homeowner must have received a notice of default after July 1, 2009. The homeowner must pay a fee of $200 if they request a hearing and the lender is also required to pay a $200 fee. In anticipation of a flood of requests, the state has trained in excess of 100 lawyers and ex-judges to handle the cases.

Where is Everybody?

The official estimates were that between 1,250 and 1,500 homeowners per month would participate in the program. However, after six weeks there have been a total of ten requests. Not ten per day or ten per week, just ten total. That amounts to 1.67 requests per week! How did they get it so wrong?

 The fee may have kept some from asking for mediation but $200 isn’t exactly an exorbitant sum. The more likely reason is that no amount of mediation helps someone who has lost a job. If a payment is reduced from an unmanageable figure to a lower, but still unmanageable amount, does it make a difference? People who are significantly underwater, or owe much more than a home is worth, don’t see the benefit of a lower interest rate or more time to pay.

Starting Over

So many people have made a decision to walk away from their obligation and start over. It is happening to so many people that the stigma seems to have disappeared. In the Las Vegas area just about everyone knows someone who is in foreclosure. It is not limited to one income group either, many multi-million dollar homes are being taken back by the banks.

 The idea of mandatory mediation may have been a good idea. Why not see if there is a solution to foreclosure? However the Government grossly overestimated the demand for the program. Imagine that, the Government got it wrong.

The government solution to a problem is usually as bad as the problem. – Milton Friedman

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

What If We Had A Mortgage Mediation Party And Nobody Came?

While visiting the Starting Out Forum here on BiggerPockets, I read through a thread titled “LLC Controversy”. Instead of responding to the thread directly, I decided to write this blog to address a fundamental issue for every investor, myself included: Why even bother setting up a business entity if my assets will be attached from a lawsuit arising from the acts of the business?

This thread started because of some erroneous information that was posted on another, very well known website, regarding business entities. I am absolutely astonished at the level of incorrect information that circulates to investors from various websites regarding business entities. Most often this misinformation is advanced by a gurus to steer you into to their complex webs of trusts and business entities. Let’s set the record straight:

It is extremely difficult to lose liability protection of your business if you follow a few simple rules.

Types of Liability Exposure

Before we delve into how you could potentially lose liability protection, it is important to understand the two different types of liability exposure when dealing with businesses and owners: Outside Liability and Inside Liability.

• Outside Liability refers to injuries (personal and financial) that occur in connection with the owners of the business personally and have no direct connection to the business activities. Example: I get into a car accident on my way home from work, this accident had no direct connection to the fact that I own several LLCs.
• Inside Liability refers to injuries (personal and financial) that occur within the business activity. As investors, the most common form of inside liability we are likely to see is if a tenant is injured on the property.

The level of protection your business assets receive if you, as the owner of the business, are sued (outside liability) depends solely on the laws of the state in which you are conducting business. Whether or not your separate business assets will be subject to attachment in a personal lawsuit is dependent on whether a charging order is the exclusive remedy for judgment creditors in that state.

Piercing the Veil

The main focus of this blog is whether or not you as the owner will be personally protected if the business is sued based on inside liability. Holding the owners of the business personally liable for injuries associated with the business is known as Piercing the Veil. The laws in all 50 states actively encourage formal business activity as a way to stimulate the local and state economy by encouraging businesses to conduct activities in their jurisdictions, albeit there are certainly more favorable states to conduct business activity. Even in the most pro-creditor states (i.e. California), businesses are still formed and operated because laws are designed to create a vehicle for business owners to remove themselves from personal liability exposure based upon the activities of their formal business structures. Here’s the relevant section of the California Corporations Code relating to LLCs:

17158. (a) No person who is a manager or officer or both a manager and officer of a limited liability company shall be personally liable under any judgment of a court, or in any other manner, for any debt, obligation, or liability of the limited liability company, whether that liability or obligation arises in contract, tort, or otherwise, solely by reason of being a manager or officer or both a manager and officer of the limited liability company.

As you can see, there is not automatic liability exposure for the owner of the LLC simply because that person is also a manager. The contrary is true; courts go out of their way to respect the separate existence of the business entity provided that the owner of the company followed a few necessary rules:

• The business was not undercapitalized.
• The formal requirements of the business were followed.
• The owner did not use the business as his or her alter ego.
• The owner did not use the business to perpetrate fraud.

Courts allow for the pierce of the veil as a matter of equity when the aforementioned conditions are not followed.

The Business is Undercapitalized

Undercapitalization simply refers to the business not having enough money or assets. Most states do not require a set amount to be contributed into the business account when the business is formed. Additionally, most courts do not have a bright line rule when determining whether or not there are sufficient assets within the business to satisfy its obligations. The main factor that is always addressed when determining whether or not a business is undercapitalized is the liabilities associated with the business activities.

In order for your business to be respected as a separate business entity, you must operate your business in a reasonably prudent manner. What is reasonably prudent capitalization when we are dealing with our companies that hold our investment properties? There should be sufficient funds in the business account to cover ordinary and necessary expenses associated with maintaining the business’s investments. This does not mean that we can’t put more money into our company to cover a major expense such as having to replace a roof. The business must hold funds to cover costs that arise in the course of regular business activity.

The one way I have seen courts pierce the veil when dealing with real estate investments due to undercapitalization occurs when the business owner cancels the insurance coverage on the property once it is transferred into the business entity. We cannot use our businesses as a substitute for insurance and vice versa. If a tenant is injured on the property it would not be viewed as reasonably prudent to hold assets with potential liability exposure without having the necessary insurance to cover the potential harms. This is a prime example of the court finding that it would inequitable for the owner of the business to escape liability exposure for harms that could be reasonably anticipated and easily insured against.

Failure to Follow the Formal Requirements

Each business has its own formal requirements that must be met in order for it to be respected under the laws of the state and to be allowed to avail itself to the protections offered by the state. As an owner of a business, you are going to have to comply with the formal requirements of the business entity that you have created.

Corporations: Corporations generally will have the largest number of formal requirements. In almost every state at a bare minimum the following requirements must occur upon its creation and on an annual basis.

o File Articles of Incorporation with the State
o Bylaws
o Organizational Meeting (minutes must be taken)
o Initial and then Annual Shareholders Meeting (minutes must be taken)
o Initial and then Annual Directors Meeting (minutes must be taken)
o Maintain the business in “good standing” with the Secretary of State by filing Annual Reports

• LLCs are generally less cumbersome and can generally dispense with the meeting requirements of the corporation. However, it will be the Operating Agreement of the LLC that dictates what requirements must be met, if your Operating Agreement states you have to have at least an annual meeting, you better have the annual meeting. Unless stated otherwise in the Operating Agreement ,generally all that will need to be done with the LLC is:

  o File Articles of Organization with the State
  o Maintain the business in “good standing” with the Secretary of State by filing Annual Reports

  It is extremely important to follow the necessary documentation requirements because it is this documentation that will serve to protect you from having the courts pierce the veil and hold you personally liable.

Alter Ego Doctrine

Business entities provide protection because they are a separate legal entity from the owner. The Alter Ego doctrine states that the separate nature of the business will not be respected if the owner used the business as an extension of his or herself (alter ego). As a business owner you must treat the business separately from you. This means that you must hold yourself out as an agent of the company and never act in a personal capacity.

You can accomplish this by conducting all business transactions under the name of the company and having your tenants pay rent to the name of company, not you personally. Do not use business funds for personal expenses such as groceries or diapers. Have a separate bank account for the business and pay for business expenses out of that account. Basically, treat your relationship with the business as you would if you worked for someone else’s company. Remember that just because you own the business doesn’t mean you personally own the assets inside of the business.

Fraud

Piercing the veil is an equitable doctrine to make the injured party whole and a fair remedy will always arise if the business owner uses the business to commit fraud or even acts grossly negligent. We cannot use a business as a shield for our bad acts. I once had a consultation with a contractor who was being sued personally because he spent all of the deposits for upcoming jobs to cover the expenses of the current jobs. When the money ran out the company defaulted on performing the jobs that deposits were already collected. This is a common occurrence in many industries. The contractor could not understand why he was going to face personal liability exposure. Before I sent him out the door, he learned the lesson that you can’t rely on the protection of the business entity to defraud the public.

Tying it all together

There are many factors we have to keep in mind when we are running a business. Maybe I should revise my initial question to: Why even bother setting up a business? Luckily, that is a short and simple answer: Having a business is the most tested and true method to protect you personally from being wiped out financially for harms arising from the business. Courts truly are reluctant to ignore the separate nature of the business unless the business owner forces their hand.

It is really quite simple to preserve your protection: Run the business like a business; Keep up on the paperwork; Keep business and personal assets separate and; Don’t rip people off and then look to the courts for protection. You may be asking: Then why was this blog so long? Simple, I’m an attorney and I get paid by the word.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Piercing the Veil: Holding Owners Liable for the Acts of the Business

By now most investors are aware that Limited Liability Companies (LLCs) are designed to help insulate the owner (member) of the LLC from the liabilities that may arise on an investment property held within the LLC. What has drawn confusion and massive amount of debate is whether or not an investor should create a Series LLC to protect not only the member of the LLC from the harm, but also have the ability to separate each property into its own “cell” so the liability from one property doesn’t affect all of the other investment properties. The concept behind the Series LLC is great but there can be some hidden dangers lurking under the surface for the uniformed.

An LLC is a Bucket

An LLC is really nothing more than a “bucket” that helps prevent the holder of the bucket from being drenched by water splashing around in the bucket. In this case, the water is liability. However, the water in the bucket can become tainted, although it doesn’t directly harm the holder, all of the water inside is now bad. The question often becomes, do if I need a separate LLC for each investment property? My answer to that question is the classic attorney weasel answer of “it depends.” It depends upon the investor’s level of personal risk tolerance. In a perfect world every property would be in its own LLC thereby protecting all of the other investment properties from harm, but as a practical matter, this is often not feasible from an initial and annual cost standpoint. Even though I don’t charge myself to create an LLC, I don’t have an LLC for each property because of the fees associated with each state. One potential avenue that has developed over the last dozen years is what is known as a Series LLC. The principal behind the Series LLC is that it is no longer necessary to form multiple LLCs to hold different investment properties. Instead of having all of the water mixed together in the bucket, the Series LLC bucket holds the water in several “balloons” called cells; if one balloon pops the other balloons remain unharmed.

LLCs Are State Specific

LLC formation and levels of protection are governed under state laws. Each state has its own specific level of protection that it will provide an LLC. Typically, the differences center on the level of protection that assets within an LLC will have if the member of the LLC is sued personally. These protections are found within the State’s statutes or case law. A perfect example of the different levels of protection is found in the states that offer charging order protection versus states that offer judicial foreclosure as a remedy. A court in a state that offers only a remedy of a charging order prevents the member of the LLC from losing the investment assets within the LLC if he or she gets sued personally. A charging order is basically a lien on the member’s interest, if funds are distributed out of the LLC the holder of the charging order is entitled to the distribution. However, the charging order does not allow for the holder to participate in the business or force distribution. A state that provides for judicial foreclosure will allow the courts to have the discretion to pierce into the LLC and attach those investment assets to satisfy a personal judgment against the member. In the majority of states, depending on if they are charging order or judicial foreclosure states, if an injury occurs inside of the LLC, only the LLC assets are at risk and the member of the LLC is not subject to personal liability exposure. However, there are a handful of states that allow the assets inside of the LLC to be protected from each other. These states are: Delaware, Iowa, Illinois, Nevada, Oklahoma, Tennessee, and Utah. Wisconsin has a modified version of the Series LLC law.

The Benefit of the Series LLC

In the states that have Series LLC statutes, the benefit arises in being able to have one LLC that is broken up into different component “cells” to isolate injuries from one property from spreading over to the other properties held within the separate cells. Each cell can have different members so this increases the flexibility by having different ventures with other investors within one Series LLC. Another distinguishing feature is that each cell will have its own name, contracts, accounts, and as of a private letter ruling published by the IRS in 2008, each series can have its own tax status. Thus, the Series LLC gives great flexibility of being able to create one LLC instead of multiple LLCs subject to multiple fees to the state where the Series LLC is created. However, before the investor jumps on the Series LLC bandwagon there is a very important question that needs to be asked.

Where Is the Investment Property?

If an investor has an LLC created in one state but has rental property or is wholesaling in another state, he or she must file their LLC to conduct business in that state. There is no way around it. If you own property and create an LLC, you are doing business in the state where the property is located.

Blindsided by Fees

This is known as a foreign filing. If the investor does not foreign file the LLC, the state could impose penalties and the LLC will not be able to avail itself to the protections of that state’s legal system. In several states, including California, it can be a very expensive process to either create the LLC or foreign file LLC to do business in that state. On the surface, Series LLCs seem very attractive to those investors who live in states like California where it costs $800 per year per LLC for the privilege of doing business in California. If an investor has 5 properties in California and he or she wants to create 5 LLCs, the annual fee for California will be $4,000. Unfortunately, the investor is often duped into believing that by creating a Series LLC in a state such as Nevada or Delaware they can avoid this $4,000 annual fee to California because the $800 fee will only be charged once. This is not the case. The California Franchise Tax Board has specifically stated that each series in the LLC will have to pay the $800 fee. Now the investor is worse off financially because not only does the investor have to pay California $4,000, but he or she has to pay Nevada or Delaware it’s fees, the fees to the resident agent, and the fees to maintain the necessary business presence in the state of origin.

Will it be Respected in the Morning?

Remember, LLCs are governed by State law, therein lies all of the conversation about Series LLCs. If the investor creates a Series LLC, will the separate distinct cells and added protection be respected in the state where the property is located when that state doesn’t have statutes allowing for Series LLCs? The problem is we just don’t know. There hasn’t been any case law on whether or not a state like California will offer the protections of the Series LLC. So the investor is taking a big gamble on whether or not the Series LLC is actually going to provide the protections promised. A lot of the internal protections may come down to notice: Was the party that was dealing with the LLC put on notice that he or she were dealing with a separate series and only the assets within that particular cell would be attachable? This potential lack of respect should definitely cause the investor to pause before going with the Series LLC.

Lack of Formality

Each cell within the Series LLC is treated as a separate business. That means that each cell within the LLC has to be treated as a separate business. Each cell has its own distinct name, its own distinct bank account, its own distinct book keeping and accounting requirements, and from a transaction standpoint, it needs its own contracts, letter head, business cards, etc. Therefore, even in the states that allow Series LLCs, if the investor fails to follow these formalities the separate cells may not be protected from an injury arising on one of the investment properties.

Look Before You Leap

The idea behind the Series LLCs is a great one: Consolidate all activities in one LLC to cut down on costs of forming multiple LLCs to protect the different investment assets. Unfortunately, it is currently uncertain whether this benefit will be realized in the states that do not recognize Series LLCs. It is important that the potential pitfalls of additional fees, lack of respect and formality requirement are properly weighed against the promised benefit when determining whether or not to create the Series LLC. Until there is some definitive law in the other states, I’m going to let the uninformed test the waters for me.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Series LLCs and Real Estate Investing: A Primer – Look Before You Leap, Though!

“Why did my financial advisor tell me that in order to achieve asset protection for my investment properties, I only need a general liability policy?” This is a question I am consistently asked by investors when I am speaking throughout the country. Don’t get me wrong, I am a huge advocate of insurance, but in order to achieve proper asset protection, insurance must be used in conjunction with a proper legal entity.

Not to state the obvious, but an investor invests in real estate to build net worth, not to deplete his or her personal holdings if an injury occurs. Insurance is a contract between an investor and the insurance company. The investor pays the insurance company a monthly premium to provide coverage for injuries arising from activities associated with the policy. The most common type of policy that is acquired is a general liability policy, which provides coverage for damages caused to other persons in the form of personal injury. This coverage makes sense to the investor because the purpose of the insurance is to provide a shield between the investor’s investment properties and the investor’s personal assets. However, the investor must always remember that this policy is a contract with the insurance company and both the investor and the insurance company each have goals. The investor is seeking to minimize loss while the insurance company is seeking to make money by minimizing losses. The lack of focus on these competing goals often causes the investor to overlook the most important part of the contract: The Exclusions.

Beware of Exclusions

Exclusions are written into policies to allow insurance companies to achieve their goal of making money while minimizing losses. This is not a knock on insurance companies, they are a business and their goal is to generate profits. The methods that insurance companies use to control potential losses are through the exclusions in the contract. The exclusion that investors should be most mindful of is that environmental claims are going to be specifically excluded on all general liability policies. Most investors will glance right over this exclusion because the first thing that pops into an investor’s mind is chemical or oil dumping, but the biggest claim for environmental harm is Stachybotrys chartarum, commonly known as toxic black mold. Between the years of 2001 and 2002 there was an explosion of toxic black mold cases in the United States. With the dwindling number of asbestos cases at that time, the real estate litigators had found their new cash cow. I have attended classes on how to litigate toxic black mold cases in the past and the phrase thrown around is that “Mold is Gold.”

This left the insurance companies scrambling to minimize their loses, thus the exclusions in the policies. There are a handful of insurance companies that will insure for environmental injuries but the policies are often cost prohibitive to the standard investor and extensive study of the property is required by the insurance company before the policy is issued. Therefore, for most investors that only have insurance for protection, if a tenant brings a claim for toxic black mold exposure don’t look to your insurance company for assistance. You are literally on your own. Since the investor held title to the property personally, the investor is personally sued. Not only is the investment property at risk but so is every other asset that the investor owns. Unfortunately, the legal system in our country is now viewed with a lottery mentality and new lawsuits are filed at a staggering rate of 1 new lawsuit every 1.5 seconds. It is no wonder that it takes an average of two years from the time the case is filed to reach the trial date. Now that the investor is sued personally, he or she has to hire an attorney out of his or her own pocket to cover the defense costs.

No Need to Play the Lottery Just File a Lawsuit

Defendants have a saying “Even when you win, you lose.” If the investor has the significant financial resources to cover the tens of thousands of dollars it will cost to defend the lawsuit, if the court enters a judgment for the investor, the defendant is still out of pocket tens of thousands of dollars. Therefore 98% of all lawsuits filed end up settling before going to court. As an investor, you want to minimize your loses so it often makes sense to settle because our nation’s juries are treating these cases like lotteries.

Some examples are:

• $1.08 million in Delaware when the landlord failed to fix a leaky faucet and mold grew;
• A Texas jury awarded $32 million, which was reduced to $4 million on appeal;
• A California case where a jury awarded $18 million for toxic mold claims, but the award was reduced on appeal to $3 million.

These cases are not random occurrences, they happen every day in every state of our country.

Be Proactive Implement a Solution

So what is the investor to do? When the investor holds the investment property in his or her name, the investor has everything to lose in a lawsuit. The first course of action is to immediately minimize risk exposure. Risk exposure is minimized by transferring the titles of the investment properties into business entities that provide liability protection. These business entities include corporations, limited partnerships and limited liability companies (LLC). Each of these entities have different levels of protection and different tax implications depending on the type of investing, i.e. holds, wholesale, lease options, etc., but that will have to wait for another day. The purpose of using a business entity is to contain the risk exposure inside of the business itself. The problem with holding investment assets personally is that there is no legal way for the investor to separate his or herself from the investment property. Therefore, any harms associated with the property potentially risk the investor’s personal assets.

If a business entity is properly created and maintained, there is a layer of separation between the investor who owns that company and the activities of the business. Courts are extremely reluctant to allow liability exposure to flow outside of the business to attach to the personal assets of the owner of the company. This level of protection has been maintained not only via state statutes but in court cases over the last two centuries. The government wants to promote investment in businesses and this is achieved by not making businesses owners and investors personally liable for harms arising out of the business. There are cases where the “veil” is pierced by actions of comingling assets, fraud, gross negligence and failure to follow formalities, but as a whole the owners are well protected if the owners acted as reasonably prudent persons.

Putting it all Together

A business entity alone will not guarantee liability protection if the business does not operate in a reasonably prudent fashion. What is reasonably prudent for an investor’s business holding investment property? Having adequate insurance. Just as individuals need to carry insurance, the business needs to also carry insurance to minimize its loses. Just as insurance is not a substitute for business entities, the business entities are not a substitute for insurance. There have been cases where the “veil” was pierced resulting in an injury on the business property because the business did not have insurance.

You may be wondering “why even bother setting up a business entity if a lawsuit can still occur?” An investment property can never be protected from harms arising from the property itself. However, the investor must be proactive to insure that the harm does not wipe out everything that he or she has accumulated over the years. The use of the business entity in conjunction with insurance helps to insure that if the harm exceeds the insurance coverage, or if the harm arises from an excluded injury like toxic black mold exposure, the investor only has that particular property at risk and not his or her personal assets.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

The Asset Protection Misconception: Why Insurance Alone Isn’t Enough

There has been much published in regard to land trusts. However, many real estate investors are completely oblivious to the fact that the land trust, in and of itself, provides absolutely no asset protection. Don’t get me wrong, land trusts are great vehicles for privacy, but privacy will only take you so far. You must use a land trust in conjunction with an entity such as an LLC in order to gain the benefits of asset protection.

The Land Trust Structure

There have been some very good articles written on the mechanics of land trusts to serve as an excellent resource on how land trusts are structured, such as those found on BiggerPockets.com. In a nutshell, a land trust is a grantor trust. A grantor trust is a contract between three parties: the Grantor (creator of the trust), the Trustee (holds legal title to the property through the trust and typically controls the trust assets), and the Beneficiary (holds the use and enjoyment of the assets within the trust). The most common form of grantor trusts in our country is revocable living trusts. The great thing about grantor trusts is that separate tax filings are not required since the profits, depreciation, and expenses associated with the asset will report on your personal 1040 return. Often investors are told they cannot form a land trust in a given state because there are no land trust statutes in said state. This information is not wholly correct. Even though only a handful of states have formal land trust statues, every state has statutes regarding grantor trusts and thus the land trust would be recognized as viable entity in that state since it is a grantor trust.

Privacy

One of the benefits that a land trust offers is anonymity for the investor. When a property is purchased and the investor desires anonymity, the property should be deeded directly into the land trust. The title will vest to the trustee of the trust. In order to achieve anonymity, a third party must be designated as the trustee in the trust documents. Therefore, when the deed is recorded with the county, the third party trustee will be listed on title instead of the investor. As a practical matter, the investor should be designated as the successor trustee and have a resignation ready to be signed from the third party trustee. If any action needs to occur regarding the property, whether it be a refinance or an unlawful detainer action, the only party that can act on behalf of the trust is the trustee. An investor needs to be able to act immediately on behalf of the trust property if the third party trustee is unavailable to sign the necessary documents.

Anonymity is an extremely useful tool when you are looking to shelter your assets from prying eyes. In a typical lawsuit scenario, before the attorney takes a potential case the he or she will perform an asset search on the party they are looking to sue. The more assets a person has in his or her name the more attractive he or she becomes. The practice of law is a business and the attorney wants to be sure that there are enough assets to recover and attach to the case before undertaking several years of costly litigation. Having a third party serve as the trustee can decrease the investor’s overall target exposure. However, anonymity alone does not guarantee that you will not be sued. We can never protect the property from injury associated with the property. As long as the investor holds the beneficial interest, not only is the property at risk but so are the investor’s other assets.

Lack of Asset Protection

Even though the investor may not be the trustee of the trust he or she is the trust beneficiary. There are pros and cons to being designated as the beneficiary. The beneficiary of the trust not only receives the benefits associated with property in the trust, but all liabilities associated with the property flow down to the beneficiary as well. If the investor personally holds the beneficial interest and there is an injury on the trust property, the plaintiff will seek recovery against the property and the investor individually. If the investor holds beneficial interests in multiple trusts, all of the properties within those land trusts will be at risk even though they had no connection to the underlying harm.

Not only does the investor subject his or herself to personal liability exposure for claims arising from the trust property, his or her trust property is at risk for claims arising against the investor individually. Because the investor individually holds the beneficial interest, his or her interest can be attached by a judgment creditor. Once the judgment creditor attaches the beneficial interest, most trusts give the power to the beneficiary to terminate the trust. In this scenario the judgment creditor would exercise his or her beneficial right by terminating the trust and taking possession over the asset. In order to achieve asset protection, the investor must transfer his or her beneficial interest prior to the harm occurring.

Achieving Asset Protection

In order for asset protection to exist, we must use a land trust in conjunction with an entity that provides asset protection. In most instances, using an LLC is the appropriate entity to achieve asset protection for the investor’s long term holds. The LLC acts as a container for liability exposure, thereby insulating the individual investor, who is the member of the LLC, from harm occurring inside of the LLC. The mechanics of achieving asset protection with the land trust are fairly simple. After the deed has been filed and title has vested in the trustee, the beneficiary has the right (in most instances) to transfer his or her beneficial interest in the trust. This is where the LLC comes into play. The investor will complete an assignment form and transfer his or her interest directly to the LLC. It is also important to have the LLC, or any other entity, accept the assignment of interest. At this point LLC is the owner of the beneficial interest.

If a harm associated with the property arises, unless we are dealing with fraud or gross negligence, the liability exposure will be contained within the LLC. This containment of exposure will help shield the investor from personal liability from the harm relating to the underlying property. In many states, asset protection will also be achieved if the individual investor is subject to a personal suit, since many courts will respect the separate nature of the LLC and not allow a judgment creditor to pierce the LLC and attach assets for an unrelated harm.

Capitalizing on the Full Benefits of Land Trusts

Land trusts are an excellent tool in the investor’s arsenal, but the investor must be savvy enough to fully utilize the trust’s benefits. Not only will the trust provide the investor the desired level of anonymity, but if used in conjunction with an LLC, it will afford the investor excellent asset protection. If anonymity is the only concern then the land trust can achieve this result. However, for the investors that also desire protection, the land trust must be used in conjunction with entities that provide asset protection.

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Land Trusts and Asset Protection, a Primer

When most investors think about business planning for their real estate investments, their main focus tends to be strictly on asset protection. However, there is a genuine need to also focus on potential adverse tax consequences depending upon the type of real estate transactions that you have targeted for your investing strategy. Wholesaling properties falls within this realm. Typical investors will often enter into a wholesale in their own name since they are not concerned about asset protection because of the short holding period. Unfortunately, they are oblivious of the severe tax consequences that loom in the shadows.

Real Estate Wholesaling & Dealer Status

To give you a little background, a wholesale transaction is a deal entered into for profit in which title will transfer into the investor’s name and then be sold within a twelve month period. Investors generally believe that the gain on the property will only be treated as short term capital gain and thereby taxed in their individual tax brackets. The investors would be correct if it wasn’t for the “dealer” classification. A “dealer” in real estate is defined in Treasury Regulations Section 1.402(a)-4 as a person who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales. There is no magic number on the number of transactions you have to do before getting classified as a dealer. Unfortunately for investors this is strictly an intent based test and therefore the burden will be placed upon investors to prove that they are not dealers.

Implications of Dealer Classification

If the investors do get classified as dealers, there is a litany of negative tax consequences that will follow:

• The income earned from the investment will be treated as earned income and thus subject to a 15.3% self-employment tax that will be added on to their own personal tax bracket;
• Investors will no longer be able to capture the depreciation on their rental properties because the rentals will be view as inventory by the IRS and inventory is not subject to depreciation;
• Investors will no longer be able to enter into 1031 exchanges; and
• Investors will lose the ability to defer income recognition on installment sales.

These are tax consequences that generally want to be avoided at all costs.

It is clear that investors do not generally want to be classified as dealers, but what business entity should they use for the wholesales? If the wholesale occurs through a limited partnership, the dealer classification will attached to the general partner. If the investor is the general partner there is no tax benefit in using a limited partnership. Often investors will structure the deal through a single member LLC that is disregarded for tax purposes. However, since the LLC has no separate tax structure the dealer status will flow down directly to the single member of the LLC. Wholesale transactions are one of the few times that we want to have real estate within our corporations.

Implications & Protection

From a tax standpoint, a corporation, or an LLC that has elected to be taxed as a corporation, is perfectly suited for an investor’s wholesale activities. Since the sale of the wholesale occurs out of the corporation, the dealer status will not be attached to the owner of the corporation or the member of the LLC that is taxed as a corporation. Whether or not you use a “C” or “S” corporation is an issue that I would raise with your accountant or attorney because there are a variety of factors that should be addressed when determining the best tax structure. It is very important that title of the wholesale be immediately transferred into the corporation and that the sale occurs through the corporation. Many investors will take title personally, rehab the property, place the property on the market and then transfer title to the corporation immediately before sale. This would be viewed as a tax motivated transaction by the IRS and would be disallowed on audit.

The dealer tax classification is truly a trap for the uninformed investor. Thankfully, this pitfall is easily avoided through proper business planning. There is not a one size fits all solution for all investors, each transaction should be entered into in an informed manner, not only in terms of asset protection, but also in regard to the tax ramifications.

Photo Credit: pnwra

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

Wholesale Real Estate Transactions: Avoiding Dealer Classification

That is not a typo. In fact, I may be off by a number or two. Given today’s chaos and confusion in the real estate realm, it is a definite possibility we could find ourselves in a court room answering a complaint under one of the following 22 types of law:

Common Law
Equity Law
Admiralty/Maritime Law
Administrative Law
Private Law
Public Law
International Law
Constitutional Law
Treaty Law
Federal Law
State Law
Municipal Law
Probate Law
Family Law
Corporate Law
Contract Law
Tax Law
Civil Law
Criminal Law
Labor Law
Bankruptcy Law
Martial Law

I don’t know about you, but my imagination boggles at the mines that await us in the field. As real estate investors, we probably don’t pay much attention to most of them. We generally are pretty adept at contract law, tax law and state law and might even have a handle on civil law, but the rest of them are mere shadows. We can see them when the sun shines but otherwise they are invisible.

The intent of this post isn’t to define each one or give a dissertation on them. Rather, the intent is to provide what I call an awareness list especially with the investment arena what it is at this moment in real estate.

Desperate People Do Desperate Things

A lot of people are desperate – who can blame them, right? – and are willing to entertain any kind of “remedy” that may be presented as a sure cure to their problems. For example, look at equity law. It is supposedly the law that provides the remedy non existent in common law.

If common law doesn’t provide a remedy to foreclosure but equity law holds out a glimmer of hope, won’t people use it? Of course they will.

Let’s say you buy a foreclosed home, whether at auction or as an REO, and the homeowner (former homeowner to be more precise) decides to take you to court under a principle in equity. The ramifications can produce a phrase that has become common in our vocabulary – shock and awe.

You are not only shocked that you are the “defendant” but you are in awe at the sheer volume of the pleading called a complaint. The complaint has you painted as the evil villain in a land grab of magnitudinous proportions.

Imagine getting served this type of complaint. How would you answer? Would you even bother? Would you hire an attorney? The questions go on and on.

I put this on the table not to rattle you but because in my surfing of the web I’ve noticed a host of “solutions” being propounded as the way out for those in foreclosure or as a remedy for those about to be foreclosed upon. To me, I can’t imagine anyone falling for some of this stuff but, again, desperate people do desperate things. And, some of this stuff is touted as the silver bullet and it sounds real, real good.

Awareness

I also realize the courts should cull out the so called frivolous suits but that usually doesn’t happen until the first appearance. I don’t know about you but I don’t want to be the guy who has to go to court even the first time. Hence, awareness of not only how we conduct business but the wording of our forms and contracts becomes imperative. After all, the menu of law types doesn’t seem to be diminishing.

Again, this isn’t meant to scare anyone or be negative. It is meant to heighten awareness in an arena that most of us only have peripheral knowledge. To me, it is better to be prepared than to be surprised or shocked.

I believe you will agree.

Photo Credit: bimurch

This Article is Copyright © 2004-2009 BiggerPockets, Inc. All Rights Reserved.

22 Types Of Law that May Affect Real Estate Investors