San Jose, CA · Member since 2017 · 9 posts · 0 votes
Hi BP,
Although I’ve only started in real estate investing, I’ve been reading books on tax and legal protections. In protecting my investments, I’ve learned the importance of the first and second defense, home owner’s insurance and umbrella insurance. The third defense is minimizing your attractiveness to creditors/lawyers and lastly, isolating assets through liability separation. I also know to differentiate between inside and outside ‘attacks’. Inside relating to the property itself like tenant injuries and outside relating to my personal life like car accidents.
The book I've read suggests that an ideal structure of real estate assets in CA is to hold each property in an LP and have an LLC formed in Wyoming or Nevada as general partner - for cost and protection reasons. Unlike a CA LLC holding, outside ‘attacks' may not force sale of real estate and are limited to charging orders in Wyoming/Nevada. The rationale is that lawyers/creditors will be less inclined to spend time reaching for charging orders in different states, ie: third defense. Also LLC formation in those states are low cost.
I’m not even close to getting to this type of structuring but as an exercise of academia, I wanted to get opinions of BP members on the cost and protections of this type of asset structure.
Other forms of third defense I’ve come across include:
-Keeping LTV high
-Taking out LoC (creditors will not know the utilization of LoC until winning the case)
Attorney · Austin, TX · Member since 2014 · 1k+ posts · 932 votes
7y
Hey Alvin,
I would agree with both the guys above that you are focusing on the wrong parts of investing at your stage. When new investors get into this it's best to focus on finding the best deals that exist and making quality connections and partnerships that will carry you forward. However, it's also good to have a solid understanding of what asset protection does, and does not, accomplish. @Jerry W. is spot on with the misfortune of investing out of CA, as it blows all the other states away in the taxation of LLCs.
First, let me share with you how I break down asset protection. When meeting with clients the first order is to discuss (A) their personal assets, (B) break down their current investments portfolio and other business ventures before discussing any (C) future goals. Each of these variables will dramatically change the advice for the individual asking this question. I often break it down into the "five pillars" of protecting your assets.
1st pillar is avoiding unnecessary and risky activities (don't drink and drive, insurance generally won’t cover your poor decisions) and take good care of your investments - these simple steps will help you prevent lawsuits before they even occur.
2nd pillar is a good insurance policy as that cover the majority of your exposure. However, insurance is limited because it only protects you from one type of liability: accidents/negligence. Insurance doesn’t protect you from any part of the sale or acquisition of a property (e.x. Somebody wanting to sue for you backing out of a bad deal or accusing you of selling them a property with defects like unknown termite damage). Insurance also doesn’t protect you from misunderstandings, especially those made in writing and email. What happens in these misunderstandings is that something goes wrong either in the sale or after, and then they sue you for some statement you made that they “misunderstood”. That lawsuit is a claim for fraud, and that’s what fraud typically is...a misunderstanding and someone being “injured” and wanting to hold the other responsible for it. Insurance never protects you from these kinds of claims and they happen all the time.
3rd pillar applies after you have good insurance You need to protect yourself from what insurance doesn’t cover by compartmentalizing your assets. Compartmentalization means that if something happens to one property they can't touch you or the other properties. You should use either LLC's (the old and expensive way) or a Series LLC (the new and more cost/time effective way). No matter where you live or where you own assets, I personally recommend the Series LLC to be a great tool for the individual investor who is planning to expand their operation, as it allows for you to scale infinitely for FREE- check out this article to learn more. Since you are from California, then it would be worth looking into the Delaware Statutory Trust. The DST functions much like the Series LLC, but is not required to pay the $800 annual franchise fee per [series] LLC in California - for anyone with multiple properties this can save a lot of money.
4th pillar is somewhat similar - you want to separate your operations from your assets. One company owns everything and does nothing (this is your SLLC a/k/a "asset holding company") and a completely separate company handles all of your operations (this is a traditional LLC a/k/a "operating company") For the operating company which serves as your face to the world and through which you do all your business, you establish a Traditional LLC to carry out the operations of your investments. The operating company takes on all of the liability that would otherwise blow back on you including: paying property management, paying contractors, collecting rent, marketing, etc.
5th pillar is owning everything anonymously. If people don't know what you own, then they are less likely to sue. People don't sue people that qualify for food stamps. This anonymity can be accomplished for free by using Trusts to own your companies as well as the assets. Trusts create this anonymity by removing your name from public record. Even if they can see you used to own a property, when properly transferred it will look like it was sold to investors. If they somehow guess you are the owner still, it doesn't matter because you are not the owner. The trust and the LLC are the owner of the asset/real estate, so even in the scenario that they guess, they guess wrong.
There are still many other strategies ranging from offshore trusts to equity stripping, but those need to be executed correctly and within the correct strategy, otherwise you end up working against yourself and throwing money away. Also, not all investors should implement all of these steps. Each pillar will involve costs - so you should only add more pillars as you scale up.
The reason I don't preach the Delaware Statutory Trust to everyone I meet is that it has higher setup costs than most other entities. It's protection is arguably higher than the Series LLC, though. In the end most investors from CA will save money using it in the long run, since they won't be paying the $800+ annual franchise tax PER LLC (and PER child series in a Series LLC.)
Asset protection is pretty straightforward in reality - and each investor will have their own idea of how much protection they want. If you just scale it up AS you grow, it's really not a hassle and should only make your life easier. If you run into specific issues just message/TAG me.
Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes
7y
@Alvin Ng, the first problem is you live in CA. Their franchise tax of $800 and up on every entity that even looks west is pretty bad juju. You really need someone who knows CA law and taxation to advise you on that. I think you have the cart before the horse. You need real estate before you worry about protection. I have VERY little faith in putting LOCs on properties or artificially keeping mortgages high just to protect from liability. Those are reasons that courts can pierce the corporate veil and disregard the corporation or LLC and hold you directly responsible. I would do a basic LLC or at most an LLC as manager of another LLC for liability purposes. The guys touting trusts and series LLcs disagree. If the overhead of multiple entities renders you profitless from investing what is the use? Can your investing afford this kind of entity and the time and extra book keeping that goes into it?
There are those that disagree, and you should hear their view. I know that @Scott Smith has a program he suggests.
Good point by Jerry that isn't talked about enough:
"I have VERY little faith in putting LOCs on properties or artificially keeping mortgages high just to protect from liability. Those are reasons that courts can pierce the corporate veil and disregard the corporation or LLC and hold you directly responsible."
Look up "undercapitalization" as it relates to LLCs. Kind of defeats the point of equity stripping for asset protection. In an ironic way...
Attorney · Austin, TX · Member since 2014 · 1k+ posts · 932 votes
7y
Hey Alvin,
I would agree with both the guys above that you are focusing on the wrong parts of investing at your stage. When new investors get into this it's best to focus on finding the best deals that exist and making quality connections and partnerships that will carry you forward. However, it's also good to have a solid understanding of what asset protection does, and does not, accomplish. @Jerry W. is spot on with the misfortune of investing out of CA, as it blows all the other states away in the taxation of LLCs.
First, let me share with you how I break down asset protection. When meeting with clients the first order is to discuss (A) their personal assets, (B) break down their current investments portfolio and other business ventures before discussing any (C) future goals. Each of these variables will dramatically change the advice for the individual asking this question. I often break it down into the "five pillars" of protecting your assets.
1st pillar is avoiding unnecessary and risky activities (don't drink and drive, insurance generally won’t cover your poor decisions) and take good care of your investments - these simple steps will help you prevent lawsuits before they even occur.
2nd pillar is a good insurance policy as that cover the majority of your exposure. However, insurance is limited because it only protects you from one type of liability: accidents/negligence. Insurance doesn’t protect you from any part of the sale or acquisition of a property (e.x. Somebody wanting to sue for you backing out of a bad deal or accusing you of selling them a property with defects like unknown termite damage). Insurance also doesn’t protect you from misunderstandings, especially those made in writing and email. What happens in these misunderstandings is that something goes wrong either in the sale or after, and then they sue you for some statement you made that they “misunderstood”. That lawsuit is a claim for fraud, and that’s what fraud typically is...a misunderstanding and someone being “injured” and wanting to hold the other responsible for it. Insurance never protects you from these kinds of claims and they happen all the time.
3rd pillar applies after you have good insurance You need to protect yourself from what insurance doesn’t cover by compartmentalizing your assets. Compartmentalization means that if something happens to one property they can't touch you or the other properties. You should use either LLC's (the old and expensive way) or a Series LLC (the new and more cost/time effective way). No matter where you live or where you own assets, I personally recommend the Series LLC to be a great tool for the individual investor who is planning to expand their operation, as it allows for you to scale infinitely for FREE- check out this article to learn more. Since you are from California, then it would be worth looking into the Delaware Statutory Trust. The DST functions much like the Series LLC, but is not required to pay the $800 annual franchise fee per [series] LLC in California - for anyone with multiple properties this can save a lot of money.
4th pillar is somewhat similar - you want to separate your operations from your assets. One company owns everything and does nothing (this is your SLLC a/k/a "asset holding company") and a completely separate company handles all of your operations (this is a traditional LLC a/k/a "operating company") For the operating company which serves as your face to the world and through which you do all your business, you establish a Traditional LLC to carry out the operations of your investments. The operating company takes on all of the liability that would otherwise blow back on you including: paying property management, paying contractors, collecting rent, marketing, etc.
5th pillar is owning everything anonymously. If people don't know what you own, then they are less likely to sue. People don't sue people that qualify for food stamps. This anonymity can be accomplished for free by using Trusts to own your companies as well as the assets. Trusts create this anonymity by removing your name from public record. Even if they can see you used to own a property, when properly transferred it will look like it was sold to investors. If they somehow guess you are the owner still, it doesn't matter because you are not the owner. The trust and the LLC are the owner of the asset/real estate, so even in the scenario that they guess, they guess wrong.
There are still many other strategies ranging from offshore trusts to equity stripping, but those need to be executed correctly and within the correct strategy, otherwise you end up working against yourself and throwing money away. Also, not all investors should implement all of these steps. Each pillar will involve costs - so you should only add more pillars as you scale up.
The reason I don't preach the Delaware Statutory Trust to everyone I meet is that it has higher setup costs than most other entities. It's protection is arguably higher than the Series LLC, though. In the end most investors from CA will save money using it in the long run, since they won't be paying the $800+ annual franchise tax PER LLC (and PER child series in a Series LLC.)
Asset protection is pretty straightforward in reality - and each investor will have their own idea of how much protection they want. If you just scale it up AS you grow, it's really not a hassle and should only make your life easier. If you run into specific issues just message/TAG me.
San Jose, CA · Member since 2017 · 9 posts · 0 votes
7y
Thanks for your valuable feedback! To help provide context, I currently own my primary residence and an investment property. It (hopefully) won't be too long before I pick up another investment property or 1031 up. TBH, I'm not expecting anything to go wrong as inspections/requests are immediately followed up and umbrella insurance is in place to catch the rest. Learning these things though really helps twofold: 1) What can I do early on that will help me later? 2) What are the low hanging fruit? I had some follow up questions:
@Jerry W. Is it possible to pierce a corporate veil by taking a LOC or keeping LTV high, in advance? Refinancing a loan or not paying extra principal payments seem like normal activities that investors may do. I agree that this can be counter productive if done around a suit filing though.
Regarding LOC, it's likely that you can't withdraw from LOC around a suit filing. But I thought just by having a LOC available means creditors cannot see the equity - possible deterrent from starting a suit. Having an LOC also seems like a normal activity if setup well in advance.
@Scott Smith Wow, lots of good stuff to digest here. I believe I have 1st and 2nd pillars in place. The 3rd pillar seems the most broad in terms of range and opinions. I'll take some time to learn more about SLLC and DSTs on how they compare and their costs. One book I read mentioned SLLC but the concern was that there weren't many involved suits to prove their effectiveness, although this could be dated information. Also will need to do some research on trusts and associated costs.
Thanks for your valuable feedback! To help provide context, I currently own my primary residence and an investment property. It (hopefully) won't be too long before I pick up another investment property or 1031 up. TBH, I'm not expecting anything to go wrong as inspections/requests are immediately followed up and umbrella insurance is in place to catch the rest. Learning these things though really helps twofold: 1) What can I do early on that will help me later? 2) What are the low hanging fruit? I had some follow up questions:
@Jerry W. Is it possible to pierce a corporate veil by taking a LOC or keeping LTV high, in advance? Refinancing a loan or not paying extra principal payments seem like normal activities that investors may do. I agree that this can be counter productive if done around a suit filing though.
Regarding LOC, it's likely that you can't withdraw from LOC around a suit filing. But I thought just by having a LOC available means creditors cannot see the equity - possible deterrent from starting a suit. Having an LOC also seems like a normal activity if setup well in advance.
@Scott Smith Wow, lots of good stuff to digest here. I believe I have 1st and 2nd pillars in place. The 3rd pillar seems the most broad in terms of range and opinions. I'll take some time to learn more about SLLC and DSTs on how they compare and their costs. One book I read mentioned SLLC but the concern was that there weren't many involved suits to prove their effectiveness, although this could be dated information. Also will need to do some research on trusts and associated costs.
No worries, take your time. In regards to Series LLCs and states that recognize them or not, the issue comes down to each specific state recognizing the "internal liability shield." Not if they have a Series LLC to create in that state or not--an investor in any state can form a Series LLC in a different state if he or she wants one. Every state has an internal liability shield for LLCs and that is what is analyzed in every state: the LLC Internal liability shield of the state you're being sued in.
There is a misconception that the Series LLC is a new entity. It is not. It was first created in 1996 in Delaware, over two decades ago. While the Traditional LLC is more established, it is not much "older." The Traditional LLC first became available in Wyoming in 1977, but most other states did not follow suit until the 1990s. The next state was Delaware, which enacted LLC legislation in 1995, followed by California in 1994/5. It was not until 1996 that all states had an LLC option. The same year, the Series LLC was statutorily created. So it's interesting how people quickly fall in love with the Traditional LLC thinking it's been around forever. But the reality is that after the creation of the LLC in most states, the Series LLC immediately came into the game. Just one year after California codified the traditional LLC.
In reality this entity has gone on for nearly two decades without having case law disproving it as a legitimate structure. Anyone who could break the entity would be a very rich individual, due to it's popularity with big investors. The lack of case law is actually an argument supporting the strength of the Series LLC, rather than a weakness.
Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes
7y
@Alvin Ng, when it comes to under capitalization it depends on whether it is fake. if you have a company and take a 2nd mortgage out to buy another rental cool. it is normal business. If it is the only property in the LLC or it is a series LLC how do you rationalize why you take money out of one corporation in order to give money to a different series or or different LLC? They are supposed to be legally and financially separate. If you take $100K and give that LLC a $100K and mortgage made out to you personally doesn't that suggest fraud a little bit? Can you prove you wrote the LLC a check for $100K? what happened to the money? Is it still in a bank account in the name of the LLC? If so great, if not where is it? If it ended up in your account as wages or a dividend it looks like you intentionally under capitalized it. What value did the new LLC give to the old one? Now if it used the $100K to buy another rental in the same LLC you are fine, but that is not what the GURUs want. The bank probably won't loan you the $80% for the new property if they know the 20% down payment was also borrowed money. Think about it. If you have a property worth $200K and only owe $50K how do you extract the $100K without the deal looking like you are purposely stripping off the equity? They make it sound good when selling liability protection schemes, but most look like fraud in front of a jury if you are not honest about it.
San Jose, CA · Member since 2017 · 9 posts · 0 votes
7y
@Jerry W. Oh I got it now, your examples help shed light on the shortcomings/challenges of refinancing/LOC. What would be the right way to extract equity to purchase another property in a separate LLC to minimize this risk? I think you mentioned a structure of management LLC to handle cash flows and individual LLC per property would be ideal. The use case i'm thinking is BRRR with LLC (or SLLC) for each property.
Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes
7y
First off the easy way is to use one LLC to acquire several properties. To initially start the LLC loan it say $50K. Then you use that money for $10K down on a property and you spend $30K more to fix it up. Now you can say its worth say $100K and so you refinance and pull out the $40K you put into it and buy another property the same way inside the same LLC. If you choose to form a second LLC you can contract with that LLC to manage the other LLC's rentals for 10 or 15% of the gross income. After you get about 10 properties in the first LLC you can pay yourself some wages, pay back the loan you gave the LLC to get started, and form a new LLC to do the next 10 properties. That is way over simplified, but do you get the idea?