How to Protect Yourself When Real Estate Investments Fail

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Real Estate Investing can be dangerous to your personal financial wealth!

As real estate investors we all start off with the best of intentions. We go out into our local real estate markets and look for deals. We contact  potential capital investors and spend hours generating interest in  having them fund local real estate deals.  Finally we get that perfect deal, and it all starts to come together. Time starts to move on your investment  and  the strategy that you wanted to execute on the asset falls apart, or the tenant in your property falls and out comes the dark side of real estate investing:

Lawsuits.

Lawsuits are the dark side of real estate. Lawsuits are real and can take a bite out of you financially and emotionally. Emotionally lawsuits are a rollercoaster and strain personal relationships especially if you are working with friends or family on real estate deals. Financially you need to choose a special purpose investment vehicle that protects you and your capital partners when investments go bad.

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What is a Special Purpose Investment Vehicle (SPIV)?

A special purpose investment vehicle/entity is a legal entity created to fulfill narrow, specific or temporary objectives. The typical SPV can either be a Corporation, Sub Chapter S-Corporation, Limited Liability Corporation, or a Limited Partnership.

Four Types of SPIV 

SPV STRUCTURE

DEFINITION

KEY

BENEFITS

KEY

DRAWBACK

Valid for Real Estate Ownership?

C-CorporationThe most basic type of limited liability structure and the longest standing investment vehicle. Liability is limited for operating team and shareholders to the capital committed associated with their share value.
Shares can be freely traded among an unlimited number of ownersMost tax-efficient vehicle for taking a company public.
Taxes are paid both at the entity level and at the personal level for distributions provided to shareholders and operating partners. Not in my opinion.The double taxation is what kills it from a real estate perspective unless you can qualify as a REIT (Real Estate Investment Trust)
Limited Partnership (LP)Limited partnerships have both general partners and limited partners. The limited partners in the relationship are usually investors who do not have the same day-to-day responsibilities as the general partners Limited Partner liability for the partnership’s debt is limited to the amount of money or property that individual partner contributed to the partnershipLP memerbship units  are freely transferrable: limited partners can be replaced without dissolving the limited partnersh

LP is a pass-through entity meaning the profit, losses, credits and deductions flow through to the LP and GP members without entity level taxation.

Limited partners lose all of their limited liability if they participate in any management functions within the company.LP can have no real say in the business which can be a negative drawback when it comes to finding investors. Not in my opinion.The loss of limited liability feature and the capital investors not having any say in the investment decision can limit your capital investors ability to make appropriate decisions for their portfolio.
S-CorporationS-Corporation is basically a C-Corporation corporation that is not subject to double taxation. Liability is limited for operating team and shareholders to the capital committed associated with their share value.Shares can be freely traded among an unlimited number of ownersIncome flows through to the individual shareholders and federal tax is paid only at the owner level Ownership is limited to no more than 100 US shareholders with one class of stock. This is a good structure for the joint ownership of real estate asset given that you can raise capital efficiently and keep the limited liability feature.
Limited Liability CorporationLLC structure essentially melds a partnership with the limited liability protection offered by a corporation. LLC a pass-through entity meaning the profit, losses, credits and deductions flow through to the LP and GP members without entity level taxationIncome and benefits can be distributed unequally among membersMembers can use losses and income to offset income and losses from other passive investment activities subject to the passive tax loss rules.

Members liability is limited to the amount of money or property that individual partner contributed to the LLC.

This is an optimal structure for joint real estate asset ownership in my opinion given that you can raise third party capital and divide up ownership benefits in a personalized manner to each capital investor.

The table above is meant to serve as a reference tool for real estate investors considering which investment vehicle that they want to use for owning their next real estate asset. The investment vehicle choice should be made balancing the following objectives:

  1. Liability Protection for yourself and your capital partners
  2. Capital Raising capability at the time of acquisition and the future
  3. Taxation Implications for yourself and your capital partners

Utilize this table, your lawyer, and your accountant team members to choose the right investment vehicle.

Happy Investing!
Photo: Photo Extremist

About Author

Ankit Duggal

Ankit Duggal(G+) is the Investment Director of a New Jersey Income Operating & Consulting Company . Ankit is a seasoned value investor who enjoys achieving a zen through surfing, hot yoga, and snowboarding.

5 Comments

  1. All I have to say is avoid lawsuits at all costs! We were part of a frivolous lawsuit after purchasing a home at the trustees sale. The previous owners decided they should get the house for free for some unknown reason. The lawsuit was thrown out after the judge looked at it, but it took him almost a year to look at it! Talk about frustating!

  2. There was no way we could avoid it. We bought the home at the trustee sale and it appeared vacant. When we opened it up it was empty except for a newer BMW in the garage. I knew something was weird at that point. We tracked down the old owners and they informed us it was still their house and they were getting it for free. That had filed a lawsuit agsinst the bank shortly after we bought the home. We weren’t involved in the lawsuit but could not selle a home with pending litigation against it. We tried to offer them 5,000 to go away and they wouldn’t take it. Their lawyer had convinced then they were getting the house got free.

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