Protecting Against Lawsuits for Buy-and-hold Real Estate Investors
When the dean announced that Goldman Sachs would be visiting to recruit two students for their new analyst training program, I jumped at the opportunity to interview for the position. It wasn’t often the prestigious private wealth management firm recruited at my college—and it was a truly rare event when they came with a quota to fill. It was a once in a lifetime opportunity to launch my career into the stratosphere and I was eager to seize the opportunity. I had the education, the knowledge, the experience and the resume. I was a shoo-in—the obvious choice for the job. All I needed to do now was buy a three-piece Armani and prepare myself to join the ranks of the elite.
In preparation for the interview, I learned everything there was to know about Goldman Sachs. I reviewed commonly asked interview questions, brushed up on my technical skills, even did a little bit of research on the interviewer. The day and hour of my job interview arrived. I was ushered into a small room and invited to take a seat. After a few minutes of small talk, the interviewer said to me, “I just have one question for you today. Why do our clients come to us?” What? That’s it. There had to be more to it. It was such an easy question to answer. I quickly—and naively—responded, “So you can help them take their wealth, reinvest it, and get wealthier.” The interviewer sat pensively for a moment and then said, “Our clients are already wealthy. They come to us because they don’t want to loose the wealth they’ve created.” Needless to say I wasn’t extended an offer of employment—and I left the interview a little bit wiser and a lot more humble.
It wasn’t until years later, after having owned and operated my own business, and was heavily invested in real estate, that I came to really appreciate the truthfulness of that lesson. When you’ve worked hard to get where you’re at, saved, invested and built a nest egg, the last thing you want is to loose what you’ve created. Most of us who own income property worked hard to acquire it. It didn’t come easy. We worked years to acquire that first property—and most of our life to build our real estate portfolio. Unfortunately, when it comes to personal wealth preservation and asset protection for real estate, many otherwise savvy business owners and investors just don’t understand, nor appreciate, the growing risk lurking right around the corner—lawsuits.
If you speak with your local CPA or attorney, they’ll advise to you buy ample liability insurance and tell you that the risk of being sued is negligible. They’ll back that up with a statement like, “I’ve been a CPA for 10 years and none of my clients have ever been sued.” I hope you’re never sued—but don’t believe it never happens, or that it won’t happen to you. Lawsuits against income property owners happen all the time and they’re growing in number. Personal asset protection and risk management should be at the core of any sound real estate investment strategy.
If you have a buy-and-hold rental real estate investing strategy, like I do, you’re going to see hundreds of tenants come and go over the years. With disgruntled tenants feeling entitled to compensation for the slightest perceived malfeasance, the proverbial “ambulance chaser” now finding greener pastures among rental suburbia, and liberal courts siding against wealthy landlords and awarding historically large verdicts, what are the chances you could be party to a lawsuit at some point in your life? I can tell you, they’re much greater than they used to be. Did you know that one outbreak of black mold can cause a tenant respiratory damage for life? Believe me, their attorney does. Whether you own just one rental home, or an entire complex of rental properties, it only takes one lawsuit to wreak financial havoc.
If you’re unprepared and exposed when that lawsuit arrives, there’s nothing anyone can do for you at that point. After you’ve been sued, any attempt to mitigate or minimize exposure to the risk by transferring or restructuring assets (personal or business) will likely be viewed as fraudulent and do nothing more than anchor a bulls eye on your forehead.
So what is the best way to mitigate the risk of a lawsuit? Easy. Do every thing you can today to ensure you’re never in one. Below we’re going to explore three asset protection and risk mitigation strategies for the long-term buy-and-hold real estate investor.
Choose the Right Entity for Your Rental Real Estate Property
The first step to reduce legal liability associated with buying and holding real estate is to develop a holding company. If you’re a seasoned investor, or just considering buying a rental property, you’re probably aware that the limited liability company (LLC) is the best business structure for holding real estate. The LLC is the structure of choice among real estate investors and income property owners because, unlike corporations, the LLC provides both inside and outside protection.
Most people form an LLC to provide inside protection; that is, protection against liability from something that may occur inside the company. For example, when your tenant slips and falls down the stairs to his unit, you won’t be held personally liable when the he sues you or brings an action against the LLC. The LLC creates a legal layer of separation, commonly referred to as a “corporate veil”, that insulates you, the property owner, from any liability that arises as a result of the property creating a harm.
Basically, any liability or lawsuit that originates from within the LLC, stays inside the LLC. Only the LLC’s assets can be used to settle debts and pay tenant claims. When structured and maintained in accordance with state and federal law, the LLC offers its members the same level of personal liability protection as the corporation offers its shareholders.
In order for an LLC to fully insulate it’s members from inside liability, it must be set up correctly and remain compliant.
LLCs can also provide their members protection against outside liability. As the name suggests, outside liability comes from outside of the LLC. Here the harm is not created by the property, but rather by you personally. For example, let’s say you’re involved in a car accident and subsequently found liable for a million dollars in damages. As a result of the judgment, you could loose your vehicle, house, cash, savings, other personal assets—even your business interests. But what about those business interests within limited liability companies? Can these also be taken?
The amount of outside protection afforded limited liability companies varies from state to state, but most states do provide LLC owners protection against personal creditors. Some states will foreclose on the owner-debtor’s LLC or allow for a court to order the LLC to be dissolved as creditors’ legal remedy. However, about two thirds of all states only permit personal creditors of an LLC debtorowner to obtain a charging order against the debtor-owner’s membership interest—otherwise leaving the LLC and its assets intact.
So what is a charging order? It is a court order entitling a creditor to receive any distributions that would otherwise be distributed by the LLC to the owner-debtor until the judgment against the owner-debtor is paid off. In most states, obtaining a charging order is a creditor’s only legal remedy to collect against an LLC.
For the purpose of outside protection, the LLC is a more advantageous business structure to income property owners than the corporation. If your real estate is held in a corporation, creditors can obtain ownership of your stock in the corporation, share in profits, and participate in the corporation’s management. If they obtain more than 51% of the corporation’s stock, they can even have the corporation liquidated to satisfy the personal debts of the owner-debtor. However, personal creditors of LLC owner-debtors cannot obtain ownership of the owner-debtor’s membership interest, participate in management, or obtain control of the LLC. Again, a creditor’s exclusive legal remedy against the owner-debtor is to obtain a charging order against the LLC and receive distributions–if and when distributions are made. Since charging orders cannot force an LLC to liquidate assets or make distributions, a creditor may end up with nothing.
The rationale of limiting a creditor’s legal remedy to charging orders may disappear where the owner-debtor belongs to a single-member LLC (SMLLC). The reason personal creditors of LLC owner-debtors are limited to charging orders is to protect the other members (owners) of the LLC. Most courts do not believe it is fair that all members of an LLC should end up paying for the personal debts of just one LLC member. However, when an owner-debtor is the sole member of an SMLLC, all bets are off. A simple way of avoiding the outside liability associated with SMLLCs is not to have one. Instead, form an LLC that has at least two members.
An LLC is the best legal entity for holding real estate because it provides both inside and outside protection. Understanding the laws that regulate LLCs in your state is also important, because not all states provide charging order protection.
Setting Up a Real Estate LLC
The best protection against lawsuits is avoiding them altogether. The best way to avoid lawsuits is to make sure you and your assets never show up on a tenant’s or attorney’s radar. Attorneys don’t sue people who don’t have assets. Why? Because attorneys get paid based on what they’re able to collect. If an attorney feels they won’t collect against a landlord, they’re very unlikely to sue. Your strategy is to become as undesirable a target as possible.
As good as LLCs are for holding real estate and limiting personal liability, in and of themselves they are not sufficient to guarantee your anonymity as an income property owner. In fact, in most states, when you register an LLC, your name, as the manager or member of the LLC, will likely end up listed on Secretary of State’s website—publicly available for all to see. If someone wants to find all the real estate you own, they simply perform a search using your name and there you are holding your piggy bank. Not a step in the write direction, if your goal is stay off the radar.
There are only a handful of states that allow investors to establish an LLC without disclosing their personal information during the registration process. So this begets the question, “Where do I create the LLC to hold my rental properties?” Simple. You always create your LLC in the state where the rental property is located. Why? Because this is where the LLC will be conducting business.
So now you’re asking yourself, “If I set my LLC up in a state where the details of my real estate holdings and personal information are posted publically on the Secretary of State website, isn’t this going to leave me vulnerable?” Not if you set your LLC up correctly.
STEP 1 – ESTABLISH A HOLDING LLC IN A STATE THAT ALLOWS NOMINEE REGISTRATION
Establishing a sound asset protection strategy requires making sure your personal information, and that of your real estate holdings, is not made accessible to the public. If your holdings include rental properties in multiple states, you’ll want to begin by creating a Holding LLC in a state, such as Nevada or Wyoming, which allows the use of a nominee manager.
A nominee is an individual the owners of a business seeking LLC status hires to act as the initial manager of the LLC for filing purposes, so that your personal information is not disclosed with the Secretary of the State. The nominee’s name will be placed on the articles of organization that are filed with the state as a matter of public record, in place of your name. Once the LLC has been established, the nominee resigns, you or the LLC member manager is privately appointed the new manager of the LLC and you take back control from the nominee. If anyone were to lookup your LLC on the Secretary of State’s website, they would only see the name of the initial nominee. The filing of the resignation of the nominee is done privately, and kept only in your personal documents.
We refer to this process as “nominee protection.” The LLC you establish using nominee protection will become the basis of your overall asset protection strategy. This LLC is often referred to as a “Holding LLC” because we’re setting it up to hold other business interests.
Sole proprietorships and partnerships typically are not required to register with the state, so they’re able to maintain a certain level of anonymity not automatically afforded LLCs. However, owning and operating income properties as a sole proprietor or through a partnership, without the legal protections of the LLC structure, may open real estate owners up to massive personal liability.
STEP 2 – ESTABLISHING STATE SPECIFIC ENTITIES
So now you’ve established a holding LLC with nominee protection, ensuring that your personal information, and that of your LLC, is not made available to the public. For sake of discussion we’ll assume it’s a Wyoming LLC. But, your Wyoming LLC structure cannot directly be used to hold properties located in other states. Remember, you need to establish a separate LLC for the state where you are going to purchase property and conduct business.
Unfortunately, most states, other than Wyoming, Nevada and few others, do not offer nominee protection. So now you may be asking yourself, “If I have to establish a new non-nominee protected LLC in the state where my property is located, how do I maintain my anonymity?” Simple. When establishing your new LLC you list your Wyoming holding LLC as the only member manager on the filing documents.
So now, when a creditor, disgruntled tenant or attorney looks up the address of your rental property on the Secretary of State website to see who owns it, all they’ll find is the information for your Wyoming LLC, along with your initial nominee manager and the registered agent for the state where your property is located. Your personal information doesn’t appear anywhere.
A registered agent? What’s that? A very good question.
Almost every state requires a business entity to have a registered agent. A registered agent is a third-party who is registered in the same state in which a business entity is formed and who is designated to receive service of process notices, correspondences from the Secretary of State, and other official government notifications, such as tax forms and notice of lawsuits, on behalf of the LLC or corporation. Basically, a registered agent is the party responsible for receiving official mail on behalf of your company. They must have a permanent address and be available to collect mail during business hours.
The name and legal street address of an authorized registered agent for the state must be included when filing the documentation to form your LLC. While you can act as your own registered agent, doing so would blow your anonymity and nominee protection strategy out of the water because now you and your personal information would be listed in the public record along side your LLC and rental property. This is why you always want to use a third-party commercial registered agent when establishing an anonymity compliant holding LLC for your rental properties.
STEP 3 – ESTABLISHING A LAND TRUST TO AVOID THE DUE-ON-SALE CLAUSE
Unless you own your rental property free and clear, you likely have a mortgage on it that is underwritten by a bank or lending institution. Almost every mortgage includes a “due-on-sale” clause. The due-on-sale clause essentially states that the lender has the right, but not the obligation, to call the note due, or accelerate repayment of the loan, if and when ownership of the property used to secure the loan is transferred. When you transfer ownership of a property from your name into the name of your LLC, your bank technically could call your note due and force you to refinance. In all my years as a real estate investor, I’ve never seen a bank call a loan due, or accelerate repayment of a loan, nor have I spoken with any attorney who has had a client who has been forced to refinance simply because they decided to transfer their property into an LLC. However, because of the possibility of this potential outcome, investors may choose to not protect themselves or their property by forming an LLC and transferring deed of their property(s) to the LLC.
Now you may be asking, “What is a land trust and where does it fit in to all of this?”
A land trust, also known in many states as a “grantor” trust, is a contract between three parties:
- The Grantor – The person who sets up the trust and transfers assets
- The Trustee – The person who manages the trust. (The trustee should have active duties so that the trust isn’t seen as a passive trust.)
- The Beneficiary – The beneficiary is usually grantor—who receives the “beneficial interest”, i.e. ownership, of the trust.
The most common form of land/grantor trust in the United States is the revocable living trust, which—unlike the irrevocable trust—can be changed, modified, or terminated at any time. The land trust, in and of itself, does not provide any legal protection to the beneficiary of the trust holding real property. It does, however, provide (1) privacy of real estate ownership and (2) a means for moving your mortgaged property under the protection of an LLC without alerting your lender to the transfer.
While a property’s title can’t be transferred to an LLC without violating the due-on-sale clause, a property with fewer than four housing units with a federally backed loan, can be transferred to a land trust without penalty. Under the Garn St. Germain Act, a real estate owner can create a land trust to hold title to his or her rental real state without fear of the lender calling the mortgage due and payable. In addition, U.S. Code Title 12, Chapter 13, Section 1701j-3 limits a lender from accelerating a note when there is a transfer to an inter vivos trust in which the borrower is and remains a beneficiary.
Once title to the property is held by a land trust, the real estate owner (and “beneficiary” of the trust) has the flexibility to assign his or her beneficial interest in the trust to an entity without alerting any third parties to the fact that a transferred occurred.
so what is the exact process for forming a trust to avoid the due-on-sale clause and transfer title of your real estate holdings to an LLC while protecting your identity?
- The grantor (trustor) creates a land trust using properly prepared documents.
- An individual—other than the grantor or beneficiary—is selected and assigned as the nominee trustee (preferably an attorney). The name of the nominee trustee—not yours—will appear on the public record.
- The grantor assigns himself (or herself) as the beneficiary of the trust.
- Property title for the real estate is deeded to the trust. (The deed does not include the name of the trustee.)
- The trust is notarized (depending on state requirements)
- A deed is prepared. (Use a PO Box for receipt of tax statements to maintain complete anonymity.)
- A record of property deed transfer is filed with the Secretary of State
- A copy of the deed transfer—showing the mortgagor (borrower) as the beneficiary of the trust—is provided to the mortgagee (bank/institution servicing the loan) for their record.
- The trustees resigns
- The beneficiary of the trust is assigned as the new trustee.
- You assign your beneficial interest in your land trust to your LLC. Now your LLC is the party liable for any catastrophic claims—not you.
- A private copy of the amended trust, with your llc listed as the beneficiary, is held by your law firm and another copy is kept in your personal safe—only to see the light of day if you’re ever sued or face a catastrophic claim against you or your property.
Steps 8 through 11 are not made a matter of public record. The new trustee assignment—which is legal and binding—is not seen by anyone other than you and your attorney. If anyone performs a search on the property, all they’ll find in the public record is the original trust and trustee information, along with the address for the registered agent on file.
Even though the Garn St. Germain Act stops banks from accelerating your mortgage or calling it due when transferring property title to a trust, it doesn’t prevent them from charging you a title transfer fee. Before signing a mortgage, or setting up a land trust for the purpose of transferring property title, you should find out if your mortgage clause includes title transfer fees.
While business structuring is an effective means for protecting you—and your assets—from inside and outside liability, it’s not a simple process of forming a LLC and transferring property title. Laws regulating deeds and trusts vary from state to state. You should be familiar with your state’s laws regulated trusts and business structures. Additionally, there are several ways you can utilize entities and trusts to provide long-term asset protection. The specific strategy you adopt and implement will be determined by the state where your real estate is located, your current financial position, your risk profile and your investing strategy.
*This article is intended for informational purposes only. Always consult with an experienced real estate attorney before implementing an asset protection strategy involving business structuring and real property.