Saturday, February 27, 2010

Asset protection and real estate

Seal of NevadaImage via Wikipedia
Mr. Sutton, esq., wrote a very nice article in "The Real Book of Real Estate" about asset protection. I will go into a tiny bit of that. Please keep in mind, he is the attorney, I am not. So this is NOT legal advice. And to read the whole thing, you need to get that book (there's a link at the end to Amazon.com). However, here's a taste, just a tiny bit.

So what do you need to know about asset protection when it comes to real-estate? A lot, and the earlier you know the better. Basically, it is to setup a 'separate you' to own the properties, so that what happens to 'separate you' will not wipe you out, and vice versa.

First of all, asset protection is an overall strategy, one that starts when you invest, not something tacked onto it much later. You should have the entities that you will use setup before you invest. After all, a corporation is just a few pieces of paper and some annual paperwork. You can have it setup way ahead of time.



Second, asset protection is a strategy consists of MORE than just arranging some corporations. Insurance is an important part of the equation, but NOT the only part. Rely on only one or the other invites disaster. It is always better to have a backup. If you have one defense that works 90% of the time, and you install two layer of it, you now have a defense that works 99% of the time! Furthermore, having the right entity setup will tell the plaintiff's attorneys that they won't get any more money by suing than claiming insurance alone, so they shouldn't bother to sue and rack up attorney fees. In other words, it will discourage lawsuits.

Third, don't believe offshore companies, land trusts, living trusts, and so on when it comes to real estate asset protection. You run into those "seminars" all the time, all trying to sell you their services. They have their uses when it comes to estates, foundations, and whatnot, but they will NOT protect your assets. Have an attorney explain to you why that is the case, or get the book. :D

Fourth, stay AWAY from "joint tenancy" and "tenants in common". They provide NO protection at all. They may be fine for private ownership (esp. married couples), but they are horrible for investment properties. It's like general partnership: multiple exposure to risk. Even worse, one's personal property may be at risk. What's worse, one can "petition for partition", which basically means one party can force the asset to be sold so he can pocket his share.

Fifth, the true protection when it comes to real estate are LPs and LLCs. Those are flexible, easy to setup, and provides almost ironclad protection when combined with proper insurance. And they are not subject to double-tax if you decided to choose partnership tax rules for your LLC. In the example above, if one uses multiple LLCs to own the separate interests in "tenants in common", then they are protected from each other's liabilities.

Why not a C Corp? Two primary reason: 1) C Corp is subject to both a corporate tax, AND the individual shareholder's individual tax. That can almost DOUBLE your tax load. 2) a real estate holding corp would have little if any expenses to write off, but plenty of income. There are other reasons, but you'll need to read the book. :D

Six, California has one of the weakest laws protecting assets, so you really should consider incorporate in Nevada or Wyoming where laws are better at protecting assets. The trick here is called "charging order". This takes a little to explain:

Example. There's John, who formed an LLC that owns a 4-plex. If John owns the 4-plex directly, then any one who slipped at the 4-plex can sue John (as the owner), and John's personal assets are at risk (car, home, bank account...) However, John has setup the LLC as the owner, so whoever slipped can only sue the LLC, not John directly. Only the LLC is at risk.

But what if the suit is again John himself? What if there's an auto accident, and John was ruled at fault, insurance aren't enough, and attorneys are out for blood? Attorneys can sue John for all his personal assets, but they can't sue the LLC. They can sue to get John's portion of the LLC, which is quite different. This is where charging order comes in. (Without the LLC, the 4-plex is at risk)

Charging order says that whoever sued John, let's called him Nate, even if Nate wins, Nate cannot actually take ownership of John's interest in the LLC. If he did, he could sell the property, and pocket what he won. Instead, charging order says that he can only sit in line, and take John's distribution (it's not called dividend because this is not actually a Corp), with NO voting/ownership rights. In other words, it's a lien, not a levy, so he gets "first dibs"... if there's anything to dib at all. John, with his ownership rights still intact, can elect NOT TO PAY OUT any distribution, not even for the taxes. If Nate want to stick around and get paid, Nate would actually have to pay the taxes, on money he did not receive! This is called "phantom income", and this would force almost any creditor to settle for pennies on the dollar, or not even file a suit at all.

Remember, this is best done with a Nevada or Wyoming corporation, as NV and WY limits any creditors suing an LLC's owner to ONLY a charging order, whereas in CA there have been cases where the creditor was able to force an LLC's asset to be sold to cover the judgement.

Seventh, segregate the assets under different LLCs. Individual properties should be under separate LLCs, so problems at one property cannot affect other properties, even though they are all controlled by you ultimately. While this involves a lot more paperwork, this, as shown before, would also discourage lawsuits. When lawyers see that they won't be able to touch anything else, they will probably settle for the insurance max payout and be done with it.

Eighth, don't go overboard when it comes to setting up entities. Mostly one entity per property is enough. Beware of those who suggest a bunch of trusts and LLCs and C corps. and such, like a Babushkha Russian doll, one inside another, and charge you a bundle for it. Remember, you have to actually DEED the title to the entity, or else the entity don't do squat. The trick is making sure that fees and taxes are paid, and that differs from state to state. So beware.

As eight is a lucky Chinese number, I'll stop there. However, I do want to share Mr. Sutton's final points:

* is the 'expert' really an expert?

In other words, does this person actually qualified to give advice in that field? Only attorneys can give legal advice, and so on. If you see a salesperson telling you something is perfectly legal, alarm bells should go off immediately.

(And I must emphasize that the stuff above is NOT legal advice, and you should consult a real estate attorney in your state for your particular situation, preferably someone who is familiar with "asset protection".)

* is whatever being "sold" for your benefit, or for theirs?

The more complicated the "scheme" seems, and the more it costs, the less likely it is for your benefit. In all "free" seminars that offer services and whatnot for sale at the end, it's THOSE that actually makes money.

(I can tell you that I just promote the books that are related to the topic, and get a tiny bit of commission from the sales)

* "trust, but verify"

Find a REAL expert, unrelated to you or them, and see that the expert says about it. It is very easy to get swept up in the fever "greatest offer ever, limited time only!" In fact, I'll bet you that in those seminars, somebody there are shills. They have been paid to jump up at the first sign of offer and wave their money (provided by the promoters) in order to tempt the people who're hesitating.

It's also commonly known that in some seminars the local promoter splits the profits with the service provider. I don't sell you services. I offer information. I'll tell you outright that I want to sell you the books I've mentioned. If you want to retain Mr. Sutton's services (http://www.sutlaw.com) that is your business. :D

So, to sum up, asset protection is a strategy with multiple components, and there are plenty of special considerations when it comes to real-estate, which also has implications in taxes among other things. By setting things up the right way, you can substantially reduce you risk when it comes to lawsuits, perhaps even discourage some of the more frivolous lawsuits, with relatively minimal cost, but it must be done EARLY, BEFORE there is a problem.

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