When choosing an entity for your real estate investment, it is vital that you understand the legal issues involved, so you can protect your assets. We have already explored the tax implications of entity structuring. In this article, we will look in depth at the LEGAL side of entity structuring, Land Trusts as well as LLC transfer tax issues.
Bottom Up Creditors & Top Down Creditors
With the legal side of entity structuring, you need to ensure that you have an entity that shields you, does not leave your personal assets totally exposed, and protects you from legal actions. It is not the size of the entity, but rather the existence of complete and proper documents which provide protection from personal liability for the LLC members.
A water-tight entity also protects you and your business from BOTTOM UP CREDITORS(has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager, or employee) as well as TOP DOWN CREDITORS (gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers or employees).
Multi-member LLCs can help protect your assets. With a good operating agreement and an umbrella insurance policy, you can minimize (NOT MITIGATE) your exposure.
1. LIMITED LIABILITY COMPANIES (LLC): The legal rights of members are governed by state LLC statutes (like corporations), but LLC laws vary from state to state.
2. PARTNERSHIPS: In a partnership, each partner is jointly liable for all partnership debts. These are inexpensive and simple to form. General partnerships are not recommended for real estate investments because of the liability exposure.
3. LLC-PARTNERSHIPS: In most cases, the LLC partnership will be the ideal entity preference for real estate ownership. The corporate structure of an LLC protects its owner-members and their assets.
4. LIMITED PARTNERSHIPS (LP’S): Limited liability for the limited partners, but personal liability for the general partner.
5. CORPORATIONS: Corporations give their shareholders limited liability protection.
6. SERIES LLC – Reduced startup cost. Only one filing fee is required, and an attorney can set up the parent and cells at less cost than setting up multiple LLCs.
- Protection of Assets. Assets of each cell are protected from judgments against assets in other cells.
- Less Administration. You can set up as many LLCs as you want, but each would be separate and would have to be administered separately. A series LLC allows you to save on administrative time and expenses.
- Less Complex than Corporation/Subsidiary Structure. A series LLC doesn’t have the same complexities of taxes, structure, and formalities (corporate records, for example) as a corporation with subsidiaries.
- Less Sales Tax. Depending on the regulations in your state, the rent paid by one cell to another cell in the series might not be subject to sales tax. Check with your state on this issue.
- Only one state registration. Only the parent LLC must be registered with the state, which means fewer legal costs and registration fees. It also means only one annual or biennial fee is needed for the series.
- Only one tax return. Only the parent LLC is required to file a tax return, which includes all the cell LLCs. Of course, this is going to be a complicated tax return, so you will need a tax preparer who is experienced with this type of return.
- No separate registered agent. Your state will likely require you to have a separate registered agent for each LLC in the series, which means additional expense for all of these registered agents.
- Separate bank accounts, and accounting. Each cell LLC must have its bank account and, since each is producing separate financial statements, each must have separate accounting. If there are several LLCs in the series, this can be a big administrative issue.
- Cost of formation. The cost of forming a series LLC may be higher than the cost of forming a regular LLC. The state of Illinois, for example, charges $600 to form a regular LLC and $850 for a series LLC. But there is no additional cost for adding more LLCs in the series.
- Bankruptcy questions. Because the series LLC concept is so new, there are many legal questions still to be answered; one is how the individual LLCs might be handled in a bankruptcy, or if a bankruptcy court will recognize the separateness of different LLCs within.
Drawbacks of Series LLC’s
LLC Transfer Taxes
Some state states impose a transfer tax when real estate is transferred from one owner to another. Taxes can vary from a few hundred dollars to several thousand dollars. Some states say as long as the ownership of the property does not change, the name in which you hold the property doesn’t matter.
As long as you are the 100% owner of the LLC, you will pay just minimal document recording fees (between $20 and $70). Other states say EVERY transfer is taxable. Check with an attorney or title company to see if there are any legal ways to avoid transfer taxes.
One possible way is to transfer the property to a land trust and then privately amend the trust to change the beneficiary from the individual investor to the LLC.
Real Estate Land Trusts
Unlike a typical living trust, in a true Land trust, the Trustee’s role is not to operate the trust, but simply to hold legal and equitable title to the real estate properties held within the trust. The trust is controlled and operated by its beneficiary, while the Trustee serves as a figurehead – holding the title and signing documents, contracts, deeds, etc., as directed by the beneficiary. Here are some key components of a Land Trust:
- Privacy– Gives your assets privacy because the title to the property is held in the name of a ‘trustee’, not in the investor’s name. The investor is the beneficiary and equitable owner of the trust’s assets and thus retains control and management of the property
- Not a separate entity– A land trust is not a separate legal entity and does not give limited liability the way an LLC does.
- Tax Ramifications– None: Land trusts are grantor trusts, NOT separate tax entities.
- LLC Combination For Enhanced Privacy & Protection: An LLC can be a beneficiary in a land trust. If the beneficiary of the land trust is an LLC instead of you personally, then the land trust LLC combination should insulate you even further with more privacy.
Here are some recent questions about LLCs from my blog:
For a real estate investor who lives in NY, operates an LLC in NY, and has investment property in Arizona, Florida, Tennessee, and Indiana, how would the Series LLC work?
My Answer: At this time, the states that allow the formation of a series LLC include: Delaware, Illinois, Iowa, Nevada, Oklahoma, Tennessee, Texas, Utah, and Wisconsin. The other 41 states do not currently recognize the series LLC. It is important to note that California does not support the formation of a series LLC, but allows for the registration of a series LLC if it was formed in another state. NY and every other state recognize the series LLC but in a different way.
If a Series LLC, formed in Nevada, has property in a non-series-LLC state such as California, will California recognize the separateness of the internal series for asset protection purposes, or will the state apply its own, non-series-LLC laws and interpretation?
My Answer: The best answer to that question is that no one really knows. The second-best answer is that each state has the power and authority to act in its own best interest, and is not obligated to recognize legal separation for assets within its borders that are owned by an entity for which it has not adopted governing laws. Given that, who wants to volunteer to be the first test case with serious money on the line? DE and other states put a name on this type of entity, but it is similar to setting up multiple LLCs run by one LLC and this is how some states that do not have a series LLC may treat each cell/business as a separate LLC owned by another LLC. Cab companies use this type of LLC many times, where one LLC has numerous cabs and each cab is its own entity LLC for protection of the main LLC and the other cabs.
NOTE: No Series LLC has been tested in the U.S. Bankruptcy Court.
“I have just completed my real estate broker course and am waiting to take the state exam. I already set up an LLC a couple of years ago to buy and flip properties. If I do set up my own real estate brokerage office as opposed to working with a non-licensed partner, will it be ok to use my existing LLC to buy sell, and broker properties, or do you recommend setting up a new separate LLC? Thanks in advance for your suggestions.”
My Answer: This is ok to maintain history as long as you originally set up the LLC right by not using your home address or yourself as the resident agent. These are asset protection busters. You would only need to update your operating agreement for the new brokerage office.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. Book a Free Tax Consultation with me at www.wealthbuildingcpa.com
