4 Robust Real Estate Asset Protection Strategies for Investors
You are about to learn how to protect your real estate assets by using the real estate protection laws contained in legal business structures.
We will show you how to separate your business and its debts and liabilities in order to protect your personal assets.
Let’s go over some proven asset protection strategies.
#1 Real Estate Holding Companies
How do real estate investors protect themselves from lawsuits? One method is to use a real estate holding company.
A holding company is a legal entity that owns or holds a business. The liabilities of that business are assumed by the holding company, along with its assets. The entity, which you control, owns the assets, not you.
When you use the correct type of holding company, you can protect your business assets from being taken to satisfy personal obligations.
The two basic types of holding companies are partnerships and corporations. We’ll also discuss LLCs which are a bit of both.
Partnerships
Partnerships exist for business owners who want operational flexibility and pass-through tax treatment to be a part of their real estate investing tax strategy.
Different types of partnerships offer different levels of protection from business liability. The state in which the partnership was formed can affect that protection.
You do not have to organize in your home state. You can pick one of the most creditor friendly states in which to form your partnership.
It is easier to establish and operate a partnership than a corporation. Business decisions and use of funds are under less scrutiny in a partnership.
However, depending on the issue involved and the state where the partnership was formed, a single person might not be recognized as a partnership.
The legal structure of a partnership may not “separate” the business from the personal as strongly as corporations and LLCs.
They may not be the best structure for those wanting to know how to protect real estate from lawsuits.
There are three types of partnerships:
- General Partnership (GP) — All partners are treated the same, all are active in the operation of the business, and all assume liability for the debt and actions of the company. GPs are easy to form and maintain. They are not appropriate for novice investors.
- Limited Partnership (LP) — At least one partner serves as a General Partner who is responsible for the operation of the business. They are personally liable for the debts and actions of the company. Other partners are considered Limited Partners who do not manage the business and are not responsible for business debts or actions.
- Limited Liability Partnership (LLP) — All members make business decisions with limited liability for business debts and actions. LLPs are often used for “professional” occupations such as doctors and lawyers. Some states require that only these professionals can form an LLP.
Although rules can vary from state to state, creditors cannot take partnership assets, such as real estate, to satisfy personal debts. They can, however, do one of the following:
- Obtain a charging order from a court forcing the partnership to pay the creditor any distributions due to the debtor. They can’t force the partnership to pay distributions.
- Foreclose on the debtor’s ownership interest. They still can’t force a sale of the assets unless the debtor owned a majority of the partnership.
- Ask a court to dissolve the partnership. Not all states allow this.
Corporations
Corporations are owned by shareholders. Corporations create a strong “corporate veil” that protects the shareholders from personal liability for corporate actions.
It also protects the corporation’s assets from the shareholders’ personal creditors.
Corporations are more formal and difficult to create and maintain.
Regular meetings are required, certain business decisions require a vote of the shareholders, and IRS rules governing corporations are more complicated.
Small investors can designate their corporation as a Sub S Corp. This allows their income from the corporation to “pass-through” to their personal tax filing, eliminating “double taxation”.
S Corporations have a proven track record of providing corporate protections with pass-through treatment of income and losses.
For those looking for a stronger corporate veil to protect them, they should consider a C-Corp as it also allows for earnings/profits to stay within the corporation and not automatically pass through to the owner(s) of the corporation.
Although personal creditors cannot take real estate assets from a corporation to satisfy a personal debt, they can take the debtor’s shares.
This effectively takes control of the assets away from the debtor.
If the shares taken by creditors equal a majority of the corporation’s shares, they can close the corporation and sell off the assets to pay the debt owed.
Individuals may now form corporations with only themselves as a shareholder, but the process is more complicated than with other single-person entities.
LLCs
LLCs have been called a hybrid of partnerships and corporations. They are simple to create and manage but have strong protection against personal liability.
An LLC is a great option for most real estate investors/owners. It is the lowest cost to establish a veil of protection so that the liability would fall onto the corporation instead of the individual.
The investor(s) in an LLC are called members. There can be any number of members in an LLC, including single-member LLCs.
LLC members can decide whether to be taxed as a corporation or a partnership.
Most choose to be taxed as a partnership where the profits and losses pass through to the member(s) and account for them in their personal tax filings.
LLC members have a lot of flexibility in the operation of their business. One or more people are designated as managers of the entity.
The manager is responsible for the operation of the LLC including ongoing business decisions, preparation of company financials, and reporting to the members.
The manager doesn’t have to be a member of the LLC. If all the members want or need to be passive investors, someone outside the LLC could be selected as the manager.
Personal creditors cannot seize LLC assets for the personal debt of a member. They can go through the steps previously discussed when dealing with partnerships: charging orders, foreclosure of membership interests, and possibly dissolution.
These rules were originally put in place to protect members from losing their business assets because of a fellow member’s personal debt.
With a single-member LLC (SMLLC) there are no other members to protect. Some states believe that these protections should not apply to SMLLCs, and their laws reflect this.
A few states such as Delaware, Wyoming, and Nevada extend these protections to SMLLCs as well. Make sure that you carefully check the laws in the state in which you form your LLC.
As we’ve seen, the asset protection provided by partnerships and LLCs is not absolute.
To protect assets, have a real estate attorney at an asset management firm create an asset protection plan. This might involve placing separate properties in separate LLCs.
Some of you might be wondering how to protect real estate from divorce. It may depend on when the assets were purchased and when the entity was established.
Assets purchased and placed into an LLC prior to the marriage may not be designated as marital assets.
If this was done after being married, the real estate may be considered a marital asset and have to be accounted for in a settlement.
The most secure asset protection plans incorporating LLC real estate protection are complicated strategies involving International LLCs and Offshore Trusts.
Investors should engage the services of a real estate asset protection attorney to assist in creating these plans.
To help you navigate the bookkeeping specifics of each of these ownership forms, we created a guide to the best accounting software for real estate investors.
#2 Real Estate Asset Protection Trusts
A trust is a relationship where a trustor gives their assets to another person (trustee) to hold for the benefit of their designated beneficiaries.
Trusts give protection from legal liability to the trustor, avoid probate costs and inheritance taxes, and ensure that their assets are dealt with according to their wishes after their death.
The key is that an entity takes ownership of the assets so that the trustor no longer owns them.
There are different types of trusts — charitable trusts, special needs trusts, blind trusts, etc. All trusts fall into two of the following four categories:
- Revocable or Irrevocable
- Living or Testamentary
A Living Trust goes into effect during the trustor’s lifetime.
A Testamentary Trust doesn’t become effective until the trustor’s death. All trusts are either a Living or Testamentary Trust.
Revocable Trusts can be revoked or dissolved by the trustor. A Revocable Trust usually allows the trustor to continue to manage the assets.
Unfortunately, for our purposes, this means that the assets are still considered the property of the trustor.
An Irrevocable Trust cannot be undone. This gives the trustor the greatest protection against creditors but takes control of the assets out of their hands.
Trusts can be very beneficial for asset protection but leave very little room for the investor to control the assets, which can be problematic.
When you want to get the asset out of your name and estate for estate tax purposes, you will want to consider a trust.
If you want to control the real estate as an investment, it does not make sense to use a trust. However, there are always exceptions.
Even if you are flipping a property and holding it for a short term, the protection from liability that a trust offers is still worth keeping your real estate holdings within your trust.
A Land Trust is specifically for real estate. It can only hold real estate or assets related to real estate.
In a Land Trust, the beneficiaries control the assets. However, the critical feature for the strongest asset protection is whether the trust is revocable or irrevocable.
A form of Irrevocable Trust that offers the strongest protection is the Asset Protection Trust (APT). An APT allows the trustor to be a beneficiary.
These are considered “Spendthrift Trusts” because trustors can’t liquidate the assets without Trustee approval under specific circumstances contained in the trust agreement.
Trusts formed in the United States, including APTs, are Domestic Trusts. Not all states allow APTs. They are subject to US and state law.
Depending on the circumstances, they may not be impervious to creditors.
For instance, if the trust was established recently, a US court could rule that it was formed solely to avoid creditors, and the trust could be voided.
Some courts have a rule of thumb that a trust should be in existence for a minimum of two years to be legit.
International or offshore APTs are more secure from creditors because they are outside the jurisdiction of US courts.
#3 Equity Stripping
With equity stripping, the property owner is able to protect real estate from creditors by making the equity in the asset unavailable or unattractive to creditors.
Equity stripping is a strategy used to encumber real estate by pulling the equity (cash value) out of the asset so that if you were sued or face significant liability exposure, there would be no value in placing a lien on the property or seeking to foreclose on the property.
One way is with a line of credit. Investment assets should always be held in a separate entity like an LLC.
If you secure a line of credit (LOC) for the LLC with the asset (property) as collateral, only the maximum limit of the LOC shows on the Uniform Commercial Code (UCC) lien filing.
Creditors don’t know if there is sufficient equity or not. Typically they won’t go to the expense of going after the asset or obtaining a charging order with the existing lien in place.
Some real estate investors use separate LLCs that act as the real estate lenders to the original LLC. To add an additional layer of protection, you can hold the lender LLC in a trust.
If the courts believe that this transaction isn’t real, they might be able to seize the assets.
The lender LLC has to be able to provide loan funds if necessary, and you need a safe place to put those liquid assets to prevent seizure.
Some advisors recommend using offshore entities that aren’t subject to US law. An international LLC is the lender which is held in an offshore trust.
If you liquidate the asset, the funds are placed in the offshore trust, where you can access them as needed.
If you cannot afford the higher monthly payments that would be a result of harvesting equity through refinancing your property, that would be a time that it may not make sense to conduct equity stripping.
Also, if the investment property cannot cover the higher mortgage payment, and your other sources of income also are not sufficient to cover the payment, that may result in going late in payments on either the mortgage or other consumer debts.
This will drive down your FICO score and make it more difficult in the future to borrow money for future opportunities.
#4 Real Estate Insurance
Real estate insurance companies offer liability insurance for small businesses that own real estate. This includes different types of real estate investors and their legal entities.
Liability insurance could keep you from losing your property in the event of a lawsuit.
Real estate should always have the coverage of a real estate insurance policy. Insurance is designed for liability exposures that cannot be planned for. Litigation can come when you least expect it. I advise all my clients to use insurance as a hedge against liability.
The only time you could justify NOT having insurance in place on real estate property would be that your net worth is high enough to absorb a total loss and also would require that you have no other assets at risk in the event that you are found liable for damages.
It makes sense to use real estate insurance after you have $100K in assets so pretty much once you own one property.
There are umbrella policies that are very good for the small investors. Insurance is a very complex thing that can be very expensive if not planned well and understood what a policy covers.
If your real estate is income-generating, you’ll need insurance that covers your liability for:
- injuries that happen on your property
- damage to others’ property caused by your property or business activities
- professional liability from your interaction with tenants and customers
Personal injury and property damage liability are covered by General Liability insurance.
If these damages cause lawsuits or judgments, General Liability insurance could keep you from losing your business and its assets.
Professional liability insurance is also called Errors & Omissions (E&O) insurance. This is particularly necessary if your business involves real estate brokerage activities.
Insurers report an increase in claims in recent years for disputes with commercial tenants caused by foreclosure of the property being rented. This would involve E&O insurance.
Vacant land also needs liability coverage. If people are injured on your property, or if a tree falls onto adjacent property causing damage, liability insurance will protect your business.
An Umbrella Policy can provide additional coverage. Umbrella Policies cover amounts owed above the existing coverage limits.
It’s possible that the Umbrella Policy would also cover “Named Peril” not covered by the first policy.