Pssst - Wanna Be a Real Estate Millionaire? (Part15)

Chapter 15: Asset Protection

I was shocked the other day to read that there are more students in law schools today than the total number of existing attorneys in practice today. Think of that! If you think we live in a litigious society today, wait until those students graduate and start trying to earn a living. In my opinion, we already have too many attorneys and they’re all out there trying to create problems so they can earn a living. It will only get worse regardless of so-called tort reform measures.

Well, you have nothing to be concerned with, right? You don’t allow hazards to remain on your properties. You don’t permit drug pushers to inhabit your units. You don’t allow illegal activities to occur in your commercial properties. So you have nothing to worry about – right? You’re just a small investor.

Consider this. A woman successfully sued a major fast food restaurant because she spilled hot coffee on herself. It seems that the fast food restaurant was negligent because the coffee they served was “too” hot. Even though an appeals court reduced the initial million dollar award, the company still incurred substantial costs defending itself. This case was so onerous that the “Stella Awards” have now become an annual event where the most outrageous court cases are profiled under the name of the woman who filed the hot coffee suit. Another woman successfully sued a department store because a run-wild child tripped her while she was shopping and she broke her foot. Doesn’t sound too outlandish until you learn that the run-wild child was her own child. Then there was the woman who slipped on a spilled drink on the floor of a 7-Eleven and broke her ankle so she sued and collected. Again, doesn’t sound too unusual until you learn that she had just thrown a soft-drink bottle at her boyfriend 30 seconds earlier and then slipped on the mess she created. And you think it can’t (won’t) happen to you? Think again! As I understand the current statistics, you now face an average of seven (7) law suits during your lifetime. That’s just the average. You’re about to enter investment real estate where these odds go up exponentially. Accept the fact that you must protect yourself and you may as well start out correctly so that you don’t have to “re-do” your program later.

I’m not an attorney and you shouldn’t consider what I’m about to tell you as being legal advice (why do you suppose I even had to say that?). There are ways you can title your properties, however, to protect yourself and minimize the risk of loss in a lawsuit (notice I didn’t say eliminate). The first step is to NOT take title in your own name. When a plaintiff approaches an attorney to file a lawsuit, before accepting the case, the attorney first checks the public records to see if the person to be sued has anything worthwhile on record. If nothing shows up, the attorney most likely will not even accept the case. That’s the best you can hope for! So get over your ego trip of ownership and remain anonymous to the greatest extent possible.

For your first property, the easiest way to accomplish this is to use a Land Trust. This trust is a simple document that you create and keep in your personal file cabinet. It provides for someone you know and trust to act as the trustee of this trust. Your trustee does not have any ownership in the trust or the real estate owned by the trust. The trustee simply acts as a fiduciary. Preferably the person you select will have a different last name than yours. The trust title will read “Joe Jones, Trustee, 123 Main Street Trust” where “123 Main Street” is the street address of the subject property or whatever name you choose to call the trust, perhaps just the number “123.” The point is that only Joe’s name shows and Joe is just a fiduciary, not an owner. You, and your spouse, are the beneficiaries of this trust, but that is not disclosed to the general public. Hence, anonymity for you. The title to the real estate is then vested in Joe Jones as Trustee of this trust, and not to you. You will have Joe sign the trust and his signature will be notarized in order to make the trust official. Joe will also sign the deed and that signature will be notarized. Your Social Security number or other tax ID number will be used for tax reporting so Joe will not incur any tax liability. Joe’s only job is to be available when the property is purchased and again when the property is sold. He has no involvement during the holding period so you’re not imposing on Joe’s good nature to help you.

Be aware that all you’ve done with the Land Trust is to avoid public disclosure. You have not protected this asset from seizure via a lawsuit. If there is a valid suit against this property, you will be personably liable. To minimize your personal involvement, you should take the next steps. This is where corporations and limited partnerships and other trusts come into play. I strongly advise that you retain an attorney who specializes in asset protection to handle this portion of your real estate empire. Be sure your attorney has extensive experience in asset protection because there are many out there who only pretend to know. Be willing to pay to hire only the best. Your entire financial future is at stake.

Most likely, the attorney will establish a corporation to act as your real estate manager. The corporation will buy and sell your real estate and can supervise separate day-to-day management of your properties. Alternatively, you can establish a second corporation to provide just the day-to-day management requirements. A logical extension of this second corporation would be to make this service available to other investors as well as for your own properties. You may also have heard of the newer concept of Limited Liability Companies (LLCs) which provide protection similar to corporations. Until recently, there were high hopes for LLCs but due to recent, adverse court rulings, these hopes have been drastically diminished. Until such time as future court rulings establish the viability of LLCs, you would probably be well advised to stick with corporations.

The corporation will only act in a management capacity. It will not own the assets. Separately, you will establish a limited partnership for each investment property you own. You will not co-mingle properties into one limited partnership. That way, if one property really does get you into trouble, it will be the only property at risk. All the rest of your properties will be protected in other, separate limited partnerships. This will avoid the domino-effect.

There are numerous advantages to the limited partnership ownership concept for both income tax and asset protection reasons. A limited partnership (LP) has one or more General Partners (GP) and one or more limited partners. Only the GP can make the day-to-day decisions. You will probably use a corporation to act as the General Partner. The limited partner has absolutely no say in the operations of the LP. The GP accepts the general liability and the limited partner is only liable for his/her initial investment. The limited partner cannot be assessed additional monies unless that assessment option was part of the initial organization of the LP.

The asset protection feature of a LP is based on the concept of what is called a “Charging Order.” If a creditor obtains a judgment against a limited partner, the court gives the plaintiff a Charging Order. That means the plaintiff can then attach something that the defendant owns. In this case, that “something” is a LP. The problem for the plaintiff is that the limited partner has no say-so in the operations of the LP. All the plaintiff can do is attach the charging order to the defendant’s ownership portion of the LP and then wait for something to happen within the LP. What will happen is that the GP will decide to no-longer make annual cash distributions to the limited partners, instead using those funds within the LP for other business reasons. In the meantime, the plaintiff has attached his charging order to the LP but receives no income from that attachment, However, the IRS always wants to be paid on an annual basis, so the plaintiff now gets the privilege of paying annual income taxes on phantom income – money earned by the LP but not distributed. This feature very quickly discourages plaintiffs and their attorneys from filing frivolous lawsuits. If the lawsuit is a valid one, the LP causes the plaintiff to quickly settle that suit in a reasonable manner. The LP concept avoids the “lottery ticket” mentality. If the suit was valid, you will also have liability insurance to cover reasonable costs.

The income tax benefit of a LP is that all the taxable income is normally distributed to the limited partners and is only taxed once. Each limited partner pays tax at his/her tax bracket. In the case of minor children and young adults just starting out in life, their tax brackets are lower than the parents’- or grandparents’ brackets. Since all taxable income passes through to the limited partners, spreading this income can effect a reduced overall tax.

Another benefit of using a LP is for estate planning. The Federal Congress is still playing with the estate tax rules. At this time, the Federal Estate Tax is scheduled to end in the year 2012 but then revert back to the old schedule in year 2013 unless congress permanently enacts this legislation change. I’m not holding my breath. As such, it is still important to consider the future distribution of your successfully accumulated estate while minimizing taxes due at death. If taxes are due when a person dies, those taxes must be paid in cash within 9 months of the date of death. Imagine trying to unload a well-conceived real estate portfolio in 9 months without it looking like a fire sale. You can avoid this by simply gifting annually to children and grandchildren via percentage ownerships in your various LPs. You want to be aware that current law limits you to $13,000 per person per year without triggering the gift tax surcharge. If you and your spouse each decide to maximize your gifting, you can jointly gift up to $26,000 per person per year without paying any gift tax. You would accomplish this by simply increasing the percentage ownership in each LP each year for each child and grandchild, all of whom would be limited partners. Remember, you are still the GP and in total control of all the assets even though you are systematically gifting ownership of those assets.

While we’re at it, you should know what not to do when trying to protect assets. You should not enter into a General Partnership or a Joint Venture Partnership (ask me how I know that?). That is not to say you shouldn’t enter into business arrangements with others, if you all have a common interest or goal. It is to say that neither the General Partnership nor the Joint Venture are acceptable forms of that business entity. The primary reason is that if one partner gets into financial trouble, every other partner is also responsible for the debts of that partner. Over and over again, the innocent partner(s) gets stuck paying off a debt or lawsuit created by another partner. If you must partner with others, use a properly structured corporation. This is especially true when using a financial partner to fund your projects. Just do it correctly from the beginning and you’ll have no future problems.

It is legal for you to own foreign real estate meaning real estate physically located outside the United States. You can even own this real estate in an IRA, if that is appropriate for your situation. Owning real estate outside the country does not require IRS reporting as do foreign bank accounts and stock/bond accounts. One of the benefits of foreign real estate is that it is far away and not easily identified-by- or attachable by creditors thus providing still another form of asset protection.

NOTE: Stay tuned for Part 16 - Financing - Show Me The Money