So, you own property or want to buy some. And you want to maximize your value and minimize your risk. What do you do?
The most common answer I hear from inexperienced investors is this: “Oh, my friend/relative/neighbor/co-worker/stranger I heard of/guy I saw on a TV infomercial said to do X [insert bad advice here]. That person’s really, really smart, so I’m sure the same approach will work for me.”
Wrong, wrong¸ WRONG, WRONG. Actually, as a lawyer I should love hearing stuff like this come out of the mouth of a prospective client. Why? Because I then get to spend thousands of dollars trying to fix (not always successfully) problems that clients create because they are penny wise and pound foolish. But I don’t, even if it means making less money.
Listen, you may do the same thing that Jack down the street did and it may work out all right. If you do, count yourself lucky. You rolled a 7 this time. But what if next time you throw a 2, 3 or 12? You’ll have no one to blame but yourself.
When you buy or own property you have to consider carefully what your goals are and match those goals to the proper structure of the transaction. Some big, big investors will have a page full of different entities on the page owning a property because of different investors, developers and various profit-sharing structures, tax reasons, exchange reasons, exit strategies and the like. They also have to think about complicated things such as UBTI (Unrelated Business Taxable Income) and other sophisticated stuff way beyond the scope of this little piece (and best described by a tax expert anyway).
When making these considerations, the things that you see the most these days are: (1) limitation of liability, (2) structuring deals to minimize tax liability and (3) keeping the properties you own legally separate from one other. Why?
Let’s start with limitation of liability. Yes, you have insurance policies and all that. But what if something happens that insurance does not cover fully? 
What if you do something that exposes you to liability? What if something just doesn’t work out? You want to be protected, right? Of course. This is where limited liability companies, corporations and limited partnerships (not general partnerships; they provide no protection at all unless combined with another limited liability entity) come into play. There are other possibilities and types of entities you can use, too, but this is not a comprehensive treatise on structuring real estate transactions.
The LLC is the entity I am almost always seeing these days to own investment property, and usually as a single purpose entity that owns one property or a number of smaller properties with the goal in mind of limiting your exposure when a problem arises. So long as you maintain minimal formalities, you limit your exposure to the value of the property owned by the company. (There are exceptions such as fraud, dumping dioxin, or if you have a recourse loan with your lender as many investors do. But even with those exceptions, an LLC is still worth the money because you know your exposure is capped.)
But the second reason for properly structuring a deal, taxes, may also come into play here. In the past, with the help of able counsel in other states outside Illinois (California, Florida and Texas come immediately to mind), I’ve had to use limited partnerships and corporations –- and combinations thereof — to achieve the same goals that I can with an LLC in most states. Why? Because LLCs don’t always get preferred tax treatment in every state!
Again, just because an LLC works to own property here in Chicago does not mean it will work as well in San Diego. We don’t have minimum franchise taxes here.
And depending on your state, the nature of the property and your corporate and LLC laws, you may not want to even use an entity that is registered in the state where the property is located. For instance, some people in Illinois are using Colorado LLCs to own property because they are cheaper to maintain. Illinois law allows that. Other states don’t, so you end up paying double fees. Ouch!
Entity considerations are also important when doing a 1031 exchange. The general rule is “same party in, same party out.” However, if you have the same parties in the outbound side of the exchange as the inbound side of the exchange, you can use different entities to sell and then buy properties in a 1031? Why? Because the IRS understands that lenders require new, separate entities as borrowers in deals, so they will consider LLC1 and LLC2 to be the same party so long as the members of LLC1 and LLC2 are the same. Neat, huh?
We’ve pretty much covered (3) above. Again, think about what happens if there’s a bad slip and fall at one of your properties, and a claim is made for beyond the value of the property and the 
insurance policies. If you are sued individually, guess what? They can go after all you own! Probably not so with LLCs or similar entities; even if you are sued individually the judge should throw that lawsuit out unless there’s a good reason not to. And remember, lenders often like separate companies owning each property because it makes life easier for them in the event of, say, bankruptcy or foreclosure. Just make sure your lender understands what you are doing –- and oh, don’t just transfer property you currently own into an LLC without talking to the lender and your lawyer and your accountant! Do you want to accidentally commit an event of default under your loan or cause some taxable event nightmare? I’ve seen that too many times.
All in all, if you want to take your chances, by all means do so. Then call me or your lawyer when things are a complete mess and I can charge you a ton of money to try and get you out of the morass. Or listen up and get good professionals behind you now. They’ll ask the hard questions. They may come up with things you have not considered. They may even drive you batty! But it’s all with a great goal in mind: making sure your Purposeful Plan is not derailed.
The usual disclaimers: I’m not your lawyer and I am not giving you specific legal advice. I am only admitted to practice in Illinois and California (inactive for now), so when I work out of state I have to get one of my able friends there to check and bless my work as local counsel. Get your own people to help you with this, and again please remember: real estate investing isn’t rocket science, but it is also not something you do cavalierly unless you want to open yourself up to a big can of pitfalls.
Related posts:
- Real Estate Investors Need A Purposeful Plan And One Sharp Dirt Lawyer
- The Learning Curve of a Recovering Attorney Turned Real Estate Investor — Escaping From Dodge
- Real Estate Wives (And Husbands) — An Agent’s Wife Speaks
- Real Estate Investors: Keeping Your Eye On The Ball
- Why Are Real Estate Investors Leaving San Diego?
About BawldGuy
Great post. I could not have stated it better myself, and I have tried. A good, and enjoyable, part of my legal practice is educating real estate investors here in Kansas City on issues just like these. David’s post is right on the mark.