Ownership Structures to Avoid: Joint Tenancy, C Corps, and More

Chapter 6: Ownership Structures to Avoid: Joint Tenancy, C Corps, and More

This chapter delves into several ownership structures commonly encountered in real estate but which, due to inherent flaws, offer❓ inadequate or even detrimental asset protection. We will explore the scientific principles underpinning these vulnerabilities and examine practical scenarios where these structures can lead to significant financial exposure.

6.1 Joint Tenancy: A Recipe for Disaster (For Investors)

Joint tenancy, while seemingly simple, presents significant risks for real estate investors, primarily due to the right of survivorship.

6.1.1 The Right of Survivorship: A Double-Edged Sword

The defining characteristic of joint tenancy is the right of survivorship. This legal mechanism dictates that upon the death of one joint tenant, their ownership share automatically transfers to the surviving joint tenant(s). This immediate transfer bypasses the probate process, making it attractive for estate planning in certain contexts, particularly among married couples. However, for investment partnerships, this feature introduces significant instability and potential for involuntary wealth transfer.

• Scientific Principle: The right of survivorship operates on the legal principle of unity of ownership. This means that all joint tenants are considered to own the entire property simultaneously. Upon the death of one tenant, their interest simply vanishes, leaving the surviving tenants as the sole owners. This is a direct consequence of the initial creation of the joint tenancy, which establishes this contingent ownership structure.
• Mathematical Analogy: Imagine three investors, Peter, Paul, and Coco, each holding a 1/3 interest in a property under joint tenancy. Let ‘P’, ‘A’, and ‘C’ represent their respective shares, where P = 1/3, A = 1/3, and C = 1/3, and the total property (T) = P + A + C = 1. If Coco dies, her share (C) is not inherited by her heirs but is redistributed to Peter and Paul. Now, Peter and Paul each have 1/2 of T, demonstrating the right of survivorship transferring Coco’s wealth.
• Practical Application: Consider an investment property held in joint tenancy by three individuals. If one individual experiences financial distress and dies, their heirs receive nothing from the property. The surviving partners automatically inherit the deceased partner’s share, potentially leading to resentment and conflict. Furthermore, from a tax perspective, the “step-up” in basis only applies to the deceased owner’s percentage, while the other owner’s basis in the property remains the same which can negatively impact taxes if the property is later sold.
• Experiment: A thought experiment: Imagine you are investing with someone in joint tenancy, and they have significant pre-existing debts. Their death does not eliminate those debts. Instead, you inherit their share without the ability to shield it from their creditors.

6.1.2 Investor Aversion

Savvy real estate investors typically avoid joint tenancy due to its inherent risk. The possibility of one’s investment automatically transferring to others upon death, without control over who those beneficiaries are, is a significant deterrent. This creates a situation where investors benefit from your demise, which is often undesirable.

6.2 Tenancy in Common: Slightly Better, but Still Flawed (Individually Held)

Tenancy in common (TIC) offers a more flexible ownership structure than joint tenancy but still carries significant asset protection risks when held individually.

6.2.1 The partition suit❓ Problem

Unlike joint tenancy, tenancy in common does not include the right of survivorship. Each tenant in common owns a specific, undivided share of the property, which they can sell, transfer, or bequeath. However, this divisibility also introduces the risk of a partition suit.

• Scientific Principle: Tenancy in common is based on the principle of unity of possession. All tenants have the right to possess the entire property, regardless of their ownership share. This shared possession, while seemingly equitable, creates a potential for conflict if tenants disagree on property management or disposition. The right to file a partition action is a legal consequence of this principle.
• Mathematical Analogy: If two tenants in common own a property with shares X and Y, where X + Y = 1, either tenant can legally compel a sale of the entire property. If they cannot agree to sell at market rate, the sale can be forced by a court and the value of the property might be less than ideal.
• Practical Application: If one tenant in common is sued, their creditors can place a lien on their share of the property. The creditor can then initiate A partition suit❓, forcing the sale of the entire property to satisfy the debt. This can disrupt the investment for all tenants in common, even those who are not involved in the lawsuit.
• Example: Peter, Paul, and Coco each own a 1/3 share of a property as tenants in common. Peter is sued and loses. Peter’s creditors can obtain a judgment lien against Peter’s 1/3 interest. If Peter can’t pay, the creditors can force a sale of the property through a partition suit to get their money. This means Paul and Coco are forced to sell as well.

6.2.2 Direct Liability Exposure

Tenants in common are generally directly liable for issues related to the property. This means they can be personally sued for events occurring on the property, such as tenant injuries or property damage.

• Scientific Principle: The legal principle of joint and several liability can apply to tenants in common. This means that each tenant can be held fully liable for the entire damages resulting from an incident on the property, regardless of their individual ownership share.
• Practical Application: A tenant slips and falls due to a faulty water heater. The tenant sues all tenants in common. Even if Paul and Coco had nothing to do with the incident, they can be held personally liable for the entire damages. This exposes their personal assets to the claim.

6.2.3 Tenancy in Common (TIC) with Protected Entities: An Improvement

TIC is suitable when investors take their interests with protective entities such as LLCs.
* Practical Application: Investors using 1031 exchanges or just pooling investment money will buy a large property. This property will be held as a TIC with the investors holding their TIC interest through a protective entity such as an LLC. The LLC protects the investors from the liability of the property.

6.3 C Corporations: Tax Inefficiency Personified for Real Estate

Holding real estate within a C corporation is generally a poor asset protection strategy due to its significant tax disadvantages.

6.3.1 double taxation❓❓: The Fatal Flaw

The primary drawback of C corporations is double taxation. Profits are taxed at the corporate level, and then again when distributed to shareholders as dividends. This significantly reduces the overall return on investment, especially when compared to flow-through entities like LLCs or S corporations.

• Scientific Principle: The concept of double taxation arises from the C corporation being treated as a separate legal entity from its owners. This separation subjects its profits to corporate income tax. When those after-tax profits are distributed to shareholders, they are treated as personal income and taxed again. This stems from tax law which treats the corporation as its own distinct entity, not simply an extension of its shareholders.

• Mathematical Illustration:

  • Let ‘P’ represent the profit generated by the real estate held in a C corporation.
  • Let ‘Tc’ represent the corporate tax rate.
  • Let ‘Td’ represent the dividend tax rate.
  • Taxable Income (Before Corporate Tax): P
  • After Corporate Tax: P - (Tc * P) = P * (1 - Tc)
  • Dividends to Shareholders: P * (1 - Tc)
  • Tax on Dividends: Td * [P * (1 - Tc)]
  • Net Amount After Both Taxes: [P * (1 - Tc)] - [Td * P * (1 - Tc)] = P * (1 - Tc) * (1 - Td)

  This formula clearly demonstrates how the initial profit (P) is reduced by both the corporate tax rate (Tc) and the dividend tax rate (Td), resulting in a significantly lower net return. This result can be compared to using an LLC where the income is only taxed once.

• Practical Application: Selling a property within a C corporation triggers capital gains tax at the corporate level. The remaining profits are then distributed to shareholders, who pay individual income tax on the dividends. This double taxation severely erodes the overall profit. As shown in the PDF example, the difference between capital gain held in a C corporation vs. an LLC is $144,500 on a $500,000 long-term capital gain.

• Experiment: Conduct a comparative analysis of the tax implications of holding a $1 million real estate asset in a C corporation versus an LLC over a 10-year period, factoring in rental income, depreciation, and potential capital gains upon sale. The results will highlight the significant tax disadvantage of the C corporation structure.

6.3.2 Alternative: Flow-Through Taxation with Management C Corporation

A more tax-efficient approach involves using a management C corporation in conjunction with flow-through entities like LLCs.

• Scientific Principle: This strategy leverages the benefits of both flow-through taxation and the potential deductions available to a C corporation, while avoiding the double taxation of real estate ownership. The legal framework allows for contractual relationships between entities, enabling the C corporation to provide management services to the LLC and receive compensation.
• Practical Application: The title-holding LLC owns the real estate and pays a management fee to the C corporation. This allows the real estate holding LLC to pass-through income to the individual and the C corporation can capture income as well.

6.4 Offshore Strategies: A Mirage for Onshore Real Estate

Attempting to protect U.S. real estate using offshore structures is generally ineffective and can lead to legal and financial complications.

6.4.1 Jurisdiction Limitations

U.S. courts have jurisdiction over real estate located within the United States, regardless of the ownership structure. Offshore entities offer no protection against lawsuits filed in U.S. courts concerning U.S. real estate.

• Scientific Principle: The principle of in rem jurisdiction grants courts the power to adjudicate rights related to property located within their geographical boundaries. This principle is a cornerstone of property law and ensures that disputes concerning real estate are resolved in the jurisdiction where the property is situated.
• Practical Application: If a tenant sues for injuries sustained on the property, a U.S. court has jurisdiction, regardless of whether the property is owned by a domestic LLC or an offshore trust. The court can order the transfer of the property to satisfy the judgment, effectively nullifying the offshore structure.
• Example from PDF: The “Real Life Story” highlights how the promoter from the Caribbean Island of Nevis misled the doctor, John, into thinking he did not need insurance on his apartment building. However, because the building was located in California, California courts had jurisdiction over any claims. The offshore protection did not matter.

6.4.2 IRS Reporting Requirements

U.S. citizens are required to report all offshore financial activities to the IRS. Failure to comply with these reporting requirements can result in severe penalties.

• Scientific Principle: The U.S. tax system operates on the principle of global taxation, meaning that U.S. citizens are taxed on their worldwide income, regardless of where it is earned or held. This principle necessitates comprehensive reporting of offshore assets to ensure compliance with tax laws.
• Practical Application: The PDF example, “Real Life Story” explains that failing to report financial information about offshore assets can result in IRS penalties and fees.

6.4.3 The Illusion of Privacy❓❓

The promise of absolute privacy offered by some offshore promoters is often misleading. The IRS reporting requirements and the potential for court-ordered disclosure significantly limit the privacy afforded by offshore structures.

6.5 Living Trusts: Estate Planning, Not Asset Protection

Living trusts are primarily estate planning tools❓❓ and offer little to no asset protection benefits.

6.5.1 Revocability: The Undoing of Protection

The key feature of a living trust, its revocability, is also its biggest weakness from an asset protection perspective. Because the grantor (the person who creates the trust) retains the power to alter or terminate the trust, creditors can typically reach the assets held within it.

• Scientific Principle: The principle of dominion and control dictates that if the grantor retains significant control over the trust assets, those assets remain subject to the grantor’s creditors. This is because the grantor effectively owns the assets, even though they are formally held in the trust.
• Practical Application: A judgment creditor can obtain a court order forcing a transfer of property from the living trust to satisfy a debt. This is because the grantor retains the power to change the trust terms and can be compelled to do so by the court.

6.5.2 Combining Living Trusts and LLCs: The Right Approach

A better strategy is to combine the probate avoidance benefits of a living trust with the asset protection benefits of an LLC.

• Scientific Principle: This strategy leverages the distinct advantages of both legal structures. The LLC provides asset protection by shielding the property from personal liability, while the living trust ensures the smooth transfer of the LLC membership interests upon the owner’s death, avoiding probate. This hybrid approach balances asset protection and estate planning considerations.
• Practical Application: The LLC owns the real estate, providing asset protection. The living trust owns the membership interests in the LLC, ensuring probate avoidance.
• Example: The Sanchez Living Trust owns the real estate through a LLC. The LLC provides protection from anyone wanting to sue on any claim of the real estate while the Living Trust avoids probate if Mario and Carmen die.

6.6 Land Trusts: Privacy, Not Protection

Land trusts, similar to living trusts, primarily offer privacy, not asset protection.

6.6.1 The Privacy Benefit

Land trusts can shield the owner’s identity from public records by using a trustee to hold title to the property. However, this privacy alone does not provide significant asset protection.

• Scientific Principle: The principle of beneficial ownership dictates that creditors can reach the assets of the beneficial owner of a land trust, even if the legal title is held by a trustee. The beneficial owner retains the economic benefits of the property, making it subject to their debts and liabilities.
• Practical Application: Even if the owner’s name is not on the public record, a creditor can still discover the owner’s interest in the land trust through legal discovery and can levy against that interest.

In conclusion, while these ownership structures may seem appealing at first glance, their inherent flaws make them unsuitable for effective real estate asset protection. Investors should carefully consider these drawbacks and explore alternative strategies that provide greater security and financial stability.