Ownership Structures: Avoiding Pitfalls

Chapter: Ownership Structures: avoiding❓ Pitfalls

This chapter delves into common pitfalls associated with various real estate❓ ownership structures and provides guidance on how to avoid them. We will explore the scientific underpinnings of these structures, analyze their weaknesses, and highlight strategies for robust asset protection.

1. Joint Tenancy: The Illusion of Simplicity

Joint tenancy, characterized by the right of survivorship, appears attractive due to its simplicity, especially for married couples. However, this very feature makes it unsuitable for investors.

• Scientific Basis: Joint tenancy operates under the legal principle of unity of ownership. This principle necessitates four unities: possession, interest, time, and title. Upon the death of one joint tenant, their interest automatically transfers to the surviving joint tenant(s), regardless of their will or other legal documents.

• Pitfalls:

  • Loss of Control: A joint tenant cannot bequeath their share of the property through a will. The surviving joint tenant(s) inherit the interest by operation of law.
  • Vulnerability to Creditors: If one joint tenant faces legal action, the entire property may be at risk. A creditor can potentially force the sale of the property to satisfy the debt.
  • Investor Unsuitability: Savvy investors avoid joint tenancy because it creates a scenario where others benefit from their demise. The right of survivorship eliminates their ability to pass their interest to their heirs.

• Practical Application: Consider three investors, Peter, Paul, and Coco, who own a sixplex in joint tenancy. If Coco dies, her interest automatically transfers to Peter and Paul. Coco’s heirs receive nothing from the sixplex, regardless of her wishes.

2. Tenancy in Common: A Step Up, But Still Exposed

While offering more flexibility than joint tenancy, tenancy in common still lacks robust asset protection when held individually.

• Scientific Basis: Tenancy in common allows each owner to hold a separate, undivided interest in the property. Each tenant in common can own a different percentage of the property and has the right to sell, lease, or bequeath their interest independently. The key distinction from joint tenancy is the absence of the right of survivorship.

• Pitfalls:

  • Lack of Asset Protection: Individual tenants in common are personally liable for lawsuits related to the property. If one tenant is sued, creditors can pursue their interest in the property.
  • Forced Sale: A creditor can file a partition suit, forcing the sale of the property to satisfy a debt owed by one of the tenants in common.
  • Joint and Several Liability: In lawsuits involving the property (e.g., tenant injury), individual tenants in common can be held personally responsible, exposing their personal assets.

• Mitigation Strategy: Tenants in Common (TiC) with Protective Entities

  • Investors can mitigate the risks of tenancy in common by holding their interests through protective entities like Limited Liability Companies (LLCs). This creates a buffer between their personal assets and the liabilities associated with the property.
  • Structure: Individual investors form LLCs, and the LLCs then become tenants in common in the property.
  • Benefit: Lawsuits against the property are limited to the assets within the LLC, protecting the investor’s personal wealth.

• Example: John and Jane are tenants in common, each individually owning a 50% share of a fourplex. If John is sued, his share of the fourplex, and potentially his personal assets, are at risk. However, if John and Jane each hold their share through an LLC, only the assets within their respective LLCs are exposed to the lawsuit.

3. C Corporations: A Taxing Choice for Real Estate

Holding real estate within a C corporation is generally ill-advised due to the double taxation inherent in this structure.

• Scientific Basis: C corporations are considered separate legal entities from their owners (shareholders). They are subject to corporate income tax on their profits. When profits are distributed to shareholders as dividends, the shareholders pay individual income tax on those dividends, leading to double taxation.

• Pitfalls:

  • Double Taxation: C corporations face taxation at the corporate level and again when profits are distributed to shareholders.

  • Higher Capital Gains Taxes: Capital gains from the sale of real estate held by a C corporation are subject to corporate tax rates, followed by individual tax rates when the remaining profit is distributed to shareholders.

  • Mathematical Illustration:

  Let:

  • G = Capital Gain = \$500,000
  • T_C = Corporate Tax Rate = 34%
  • T_S = Shareholder Tax Rate = 15%

  C Corporation:

  1. Corporate Tax: G * T_C* = \$500,000 * 0.34 = \$170,000
  2. Profit After Corporate Tax: G - (G * T_C) = \$500,000 - \$170,000 = \$330,000
  3. Shareholder Tax: \$330,000 * T_S = \$330,000 * 0.15 = \$49,500
  4. Amount After Tax: \$330,000 - \$49,500 = \$280,500

  LLC:

  1. Capital Gain Tax: G * T_S = \$500,000 * 0.15 = \$75,000
  2. Amount After Tax: G - G * T_S = \$500,000 - \$75,000 = \$425,000

  Difference:
  \$425,000 (LLC) - \$280,500 (C Corp) = \$144,500

  Holding real estate in an LLC yields \$144,500 more after taxes compared to a C corporation, in this scenario.

• Alternative Strategy: If a C corporation is desired for management purposes, it should not directly own the real estate. Instead, it can provide management services to LLCs that hold title to the properties. The LLCs pay management fees to the C corporation, allowing for certain deductions without subjecting the real estate to double taxation.

  • Structure: Real estate is held by LLCs, which are owned by an asset-protecting LLC (e.g., Wyoming or Nevada LLC). A separate C corporation provides management services to the property-holding LLCs.
  • Benefit: Avoids double taxation on real estate income while allowing for potential tax deductions through the management C corporation.

4. Offshore Strategies: Misplaced Faith for Onshore Assets

Offshore asset protection strategies are often touted as offering bulletproof protection and tax savings. However, their effectiveness for protecting U.S. real estate is limited and often misrepresented.

• Scientific Basis: Jurisdiction is the key principle here. U.S. courts have jurisdiction over assets located within the United States, regardless of where the ownership entities are located. The “full faith and credit” clause of the US constitution does not extend to protecting US assets from US legal decisions, merely by inserting an offshore entity into the ownership chain.

• Pitfalls:

  • Jurisdictional Issues: U.S. courts have jurisdiction over U.S. real estate, regardless of whether it is owned by an offshore entity.
  • Tax Reporting Requirements: U.S. citizens are required to report all foreign assets and transactions to the IRS. Failure to comply can result in significant penalties.
  • Lack of Privacy: Tax reporting requirements and information sharing agreements between countries can compromise the privacy promised by offshore structures.
  • Creditor Access: Creditors can often access information about offshore assets through legal discovery and other investigative methods.
  • Complexity and Cost: Offshore structures are complex and expensive to set up and maintain.

• IRS Reporting Requirements:

  • Form 3520: Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts.
  • FinCEN Form 114 (FBAR): Report of Foreign Bank and financial❓ Accounts.
  • Form 8938: Statement of Specified Foreign Financial Assets.
  • Penalties: Failure to report can result in penalties of up to 50% of the asset value.

• Example: John, a doctor in California, transfers his Roseville apartment building to a Nevis Asset Protection Trust (APT). When a tenant is injured and sues, the California court has jurisdiction over the property, regardless of the offshore ownership structure. The APT provides no protection in this case.

5. Living Trusts: Estate Planning, Not Asset Protection

Living trusts (also known as revocable trusts) are valuable tools for estate planning, primarily to avoid probate. However, they do not offer asset protection.

• Scientific Basis: A living trust is a revocable trust, meaning the grantor (the person who creates the trust) retains control over the assets and can modify or terminate the trust at any time. This control defeats asset protection because creditors can access assets that the grantor has the power to control.

• Pitfalls:

  • Revocability: Because the grantor can change the terms of the trust, creditors can obtain a court order forcing the transfer of assets from the trust to satisfy a judgment.
  • Grantor Control: The grantor’s control over the trust assets makes them accessible to creditors.
  • Lack of Protection: Assets held in a revocable living trust are considered part of the grantor’s estate and are subject to creditors’ claims.

• Combining Living Trusts with LLCs for Probate Avoidance and Asset Protection:

  • Structure: Real estate is owned by an LLC, which provides asset protection. The membership interests in the LLC are then owned by the living trust, which ensures probate avoidance.
  • Benefit: This structure combines the benefits of both LLCs and living trusts, providing asset protection and simplifying estate planning.
  • The trust specifies who will inherit the LLC membership interests, allowing for transfer of ownership without probate proceedings.

• Example: Mario titles his house and rental fourplex in the name of his living trust. When a tenant is injured at the fourplex and sues, all of Mario’s assets, including his house and brokerage account, are exposed because they are held in a revocable trust.

6. Land Trusts: Privacy, Not Protection

Land trusts, while offering privacy by keeping the beneficiary’s name off public records, do not provide significant asset protection.

• Scientific Basis: Similar to living trusts, land trusts are often structured in a way that the beneficiary retains significant control over the trust and its assets. This control makes the assets vulnerable to creditors. The trust itself offers no substantive protections.

• Pitfalls:

  • Beneficiary Control: The beneficiary typically has the power to direct the trustee regarding the management and disposition of the property. This control undermines asset protection.
  • Lack of Legal Shield: Creditors can often pierce the veil of the land trust and access the underlying assets.
  • Privacy vs. Protection: While privacy can be beneficial, it is not a substitute for a robust asset protection strategy.

• Structure: The trustee holds title to the property, while the beneficiary retains the beneficial interest. The beneficiary typically has the power to direct the trustee.

• Example: Jane creates a land trust to hold her rental property, with herself as the beneficiary. If Jane is sued, creditors can likely reach the beneficial interest in the land trust and access the underlying property, despite her efforts to maintain privacy.

By understanding the scientific principles and practical implications of these ownership structures, real estate investors can avoid common pitfalls and develop robust asset protection strategies to safeguard their wealth. Remember that the most effective strategies often involve a combination of different structures tailored to specific circumstances and jurisdictions, and that engaging qualified legal and financial professionals is crucial for optimal asset protection planning.