Ownership Structures: Avoiding Common Mistakes

Chapter: Ownership Structures: avoiding❓ Common Mistakes

This chapter delves into common pitfalls encountered when structuring real estate❓ ownership for asset protection. We’ll explore various ownership structures, analyze their weaknesses, and provide guidance on selecting appropriate strategies to safeguard your assets.

1. Joint Tenancy: A Risky Proposition for Investors

Joint tenancy, characterized by the right of survivorship, is often touted as a simple solution for married couples. However, for investors, it presents significant risks.

• The Survivorship Trap: In joint tenancy, upon the death of one owner, their interest automatically transfers to the surviving owner(s). This eliminates the ability to bequeath the asset to heirs.
  • Example: If Peter, Paul, and Coco own a sixplex as joint tenants, and Coco dies, her share automatically vests in Peter and Paul. Coco’s heirs receive nothing.
• Unsuitability for Investment Partnerships: Savvy investors avoid joint tenancy due to the potential for unintended beneficiaries. They don’t want their co-owners to benefit directly from their demise, which is precisely what joint tenancy facilitates.
• Mathematical Illustration: Let $V$ be the value of the property, and $n$ be the number of joint tenants. Each tenant’s initial share is $V/n$. Upon the death of a tenant, the remaining tenants’ shares increase to $V/(n-1)$. This increment is the windfall that investors seek to avoid.

2. Tenancy in Common: Limited Protection as an Individual

Tenancy in common offers individual ownership shares, but lacks significant asset protection when held directly by individuals.

• Exposure to Lawsuits: If one tenant in common is sued, creditors can potentially target their interest in the property, potentially forcing a partition sale.
• Liability Risks: All tenants in common can be held personally liable for lawsuits involving the property (e.g., tenant injuries). Personal assets become exposed.

• Partition Suits: A creditor can bring a partition suit to force the sale of the property to satisfy a judgment against one of the tenants in common.

  • A partition suit effectively dissolves the co-ownership arrangement and divides the property or its proceeds amongst the owners, typically based on their ownership percentages. This can be detrimental to the other owners who might not wish to sell the property.
  • Tenants in Common (TIC) Exception: Using Tenants in Common (TIC) can be a valid strategy when investors take their interest through protected entities like Limited Liability Companies (LLCs). This provides liability protection.
  • Example: Each investor forms an LLC, and the LLCs then hold the tenants-in-common interest in a large property. This shields the investors’ personal assets from claims against the property.
  • Visual Explanation:
    • Individual Tenants in Common: John (individual), Jane (individual) -> 4-Plex -> All assets personally exposed to all claims
    • TIC: John’s LLC, Jane’s LLC -> 4-Plex -> Outside assets protected from all claims

3. C Corporations: A Tax Disaster for Real Estate

Holding real estate in a C corporation is generally a detrimental strategy due to double taxation.

• Double Taxation: C corporations are taxed at the corporate level, and shareholders are taxed again on dividends received.
• Tax Inefficiency: This results in significantly higher tax liabilities compared to pass-through entities like S corporations, LLCs, or LPs.
• Capital Gains Example:
  • Consider a \$500,000 long-term capital gain.
    • C Corporation:
      • Gain: \$500,000
      • Corporate Tax (34%): \$170,000
      • After-Tax Profit: \$330,000
      • Shareholder Tax (15% on distribution): \$49,500
      • Amount After Tax: \$280,500
    • LLC:
      • Gain: \$500,000
      • Capital Gains Tax (15%): \$75,000
      • Amount After Tax: \$425,000
  • The difference is \$144,500 in extra taxes.
• Flow-Through Taxation vs. Double Taxation:
  • C Corporation: Money -> Corporate Tax -> After Tax Profits -> Dividends to Shareholders -> Taxes Paid Twice
  • LLC, LP, or Sub S Corporation: Money -> No Entity Tax -> Flow-Through Profits -> Dividends to Members -> Taxes Paid Once
• Caution against “Gurus”: Be wary of advisors who recommend C corporations for real estate ownership.
• Complex Structures and C Corporations:
  • Problematic Structure: LLC (owns 4-plex), LLC (owns duplex) -> C Corporation (owned by individual). Profits still flow to the double taxed C Corporation.
  • Better Structure: LLC (owns 4-plex), LLC (owns duplex) -> WY or NV LLC (owned by individual) -> Management C Corporation (for write-offs). Title holding LLCs pay a management fee to the C corporation for benefits, but avoid real estate ownership inside the C corporation.
• Overcomplication: Be cautious of promoters who advise setting up more entities than necessary, especially if their interests don’t align with yours.

4. Offshore Strategies: Ineffective for Onshore Real Estate

Using offshore structures to protect U.S. real estate is generally ineffective and can lead to significant legal and financial❓ complications.

• Jurisdictional Limitations: U.S. courts have jurisdiction over U.S. real estate, regardless of ownership structures.
• Reporting Requirements: U.S. tax laws require strict reporting of offshore assets, negating claims of privacy. Failure to comply can result in substantial penalties.
• Real-Life Example (John’s Bad Day):
  • John placed his apartment building (owned by Roseville, LLC) and brokerage account into Nevis Asset Protection Trusts (APTs).
  • He failed to pay taxes or obtain insurance.
  • A lawsuit ensued. The U.S. court had jurisdiction over the apartment building located in California. The tenant was able to reach the building’s equity.
  • John was forced to reveal his offshore assets because of the IRS reporting requirements.
  • John incurred significant IRS penalties and fees.

• IRS Reporting Requirements (Table Example):

  IRS Requirement	IRS Rule
  U.S. persons must report all gratuitous and nongratuitous transfers to a foreign trust.	Section 6048, Section 1494
  Foreign trusts owned by U.S. persons must file an annual tax return on IRS Form 3520-A.	Sections 671 to 679
  U.S. persons receiving offshore distributions, whether taxable or nontaxable, must report them.	Section 6677(a)
  Foreign trusts owned by U.S. persons must appoint a U.S. agent so that the IRS may examine offshore records.	Sections 7602 to 7604
  * Key Takeaway: Offshore strategies do not work for onshore real estate.

5. Living Trusts: Estate Planning, Not Asset Protection

Living trusts (revocable trusts) are valuable for estate planning purposes, specifically to avoid probate, but offer no asset protection.

• Probate Avoidance: Living trusts allow assets to pass to beneficiaries without the need for probate court supervision.
• Flexibility: Living trusts are revocable, allowing for changes in terms and beneficiaries.
• Lack of Asset Protection: The revocable nature of living trusts makes them vulnerable to creditor claims. Creditors can obtain court orders to force the transfer of assets from the trust.
• Real-Life Example (Mario’s Mistake):
  • Mario titled his house, fourplex, and brokerage account in his living trust.
  • He was sued by a tenant who fell at the fourplex.
  • All of his assets were exposed to the tenant’s claim.
  • It was too late to transfer the assets to a more protective structure.

• Combining Living Trusts and LLCs:

  • LLC owns the real estate for asset protection.

  • Living trust owns the membership interests in the LLC for probate avoidance.

  • Visual Explanation:

    • Asset Protection: XYZ, LLC (owns 4-plex)
    • Probate Avoidance: Sanchez Living Trust (owns LLC)
  • Key Takeaway: LLCs provide asset protection, while living trusts facilitate probate avoidance. They work best in concert.

6. Land Trusts: Privacy, Not Asset Protection

Land trusts offer privacy by concealing the true owner from public records, but they do not inherently provide asset protection.

• Privacy Benefits: Land trusts allow for the use of a trustee other than the beneficiary, keeping the beneficiary’s name off the title.
• Similar to Living Trusts: The structure of a land trust mirrors a living trust, with assets transferred to a trustee for the beneficiary’s benefit.
• Lack of Asset Protection: The beneficiary’s interest in the land trust is still subject to creditor claims. The trust itself doesn’t shield the assets from legal action.
• Key Takeaway: Privacy is valuable, but it’s not a substitute for robust asset protection strategies.

Conclusion

Selecting the appropriate ownership structure is crucial for safeguarding real estate assets. Avoid common pitfalls like joint tenancy, C corporations, and relying solely on offshore strategies, living trusts, or land trusts for asset protection. A combination of strategies, such as utilizing LLCs in conjunction with living trusts or structuring ownership through protected entities like LLCs in a TIC arrangement, provides a more comprehensive approach to asset protection.