Structuring real estate for cost and protection in California

[Alvin Ng]

Hi BP,

Although I’ve only started in real estate investing, I’ve been reading books on tax and legal protections. In protecting my investments, I’ve learned the importance of the first and second defense, home owner’s insurance and umbrella insurance. The third defense is minimizing your attractiveness to creditors/lawyers and lastly, isolating assets through liability separation. I also know to differentiate between inside and outside ‘attacks’. Inside relating to the property itself like tenant injuries and outside relating to my personal life like car accidents.

The book I've read suggests that an ideal structure of real estate assets in CA is to hold each property in an LP and have an LLC formed in Wyoming or Nevada as general partner - for cost and protection reasons. Unlike a CA LLC holding, outside ‘attacks' may not force sale of real estate and are limited to charging orders in Wyoming/Nevada. The rationale is that lawyers/creditors will be less inclined to spend time reaching for charging orders in different states, ie: third defense. Also LLC formation in those states are low cost.

I’m not even close to getting to this type of structuring but as an exercise of academia, I wanted to get opinions of BP members on the cost and protections of this type of asset structure.

Other forms of third defense I’ve come across include:

-Keeping LTV high

-Taking out LoC (creditors will not know the utilization of LoC until winning the case)

[Scott Smith]

Hey Alvin,

I would agree with both the guys above that you are focusing on the wrong parts of investing at your stage. When new investors get into this it's best to focus on finding the best deals that exist and making quality connections and partnerships that will carry you forward. However, it's also good to have a solid understanding of what asset protection does, and does not, accomplish. @Jerry W. is spot on with the misfortune of investing out of CA, as it blows all the other states away in the taxation of LLCs.

First, let me share with you how I break down asset protection. When meeting with clients the first order is to discuss (A) their personal assets, (B) break down their current investments portfolio and other business ventures before discussing any (C) future goals. Each of these variables will dramatically change the advice for the individual asking this question. I often break it down into the "five pillars" of protecting your assets.

1st pillar is avoiding unnecessary and risky activities (don't drink and drive, insurance generally won’t cover your poor decisions) and take good care of your investments - these simple steps will help you prevent lawsuits before they even occur.

2nd pillar is a good insurance policy as that cover the majority of your exposure. However, insurance is limited because it only protects you from one type of liability: accidents/negligence. Insurance doesn’t protect you from any part of the sale or acquisition of a property (e.x. Somebody wanting to sue for you backing out of a bad deal or accusing you of selling them a property with defects like unknown termite damage). Insurance also doesn’t protect you from misunderstandings, especially those made in writing and email. What happens in these misunderstandings is that something goes wrong either in the sale or after, and then they sue you for some statement you made that they “misunderstood”. That lawsuit is a claim for fraud, and that’s what fraud typically is...a misunderstanding and someone being “injured” and wanting to hold the other responsible for it. Insurance never protects you from these kinds of claims and they happen all the time.

3rd pillar applies after you have good insurance You need to protect yourself from what insurance doesn’t cover by compartmentalizing your assets. Compartmentalization means that if something happens to one property they can't touch you or the other properties. You should use either LLC's (the old and expensive way) or a Series LLC (the new and more cost/time effective way). No matter where you live or where you own assets, I personally recommend the Series LLC to be a great tool for the individual investor who is planning to expand their operation, as it allows for you to scale infinitely for FREE- check out this article to learn more. Since you are from California, then it would be worth looking into the Delaware Statutory Trust. The DST functions much like the Series LLC, but is not required to pay the $800 annual franchise fee per [series] LLC in California - for anyone with multiple properties this can save a lot of money.

4th pillar is somewhat similar - you want to separate your operations from your assets. One company owns everything and does nothing (this is your SLLC a/k/a "asset holding company") and a completely separate company handles all of your operations (this is a traditional LLC a/k/a "operating company") For the operating company which serves as your face to the world and through which you do all your business, you establish a Traditional LLC to carry out the operations of your investments. The operating company takes on all of the liability that would otherwise blow back on you including: paying property management, paying contractors, collecting rent, marketing, etc.

5th pillar is owning everything anonymously. If people don't know what you own, then they are less likely to sue. People don't sue people that qualify for food stamps. This anonymity can be accomplished for free by using Trusts to own your companies as well as the assets. Trusts create this anonymity by removing your name from public record. Even if they can see you used to own a property, when properly transferred it will look like it was sold to investors. If they somehow guess you are the owner still, it doesn't matter because you are not the owner. The trust and the LLC are the owner of the asset/real estate, so even in the scenario that they guess, they guess wrong.

There are still many other strategies ranging from offshore trusts to equity stripping, but those need to be executed correctly and within the correct strategy, otherwise you end up working against yourself and throwing money away. Also, not all investors should implement all of these steps. Each pillar will involve costs - so you should only add more pillars as you scale up. 

The reason I don't preach the Delaware Statutory Trust to everyone I meet is that it has higher setup costs than most other entities. It's protection is arguably higher than the Series LLC, though. In the end most investors from CA will save money using it in the long run, since they won't be paying the $800+ annual franchise tax PER LLC (and PER child series in a Series LLC.)

Asset protection is pretty straightforward in reality - and each investor will have their own idea of how much protection they want. If you just scale it up AS you grow, it's really not a hassle and should only make your life easier. If you run into specific issues just message/TAG me.