Real Estate Investments: Unforeseen Limited Liability

Posted: May 1, 2019 | Press

A limited liability company (“LLC”) has been the mainstream entity for owners of income-producing property. The start-up costs associated with a LLC are relatively inexpensive, and the owner’s desires to shield him or herself from personal liability make it a desirable choice. An LLC is a separate legal entity with a designated tax identification number and separate tax reporting requirements. An owner’s pursuit of asset protection does not come without unforeseen traps or burdens.

Lack of Planning at the Formation Stage
In the age of technology and online corporate formation services, it may seem relatively easy to plan and form an entity. While the check-the-box online websites do typically guide the user through the formation process, they do not provide the user with a strategic plan nor assist the user with future planning or growth. A property owner will typically invest a lot of time and money into the pursuit of the target property, but sometimes will cut corners when it comes to discussing the formation with a business attorney. Saving money at the outset may result in personal liability to the owner or substantially more in income taxes or property taxes if a strategic plan is not formulated at the outset. Also, without formalizing a plan at the outset, future growth or later partial transfers to investors or family members may trigger the reassessment of the property tax base.

Transfer of Encumbered Property
For individuals, typically if the LLC is not formed prior to the acquisition of the income-producing property, they will purchase the property and obtain financing in their individual names. In some instances, acquiring the property and securing financing individually will result in more favorable rates being offered by lenders instead of financing being obtained on a property that is being held in the LLC.

A property owner who acquires real property in his or her individual name faces potential problems when the owner wants the benefits of LLC protections later. A simple transfer of the property from an individual to an LLC has an unintended consequence of violating a “due on sale or transfer clause” within the mortgage or deed of trust. Trust deeds typically  restrict an individual owner from transferring property from his or her name. If the individual owner does transfer the property to an entity it may result in the lender calling the note and requiring an immediate cash payment or facing a foreclosure action.

Transfers of Insured Property
Holding insurance on real property is another arrow in a property-owner’s quiver to protect against personal liability. But, a property owner who obtains an insurance policy for a property acquired in his or her individual name and later transfers it to an LLC will have an effect on the policy premiums or effectively result in the policy being cancelled. Again, this is an issue that must be considered carefully before implementing the formation of a new entity or transferring property to an entity.

“Piercing the Corporate Veil”
The limited liability protections of an LLC are sometimes perceived as an absolute shield of protection to a manager or member. While the LLC does provide some protection against claims against an individual’s personal assets. California Corporations Code Section 17703.04 provides that a member of an LLC shall be subject to liability under the common law governing alter ego liability, and shall also be personally liable for a judgment of a court or for any debt, obligation, or liability of the LLC.  Members of an LLC do not need to follow as many corporate formalities as a corporation. For example, an LLC does not require annual meetings of the members, nor does it require the memorialization of those annual meetings.

The perception that the members do not have to follow formalities stops with the annual meetings. In fact, it is important to be counseled by a business attorney and follow the guidance of a Certified Public Accountant. The transfer of monies between an LLC and personal
bank accounts without proper documentation can potentially lead to a creditor piercing the corporate veil and attaching the personal assets of the owner. Additionally, without thoroughly understanding guarantees or indemnity language within contracts, it may also reduce the protections offer by an LLC.

Personal liability may also occur in the event of a member’s participation in tortious conduct. For example, a property owner that fails to properly light a parking lot or fails to cure a known defect on the property that causes harm to another person may subject the property
owner to personal liability. A property owner should regularly consult with a business attorney to address these issues and allow the attorney to assist in protecting a member’s personal assets to the fullest extent of the law.

Succession of Real Estate to the Next Generation:
Property Tax Perspective The transfer of wealth from the baby boom generation has begun. Much of the transfer will include real property that currently holds a low tax base. The preservation of the property tax base to the next generation can save the next generation hundreds of thousands of dollars, if not millions over their lifetime. California permits the transfer of the property tax base from a parent to a child in certain circumstances. A primary residence that is transferred from a parent to child is afforded the benefit of transferring an unlimited amount of property tax base. For all other property (other than a primary residence), the owners may be able to take advantage of the transfer of their low tax base to their children for up to $1,000,000 in property tax base. To benefit from the transfer of the property tax basis, careful planning is required as real property held in an entity such as an LLC will not afford the property owner the benefits of transferring his or her property tax basis to the next generation.

Strategic Planning
Benjamin Franklin said that “an ounce of prevention is worth a pound of cure.” The same can be said when it comes to strategic planning for entities. Whether, a property owner is going to structure a purchase of a single parcel of property or put together a complex entity structure that will require the negotiation of a joint venture agreement between a property owner and investors that provides for profit distribution, management, and defined ownership responsibilities, it is important to think through these issues at the outset.

Timothy J McElfish