Real Estate as an Estate Planning Vehicle – Part 3: More Advanced Protections for Real Estate Investors

California real estate appreciates faster than real estate in most other states, and for that reason, it’s more likely to form the largest part of a homeowner’s total estate upon death. However, real estate is vulnerable in ways that other forms of generational wealth are not, and therefore requires more planning and protection. This four-part series will explore those vulnerabilities and provide tips on preserving the value of this precious asset for generations to come.

If you haven’t read Part 1 or Part 2 of this series, you might want to check them out. Part 1 surveys the risks inherent in owning California real estate, and Part 2 discusses the basic protections that every homeowner should have in place.

In this installment, we’ll get into some more advanced protections that real estate investors might want to consider to further shield their property from liability, end-of-life taxes, and divorce.

Limited Liability Corporations (LLCs)

The essential nature of a limited liability corporation (LLC) is to separate some of your assets from the remainder, thereby containing risk within a single category of assets and keeping it from spreading to all of your assets.

Let’s look at a simple example. Say you’ve invested in a rental property. There are certain risks associated with renting real property, such as claims made by your tenant or tenant’s guests against you as the property owner. But what if you didn’t “own” the property? If an LLC owns the property, any liability associated with that property is limited to what is owned by the LLC; hence the term limited liability. Any claim arising from the rental property could not touch your personal assets because they are not owned by the LLC. An LLC is like a bucket that you put assets into, then push slightly away from you so any leakage does not affect your other assets.

Setting up an LLC is easy – Rocket Lawyer or LegalZoom can do it for you for a few hundred dollars. Maintaining an LLC, however, is the key to its usefulness and will take a little labor and discipline. As long as an LLC is properly maintained, it erects a legal fiction called a “corporate veil” between your personal assets and the corporate assets. Improper maintenance shoots holes in the veil and makes it less effective when a claim comes rolling in.

Proper maintenance of an LLC involves paying an annual state franchise tax – which is $800 in California – and upholding corporate formalities. These formalities vary from state to state, but generally involve creating and abiding by the terms of an operating agreement, holding regular meetings with stakeholders, keeping accurate records, and filing the appropriate tax returns. Single-member LLCs, meaning LLCs in which only one person or a married couple have an ownership interest, are the easiest to maintain: holding a meeting can be as simple as a conversation over dinner once a year and any income earned from the LLC’s property can be reported on your own 1040. Multiple-member LLCs will require their own tax returns and a bit more coordination and record keeping.

The absolute most important task in proper LLC maintenance is keeping finances separate. You must keep separate bank accounts and preferably separate lines of credit for the LLC, because paying LLC expenses with personal cash or credit, or vice versa, seriously undermines the protection of the corporate veil. Failure to keep separate accounts and financial records is called “commingling assets” and is probably the #1 reason why corporate veils are pierced.

In addition to your state’s formalities and the maintenance of separate finances, Congress introduced a new requirement in January this year. Under the Corporate Transparency Act, all corporate entities, including LLCs, must file an initial Beneficial Ownership Information (BOI) Report with the Department of Treasury, and update that report with every significant change in the corporation’s structure, management, or ownership. The BOI Report provides information on the individuals having a substantial ownership stake in a company, i.e., at least 25% ownership or major influence or control over a company’s decisions or operations. It’s uncertain as yet how onerous this reporting is or will become, as we are still in the first year of compliance. It may be worth working with a professional – a tax advisor, accountant, or attorney – on your initial BOI Report and any updates until you become familiar with the Corporate Transparency Act, its requirements, and its application to your LLC.

Multiple LLCs

If an LLC sounds like the right move for you, consider that multiple LLCs are also an option for multiple properties. Say you own three investment properties. If you hold each property in separate LLC, the risks associated with each are contained within the LLC holding that property. Therefore, any liability that arises from one property will not touch your other investments, nor your personal assets.

Irrevocable Trusts

Irrevocable trusts are much like LLCs in that they separate some of your property from the rest, thereby containing liability and keeping it from spreading. Some of your assets go into a trust bucket, and it exists beside you but is no longer owned or controlled by you. That’s where the asset protection comes from – the distance between you and your assets. These trusts form the foundation of most charitable giving in the United States, and are commonly used by the wealthy to shelter assets from taxation and provide for the needs of generations down the line.

Irrevocable trusts aren’t for everyone. They require maintenance, starting with an additional tax return every year. They incur added expense, including the gift taxes you’d pay to transfer your assets to the trust. Irrevocable trusts also literally separate you from your assets – unlike when you form an LLC to hold an asset, you are actually gifting your asset to this trust and thereby losing control. Furthermore, you can’t create an irrevocable trust for your own benefit in California – someone else has to do that for you, or you have to create the trust in another state that allows this type of trust, e.g., Delaware or Nevada.

For those who can make effective use of them, irrevocable trusts provide something that no other form of asset protection we’ve discussed can: protection from divorce. Assets placed into an irrevocable trust before marriage remain sheltered from division in any subsequent divorce, for the person creating the trust and their heirs. Irrevocable trusts can also help avoid estate taxes upon generational transfers.

Speaking of taxes…

In the next and final installment of this series, we’ll review the taxes assessed at a generational transfer and discuss strategies for minimizing them.

© 2024, Jane Legal PC

This article is a service of Jane Legal PC. We don’t just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That’s why we offer a free Wealth Planning Session™, during which you will get more financially organized than you’ve ever been and make all the best choices for your chosen family. Begin the process by scheduling a free 15 minute discovery call today.

This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal, or investment advice. If you are seeking legal advice specific to your needs, such services should be obtained separately from this educational material.

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