What is Real Estate Asset Protection?
Real estate asset protection is the legal process of structuring property ownership to make it difficult for a creditor of the individual owner or a business entity to reach the property.
Successful investing in Florida property has enriched individual investors for several generations. Today, individuals located in Florida and elsewhere hold substantial equity in Florida real property. Creditors who hold a judgment quickly target the debtor’s real estate ownership; a recorded judgment is automatically a lien on all non-exempt real property the debtor owns in Florida. For Florida real estate investment, asset protection entails planning ownership of rental and commercial real estate properties to protect the properties from collection by a judgment creditor.
The best time to plan protection of investment real estate is before taking title to the property. Before closing the purchase contract, the real estate investor may designate how he will title the property. Smart ownership and titling are the keys to real estate asset protection.
Real Estate Options for Asset Protection
Many individual investors take title to their initial investment property in their own names, or jointly with their spouse. Individual ownership is the simplest way to own real estate, and the mortgage lender sometimes prefers that mortgaged property be owned in the borrower’s individual name. In many ways, titling property in the name of the individual investor is efficient and simple. The individual owner claims directly on their personal tax return the tax benefits of depreciation and other expenses. There are no fees involved in establishing a legal entity or preparing annual entity tax returns.
Titling investment real estate in the owner’s individual name(s) provides no asset protection. The individual owner is liable for any claims asserted by a property tenant, ownership partner, government agency, or subsequent buyer. Individually owned property is exposed to judgments against the owner arising from the owner’s financial debts and business activities unrelated to the real estate investment.
Ownership of property through a separate legal entity provides a better legal shield against liability from property ownership. A money judgment related to property ownership will expose only the equity in the real property held in that particular entity. The judgment will not jeopardize real property owned by different legal entities, nor will the judgment threaten the individual owner’s personal assets, such as his personal financial accounts or operating businesses. There are three business entities that typically are used to own investment real estate and provide asset protection: corporations, limited partnerships, and limited liability companies.
Corporate Shield for Real Estate Asset Protection
A Florida corporation, partnership, and limited liability company (LLC) each provide a “corporate shield” that protects the individual owner and his personal assets from liability related to real estate ownership. The corporate shield means that an individual who has a cause of legal action from their interactions with the legal entity may not pierce the entity and sue the entity’s owners. Florida law makes it difficult for a claimant to pierce the corporate shield. The claimant must show that the owner established the defendant legal entity to defraud creditors or operated the entity in a fraudulent manner. That the entity operates as the owner’s “alter ego” is not sufficient grounds to pierce a corporate shield.
Using Entity Ownership for the Owner’s Asset Protection
There are significant differences in the ability of different legal entities to protect the individual’s ownership interests in a particular property investment from civil judgments against the owner from activity unrelated to the real estate property.
When an owner holds legal title to the investment property in a corporation, the individual’s investment is evidenced by common stock in the owner corporation. Corporate stock is vulnerable to judgment creditors. A judgment creditor can levy on the owner’s stock, acquire stock ownership and control over the corporation, and then liquidate the corporation’s real estate to pay the judgment. If a judgment debtor has misplaced corporate stock certificates, a court can order to issue replacement stock and give replacement certificates to the judgment creditor.
LLCs and limited partnerships provide better asset protection against creditors holding a personal judgment against the individual real estate investor. A judgment creditor cannot levy upon a debtor’s LLC membership interest, and the creditor cannot obtain a lien on the real estate owned by the LLC. Florida law provides that the judgment creditor’s sole and exclusive collection remedy is a charging lien on LLC distributions made to the real estate owner who owns the LLC membership interest. Most real estate investments do not produce significant positive cash flow, especially in the early years. Without positive real estate cash flow, there are small amounts, if any, of LLC cash available to be distributed to the owners, and the creditor gains no money from the charging lien.
Investors generally prefer LLCs over limited partnerships because the LLCs are more cost-efficient to set up and operate. With a properly drafted asset protection operating agreement, the individual Florida real estate investor acting as LLC manager controls the amount and frequency of cash distributions. If the LLC does not distribute cash flow, then the cash flow and real estate remain protected inside the LLC.
The LLC protection described above applies only when there is more than one LLC member. A judgment creditor may levy upon and thereby take over the investor’s 100% membership interest of a single-member LLC. A second investor in an LLC or partnership must have a significant ownership percentage to make the LLC multi-member.
Federal income tax planning for real estate investment is independent of the choice of ownership entity. The IRS permits LLCs and corporations to choose how they want to be treated for tax purposes. The IRS default treatment for LLCs and limited partnerships is tax treatment as a partnership. An LLC can affirmatively elect to be treated as a C corporation or an S corporation for income tax purposes. Today, most real estate investors choose to own Florida real property in multi-member limited liability companies taxed as partnerships or S corporations.