Holding property is generally a sound investment strategy to ensure positive cash flow and long-term capital growth. However, as a real estate investor, you should not only focus on building a property portfolio to grow your personal wealth but also implement real estate asset protection strategies to limit the risk of forfeitures and losses resulting from unfortunate events.
In this guide, we at Blake Harris Law discuss effective real estate protection strategies you should implement to safeguard your rental property, office buildings, or primary residence against creditor claims and lawsuits.
How Does Real Estate Asset Protection Work?
Real estate asset protection is a combination of strategies to protect real estate assets over the long term. Implementing an asset protection plan is a legal way to ensure that creditors or claimants don’t gain access to your property holdings for settlements, debt payments, or lawsuits.
Because anyone can sue you for just about any reason, you don’t need an extensive portfolio of real estate holdings to implement an asset protection strategy. For example, if you own a small business with one building, doing asset protection planning is crucial.
Real estate protection differs from real estate preservation. With preservation, your goal is to minimize taxes and other factors that can impact the value of your real estate investments. Real Estate protection is for avoiding lawsuits.
How to Protect your Real Estate Assets
Most property owners believe they can prevent civil claims by implementing business policies and other preventive measures that mitigate their risks. However, something as unpredictable as a slip-and-fall accident on your property can result in a substantial liability claim. You may need to liquidate your property to cover the compensation amount, even when settling a case out of court.
The sections below discuss the most common asset protection strategies.
Obtain Insurance Coverage
Asset protection insurance covers the gap between a property’s present market value and its original purchase price in the case of an unfortunate event. These policies may reduce property risk and offer protection if a legal judgment exceeds your coverage.
Create an Asset Protection Trust
An Asset Protection Trust allows a third party to own property for the benefit of the original owner of the property. In other words, the trustee holds the property’s title, while the beneficiary has the benefit of the property. The trust agreement contains the identities of the trustee and beneficiaries and dictates the terms, conditions, and trustee’s responsibilities.
The trust agreement also indicates beneficiary succession. As a result, trust property doesn’t go through probate.
A trust agreement is usually not a public record; setting up this arrangement protects your privacy as a beneficiary. In the case of a lawsuit, a claimant will have a more challenging time going after your real estate assets because they may not know the value of your property or that you even own it and the court will not be able to successful compel you to handover the property as that power is reserved for the trustee. Note that trusts don’t provide complete liability protection. As a beneficiary, you remain liable for the property’s direct management.
Set Up a Separate LLC to Hold Your Real Estate Asset
After creating a trust as the first layer of asset protection, the next step is transferring the trust into a limited liability company (LLC). Placing LLCs in trust is a common practice to gain lawsuit protection.
A limited liability company is a separate business entity, which means that any trusts that form part of your limited liability company’s assets are no longer considered your personal assets. As a result, these business assets are difficult for claimants or creditors to reach.
Forming an LLC also limits the liability that your business property creates. For example, you are not personally liable for the damages when someone sustains an injury on your property.
Ideally, you should form a single LLC for each investment property, including rental properties. If you have multiple properties in an LLC, and one of them faces a lawsuit, all other properties are at risk. For tax purposes, we don’t recommend transferring your personal residence to an LLC.
Formulate a Trust-Based Estate Plan
Establishing an estate plan is wise for protecting real estate assets should you pass away or become incapacitated. The asset protection documentation and vehicles you can incorporate into your estate plan can include:
- A will and living will
- A trust
- Beneficiary designations
- A trusted power of attorney
- A healthcare proxy
- A letter of intent
A comprehensive estate plan protects and preserves real property value while simplifying disbursement. An estate plan protects your personal assets, including investment properties, from seizure.
Know Your State’s Real Estate Laws
An in-depth understanding of your state’s legislation is fundamental to formulating an effective asset protection strategy.
In Nevada or Wyoming, forming an LLC is relatively straightforward, with no state income tax requirements and minimal operating agreement requirements. Note that, in the case of an out-of-state LLC, the state laws of the property’s location apply. For example, suppose you register an LLC in Arizona, but it owns property in Georgia. In this case, Georgia law will still apply to the LLC.
Equity Stripping: Encumber Your Real Estate Assets
Equity stripping is a strategy to protect real estate assets. It involves burdening your personal residence or investment properties with a lien, minimizing the equity remaining in the asset. A lien is a legal claim that allows the holder access to the property if a debt is unpaid.
This strategy aims to make a property appear worthless to a potential creditor. One of the advantages of equity stripping strategies is that they protect against both outside and inside liabilities.
Common equity stripping strategies include:
- Taking out a home equity line of credit (HELOC)
- Taking out a bank loan
The advantage of using a bank loan to strip a property’s equity is that it can be challenging for creditors to undo.
LLC or Trust: Which Is the Better Option for Real Estate Assets?
Whether real estate investors should form an LLC or trust to protect real property depends on their unique situation.
An LLC is a legal entity that exists separately from its owners and offers optimal protection against lawsuits and creditors. This relatively straightforward management structure also offers tax benefits, such as avoiding double taxation on corporate profits. Additionally, single-member LLCs don’t need to file federal tax returns.
Unlike a corporation, an LLC doesn’t need to maintain records such as bylaws or minutes. As a result, a court generally will not disregard the entity’s separate existence for failing to follow the prescribed formalities.
Trusts are not separate entities, but they offer privacy and ownership. A trust is an asset or privacy protection vehicle that allows a property owner to transfer real estate holdings to the next generation without going through probate.
In many cases, using both an LLC and a trust is the most effective way to protect an asset against liability, creditors, and taxation. Your attorney can help you determine the best asset protection method.
Does Insurance Protect Real Estate Assets?
Many property owners believe that liability insurance is the be-all and end-all of asset protection. However, contrary to what your insurance company promised when you took out the policy, you may not have coverage in the event of a lawsuit due to insurance exclusions. While insurance can mitigate your business risks to an extent, you likely need a more comprehensive strategy to protect real estate assets.
What Is the Best Type of Trust for Your Real Estate Asset?
An asset protection trust (ATP) is generally the best way to safeguard your properties against creditors. Should you default on a debt or file for bankruptcy, the assets in this type of trust don’t form part of the court or bankruptcy proceeding. Assets in your irrevocable trust may be excluded from bankruptcy proceedings.
How To Use a Trust as a Real Estate Asset Protection Vehicle
An asset protection trust can be an effective estate planning tool to protect all your assets, including real estate, while you are alive. A trust also provides directions on the handling and distribution of your assets after you have passed away. When you transfer assets into a trust, the trust becomes the owner of the assets. As a result, you save money, and preserve your assets’ value over the long term.
Is There a Downside to Placing Real Estate Assets in a Trust?
Obtaining a mortgage with a trust asset as collateral can be challenging. In the case of an irrevocable trust, it is possible to receive a loan, provided that the real estate in the trust has sufficient equity. Additionally, a beneficiary or successor trustee may only borrow against real estate in the trust if the trust documents allow it.
How Real Estate Investors Can Protect Property
While real estate investing is generally considered safe, proper risk management is critical to protecting your portfolio against lawsuits and tenant, creditor, and tax claims. With various risk management and asset protection strategies available, you can limit risk factors and leave a high-performing property portfolio to your descendants.
If you need help implementing a real estate asset protection strategy, contact Blake Harris Law today to learn more.
