Are you the owner of a vacation home or are you considering buying one? Before you do, consider that accumulating property comes with risks. Plan ahead to mitigate those risks by employing some strategies that will help to protect your assets. Someone out there wants what you have.
This cynical approach is good when it’s about your wealth and protecting it. Many investors and second home buyers have at least heard of some things you can do to protect your new property. This article will fill in gaps in your knowledge and encourage you to take action now.
The intent of this article is not to give you legal advice but to make you aware of your options. It is likely that after reading this you may want to contact both a tax advisor and a law firm to follow through. We are going to cover a few aspects that include both financial and legal. It’s all tied up in the end. That beach house can be fully secured with some early steps.
Take action now before you need it
The protection mechanisms discussed here only work if they are implemented before any legal actions are taken by third parties. In fact, if you are in the process of being sued by another party, it’s too late to take any steps to prevent the potential of avoiding potential legal actions. Any attorney will tell you to take protective actions when there are no wolves at the gate.
KEY: Do it now not when after our guest falls and breaks a hip
You will want to decide how you will purchase your property. Pay cash or finance. The reason for knowing this in advance is that you will be moving the property to a limited liability company. If you pay cash, you can form the LLC and then buy it in the name of the LLC. This eliminates a transfer later.
Most investors use leverage, that is they will finance the property when they intend to rent it for income. Regardless of the ultimate use of your property, if you intend to finance it, you will be buying it in your own name or the name of you and your spouse.
After closing quit claim the property
After closing, you can transfer (quit claim) the property from your own name to the LLC. Mortgage companies rarely permit the purchase of financed property to be in the name of an LLC at the time the mortgage is issued. No worries, you can transfer it later.
Why move your property to the ownership of a limited liability company? If someone sues you for a problem with the property either a neighbor who falls on your sidewalk or if you are renting it, they will go after the assets of the LLC and not your personal assets. Some put their property in an LLC for privacy reasons.
You can form an LLC using a registered agent and your name need never be public as the property owner. The following are ten reasons why using an LLC for your real estate assets is a good thing:
10 Reasons to Form an LLC and Transfer Real Estate Assets
- Limited Liability: LLCs protect personal assets from business-related debts and lawsuits. If a property owner faces legal action related to the rental property, their personal assets, such as their primary residence or savings accounts, are generally shielded.
- Tax Benefits: LLCs offer flexibility in tax treatment. Owners can choose to be taxed as a sole proprietorship, partnership, or corporation, depending on their specific tax situation. This can help optimize tax liabilities.
- Estate Planning: LLCs can simplify the transfer of real estate assets to heirs. The transfer of ownership can be structured to minimize estate taxes and avoid probate.
- Asset Protection: LLCs can help protect assets from creditors, especially in the event of bankruptcy.
- Privacy: LLCs can provide a layer of privacy by shielding the owner’s identity from public records.
- Credibility: In some cases, businesses or investors may prefer to deal with an LLC rather than an individual.
- Professionalism: Forming an LLC can give a rental business a more professional appearance.
- Financing: Some lenders may prefer to lend to an LLC, especially for larger commercial properties.
- Multiple Owners: If a property is co-owned by multiple individuals, an LLC can provide a clear framework for ownership and management.
- Business Expansion: An LLC can be a useful structure for expanding a rental business, such as adding more properties or offering additional services.
Forming the LLC
States regulate business registrations. Usually the Secretary of State. Go to the secretary of state office online and read the requirements. Decide what name you want to call your LLC and do an online check. When you find the name, you can proceed with creating your LLC. Fees can be deducted from a credit card.
If you own the property in a state that you do not live in, you should create the LLC in that state, not the one you live in. If you do not live in the state you will be required to pay a registered agent an annual fee.
KEY: Always form your LLC in the same state as the property. Why? So you can use the courts if necessary. Also, most states require an annual fee or renewal process.
After forming the LLC, the next step is to transfer the property to the LLC. State law where the property is located will permit a transfer using what is called a “quit claim” deed. Create this simple one or two-page document, have it notarized, and file it with the public office that records property in your area. When the quit claim deed is filed your liability protection will have started. You are not done yet.
You should create a document usually called an LLC Operating Agreement. This document explains the who, what, where, when and why of your LLC. It will include the percentage ownership for all LLC members and who can make decisions for the LLC.
This document may be requested by your bank or financial institution now or in the future. This is your document so there is no state-required template. There are however some basic things that should be in the document to make it viable such as the use of the property. Also, there is generally a term of years included in the LLC Operating Agreement.
Periodic meetings of the members of the LLC can take place via telephone, or another electronic method to discuss any new issues. When there is a meeting create a “minutes of the meeting” document and file it with the other LLC documents. The LLC agreement must indicate who can make investment decisions on behalf of other LLC members. This includes management of the property.
KEY: Update the LLC Operating Agreement by holding an annual meeting. Prepare minutes on one page and insert them in the document. Make any adjustments you need e.g. adding more members.
Revocable Family Trust
A good option is to create a revocable family trust (different names in some states). This type of trust is a living trust agreement that permits you and or your spouse to control what happens in the trust.
There are several reasons to create a revocable trust. While the LLC will help avoid legal issues, it will not be enough if the assets of the LLC, usually equity in the property are significant. Courts could issue a judgment against your LLC which would be attractive to the plaintiff if there is equity.
| Reason | Description |
|---|---|
| Avoid Probate | Assets in a revocable trust do not go through probate, saving time and court costs. |
| Privacy | Unlike wills, trusts are not public records, allowing the distribution of assets privately. |
| Incapacity Planning | The trust can appoint a successor trustee to manage assets if the trust maker becomes incapacitated. |
| Control Over Assets | Grantors can maintain control over their assets during their lifetime and specify how they are distributed after death. |
| Flexibility | A revocable trust can be changed or revoked at any time by the trust maker. |
| Avoid Multiple Probate | If you own real estate in multiple states, a revocable trust avoids probate in each jurisdiction. |
| Continuity Upon Death | The trust seamlessly continues to operate after death, allowing for quick asset distribution. |
| Minimize Estate Challenges | A properly executed trust is less likely to be contested than a will. |
Your trust is now your lender
While there are many good reasons to create a revocable trust, the one we are discussing here is to use it to hold a mortgage on the property owned by the LLC. It’s a simple process to create a mortgage. You will need to file the note and deed of trust with the county where the property is located. This “lien” on the property is discussed below.
Assume that your vacation property is worth $400,000. That $400,000 of equity is not protected. If the trust holds a mortgage on the LLC property for $380,000 (example) that leaves only $20,000 to satisfy a judgment. This means that regardless of how much the plaintiff wins in a judgment, they only have access to the unencumbered amount. Many attorneys will see the $20,000 as too small to pursue.
Usually, the court will not compel the sale of the property to yield such a small amount. I say usually because nothing is set in stone when it comes to our legal system. The following may help explain this element:
Can a court compel a sale of your property to satisfy a judgment?
A court can compel the sale of a house to satisfy a judgment, but whether it will do so in the scenario you describe depends on several factors:
1. **Judgment Lien**: If a creditor has obtained a judgment against a debtor, they can place a lien on the debtor’s real estate, including their home. However, this lien is typically subordinate to any existing mortgage.
2. **Equity in the Home**: The court will generally consider whether there is sufficient equity in the home to satisfy the judgment. Equity is the difference between the home’s market value and the amount owed on the mortgage. If the mortgage is $380,000, and the home’s value is close to that or less, the homeowner may not have enough equity to satisfy the $20,000 judgment, and a forced sale would be impractical.
3. **Homestead Exemption**: Many states have a **homestead exemption** that protects a certain amount of equity in the home from creditors. If the homeowner’s equity is within the state’s protected amount, the creditor may not be able to force the sale of the home to satisfy the judgment. Most investment properties do not qualify for a “homestead exemption”
4. **Sale Process**: Even if a sale were forced, the mortgage lender would be paid first from the sale proceeds. If there is little or no remaining equity after paying off the mortgage, the judgment creditor may receive little or nothing from the sale. In this case, the creditor may choose not to pursue a forced sale, as it may not result in full payment of the debt.
With nothing to gain
Given the high mortgage balance in your example ($380,000), unless the house has significant equity beyond the mortgage amount, it is unlikely that a court would force the sale of the home for a $20,000 judgment. Essentially there is no creditor protection available in this scenario.
You do what you can to protect yourself and hope that it is enough. There are no foolproof strategies for protecting wealth but the LLC and trust will take you down the road in the right direction. There are of course other benefits to the trust regarding taxes and inheritance.
In some jurisdictions, transferring your property to an LLC may strip away discounts such as senior or homestead. Your property taxes can be affected by these actions. I recommend that you contact the tax assessor in the county where the property is to determine any changes in property tax liability. If what I have already discussed above seems complicated, check with a financial advisor, CPA or an attorney.
Accounting and tax planning
After you have set up the basic structure of your business and transferred your property, you need to open a business checking account for the LLC. Start this process by obtaining a federal tax identification number. Your bank will require the FEIN.
This number is similar to a social security number as it identifies the LLC as a prospective tax entity. Your LLC will not pay income taxes as long as you set it up with the IRS as a partnership. This is done during the online process. You must create the LLC of course with the state before you apply for the FEIN.
If you want the maximum protection for your assets, keep personal and business funds separate. You can use a personal credit card to buy something for the business but be sure to pay it with business funds. Doing this helps to reduce potential personal liability if legal action is threatened.
Pay expenses with a business account
Payment of expenses should be done from the business checking account. You can add funds to be sure the account is solvent. If you take funds from the account, write a check to repay your equity loans.
For example, you and your wife are real estate investors. You buy a property that will be used as a family vacation property and rent when you are not there. Next, you create the LLC and transfer the property ownership from your own name to the LLC.
KEY: Create an accounting system, use a free one like WaveApps.com to show the IRS you are accounting for everything.
You create a trust and file a mortgage with the county for any excess equity. Now you open the business checking account. It will need funds so you put in $5,000 to start. This is an equity deposit that you are entitled to remove at any time without paying taxes on it.
As a vacation home owner, you are entitled to use the property which you can do without paying or you can decide to pay each time you visit the property. You are entitled to deduct part or all of your trip (discuss with your CPA). Expenses are starting to come in.
Make equity investments to over-cost
Electricity, water, gas, lawn service, etc. Income is not yet sufficient to pay all of the bills. Your equity investment covers the difference. All expenses are paid from the business checking account. Should you not experience sufficient rental income, you may be required to deposit additional funds.
KEY: Record equity payments into your business account in your accounting system it will track the balance
All of the above activities are perfectly legal and demonstrate to courts and the IRS that you have a legitimate business. You should consider hiring a professional property manager for management of the vacation home which further demonstrates that this is a business. Even have family members pay for their stays. You can always pay them back or work out something with them. The idea is to show cash flow into the property.
Where does the trust come in
The property is still owned by the LLC, it is not a “trust property” per se. The trust does hold a lein on the property but not the LLC. The mortgage will require repayment of the mortgage. A great option is to set up a monthly payment of for example $500. Open a checking account for the Trust.
Make the payment to the trust. Periodically remove the funds from the trust as payment to the trustees for management of the trust. There is more required on this topic and it’s best to have your CPA and/or attorney get into the details.
Three legs of the plan
There are three legs and all should be implemented to work. Leaving one out is to leave the gate open for the bad guys to enter.
Create an LLC – Form the LLC with the state, quit claim the property to the LLC
Set up a Revocable living trust – Create a mortgage on the property for the remaining equity and file with the county
Create a business checking account and accounting system.
If you need more information about how to accomplish the process above, check out this article with additional information.