CALIFORNIA REAL ESTATE INVESTING DONE RIGHT

AVOIDING WITHHOLDINGS, MINIMIZING TAXES, AND LIMITING LIABILITY

         Buying real estate foreclosures and distressed property in California is a two-edged sword. On the one hand, there are tremendous money-making opportunities. On the other hand, there are many pitfalls waiting to ensnare the uninformed investor. My job as a business structuring specialist is to help the investor legally avoid and/or minimize the various tax, tax withholding, and liability traps that often befall the unwary. Of course, in order to avoid the traps we must be aware of them, so let’s begin by identifying these pitfalls.

Trap #1: California Withholdings on Sale of Real Estate

          Perhaps the most immediate and brutal trap is the California withholdings requirement upon sale of real estate.[1] This law requires a real estate buyer to withhold 3.33% of the sales price and give it to the FTB, to help offset the seller’s tax liability from gain on the sale, even if the seller is a California resident. Although you might get some of this money back, most people do not want to give an interest-free loan to the FTB for a year or so. Furthermore, the following example illustrates how this withholding cuts into much more than 3.33% of a seller’s profit.

EXAMPLE 1

John buys a property in his name for $500,000. He spends $50,000 fixing up and marketing the property, and then sells it in his name for $600,000, netting a $50,000 profit. Unfortunately, 3 1/3% ($20,000) of the sales price is withheld. Therefore, 40% of John’s profit goes to the FTB, instead of into his pocket!

          Even assuming all of the $20,000 was due in taxes (highly unlikely!), John could have made $1,400 by investing the money and receiving a moderate 7% return, before having to fork it over come tax time. Or, he could have had the flexibility of spending the money and then paying what would likely be a much lower amount when tax time arrives.

Avoiding Withholding

            Avoiding trap #1 is surprisingly simple: just have either a partnership or corporation (or an LLC that is treated as a partnership or corporation for tax purposes) sell the property. These entities are exempt from the withholding requirement. Problem solved! (Be aware that an LLC classified as a “disregarded entity” for tax purposes is not exempt from withholding.)

Trap #2: Expanded Liability, Lingering Liability, and Other Lawsuit Triggers

            The 2^nd trap we must avoid is the unnecessary exposure of assets to lawsuits. As most of us know, the U.S. is a lawsuit-crazy country. Lawsuits are especially dangerous to real estate investors because they deal with valuable assets (real estate), and because they are subject to lingering liability, expanded liability, (more on these later) and the simple possibility of deals going bad. I won’t scare you into thinking you’ll be sued once or twice a year if you buy and sell real estate; you may only get sued once in ten or twenty years. However, if you only get sued once, and as a result you lose your home, your car, bank accounts, brokerage accounts, everything, wouldn’t you have wished you’d done some planning to put those assets out of harm’s reach? And although liability insurance is an excellent (and recommended) first line of defense against lawsuits, be aware that insurance has its limits: you could be sued for more than your coverage amount, or your policy may not cover you in situations where you thought it would. So let’s examine in a bit more detail specific types of liability and how we can protect our wealth against the liability trap.

            Lingering Liability

            To explain lingering liability, let me illustrate an actual court case that happened in Texas several years back. A homebuilder decided to build a home and sell it. He subcontracted another company to put in a septic system. Instead of putting in a proper system, the subcontractor decided to cut corners to save money, so he used a large propane tank. The home was then finished and sold. Ten years later, the propane tank leaked. Raw sewage seeped up through the home’s foundation and into the walls. Everyone inside the home, including an 8 month old baby, got serious staph infections, some of which required hospitalization. The original builder, who had operated as a sole proprietorship when the home was built, was sued for a very large sum of money and lost, despite the fact that it was another company that put in the faulty septic tank. In this situation, let me ask you the following:

• If at some point in the 10 year period between when the home was built and the septic tank leaked, you had sold or re-sold the home, could you be named as a party on this lawsuit?

• Do you think a real estate safety inspector would have been able to determine the incorrect septic tank was installed?

The answer to question 1 is yes. You could be sued if you sold a property with major defects, even if you didn’t know the defect existed, and even if a safety inspector checked out the property and gave it a green light. After all, the facts are decided by a jury, most or all of whom certainly haven’t the faintest idea about real estate sales. However, they probably think you’re be rich if you’re buying and selling properties, and they’re angry that a 8 month old baby was hospitalized, regardless of whether or not you reasonably could have detected and corrected the defect. Can you see this jury playing “Robin Hood” by taking from the haves (you) and giving to the have-nots, regardless of fault? In a country where over 30 million lawsuits are filed each year, this happens many times a day.

Expanded Liability

A similar situation happened to a client of mine, long before he’d seen the need for limiting his liability and protecting his assets. Many years ago he operated a car dealership in his own name (a sole proprietorship.) He bought a used car with damaged brakes, so he sent the car to a mechanic’s shop for repairs. Then he sold the car. Ten years later, the car was involved in an accident, which unfortunately resulted in multiple fatalities. The brakes of the car he sold had failed. Even though the brakes had worked perfectly for ten years, guess who got sued? That’s right, my client who had operated his dealership as a sole proprietorship, without a limited liability shield. Fortunately he only lost $50,000 in this case, but it could have been much worse. Did you notice in this case that my client’s company wasn’t even the company that fixed the brakes, yet it was the one that got sued? This is a perfect example of expanded liability. People are sued under theories of expanded liability because attorneys collect a percentage of the judgment or settlement award amount when they sue. They therefore have a direct incentive to sue as many people as possible, for as much money as possible. More people sued equals more money to grab, which means the attorney gets paid more for his or her services. This means attorneys are constantly coming up with ways to sue as many people as possible per lawsuit, even if the connection between some people and the lawsuit is very remote. To make matters worse, those with the most money are the juiciest targets, even if they have the least to do with the lawsuit. My client who was sued for selling a car has a net worth in the millions. Why didn’t they sue the original mechanic or repair shop? Because they didn’t have any money. In 2005 a baseball stadium employee sold beer to an already inebriated man. After the game, the game, the man drove drunk, got in an accident, and killed someone. The drunk driver was broke, so although he went to jail the plaintiff’s attorney didn’t pursue anything beyond his insurance’s $200,000 payout. The employee that sold the beer didn’t get sued at all. But was the vendor’s large and wealthy employer sued? Yes they were, and a jury hit them with a $110 million dollar judgment. Who had the money? Who got stung? See where I’m going? Now I ask you, if you are only remotely connected to a lawsuit, and no one involved has significant assets except for you, because you have several investment properties in your name, who do you think the plaintiff’s attorney will go down?

So how do we avoid this problem?

First, we use a limited liability entity, such as a corporation, limited partnership (LP), or limited liability company (LLC) to conduct your business. Of these three entities, an LP or LLC is highly preferred over a corporation, unless you intend on going public with your company. This is because if someone sues you personally, they can seize your corporate ownership (stock), and then possibly be able to reach corporate assets to satisfy their claim. However, they are forbidden by law from doing this if you own an LP or LLC. Furthermore, LLCs and LPs are easier to maintain, and you don’t necessarily have to spend time following certain formalities such as annual director meetings and minutes; you can instead focus on actually running your business.

Second, we may want to make assets inside the company worth less or otherwise undesirable from a lawsuit standpoint.

Third, you should consider protecting your personal assets from lawsuits. Later on I’ll explain in more detail how each of these goals may be achieved.

Trap #3: Unnecessarily High Franchise Taxes

            So we’ve figured out it’s a bad idea to run a business without using an LLC, LP, or corporation, both for withholding and liability reasons. Another trap we need to avoid (as much as is legally possible) is the state franchise tax. A franchise tax is a tax levied on a corporation or other limited liability entity for the privilege of doing business in the state. The reasoning goes that since the state grants limited liability to certain entities, it should be compensated for such protection. Most states only charge franchise taxes on corporations. Those doing business in California, however, have to pay franchise taxes regardless of what type of limited liability entity they use. Fortunately, some entities don’t pay as much tax as others, and therefore we can choose an arrangement that minimizes franchise tax liability. The tax rates for limited liability entities in California are as follows:

You’ll notice in the above table that every entity must pay at least an $800 franchise tax annually. However, the only entity that pays a flat tax regardless of revenue or net income is the limited partnership. LLCs may pay up to $12,590 in taxes; the sky’s the limit for “C” and “S” corporations.[6] Since different entities pay tax at different rates, let’s illustrate two examples and see how each entity fares.

EXAMPLE 1

For tax year 2005, each entity has $5 million in gross revenue, with a net profit of $500,000. The tax paid is as follows:

EXAMPLE 2

For tax year 2005, each entity has $249,999.00 in gross revenue, with a net profit of $107,000. The tax paid is as follows:

            In Example 1, we see that a limited partnership clearly pays the least tax by a wide margin. In Example 2, the margins are much narrower, and this time an LLC ties an LP for 1^st place, with both entities paying $800.

Based on the above data, it seems that the best entity to use is the limited partnership. However, when using an LP, we run into a snag from a liability standpoint. Because the managing partners of an LP (commonly called “general partners”) receive no liability protection, their personal assets are at risk if the partnership is sued. This shortcoming is unacceptable. Fortunately, the problem is rectified by using an LLC as the general partner. Unfortunately, the LLC must also pay a franchise tax as manager of the LP, regardless of whether it is created or otherwise doing business in California. We can give the LLC a minimal 1% interest in the LP, which means its franchise tax will only be $800 as long as partnership revenue remains under $25 million annually, however the combination of an LLC and LP together means annual franchise taxes will be $1600 annually. In light of this, we come to the following conclusion.

1. If company profits are expected to be less than $107,000 annually, it’s best to form an LLC that elects “S” corporation tax status (such an LLC will be taxed as an “S” corporation rather than an LLC. Remember, from a legal standpoint, LLCs are easier to operate than “S” corporations, plus they offer better liability protection.)

2. Otherwise, form an LP with the LLC as a 1% general partner.

Because a sale of only 2 California properties per year is likely to bring profits in excess of $107,000, a serious real estate investor should use a combined LLC/LP structure. The more casual investor, however, may be best served by forming an LLC that elects to be taxed as an “S” corporation.

Other Considerations

• When buying and selling real estate, a final consideration should be made: protecting the properties themselves from lawsuits. Remember that if an LP, LLC or other entity is sued, although your personal assets will be safe, assets within the entity may still be at risk. Therefore, as an asset protection specialist, I often recommend the following strategies, depending on a client’s circumstances.

• Financing each property directly into an LLC or LP is a good way to go. Not only is the property protected from anyone who may sue you directly, but the financial institution will have a lien on each property equal to the amount of the loan. The lien generally protects the property from lawsuits in an amount equal to the loan’s outstanding balance.
• If you’re buying properties exclusively with your own funds, consider placing these funds in a 2^nd LLC or LP. Then loan the money from the 2^nd LLC or LP to the company that’s buying the property. You can have the lending company place a lien on the property, which is then protected against lawsuits if the company that holds the property is sued. The company that loans the money generally can’t be sued as long as it doesn’t engage in business with the public. In other words, only have the lending LLC do business with your other company.
• If you’re financing properties with large down-payments (meaning each property has considerable equity after the purchase), then consider combining both of the above suggestions: finance each property directly into an LLC or LP, and then have a 2^nd company loan money to the purchasing company, which will then use the funds for a down-payment. The lending company subsequently “strips” the remaining equity from the property via a lien (to secure the loan), thus protecting it from lawsuits.
• If one LLC or LP holds multiple properties, consider titling each property in a Land Trust. A Land Trust is easy to form and use, and gives you an extra layer of privacy. If someone is looking to sue your company, they’ll do an asset search. If all the properties are titled in different land trusts, then the would-be litigant will only find one or perhaps no properties at all. This makes you appear more “broke” than you really are, making you a much less desirable lawsuit target. Furthermore, Land Trusts may sometimes (but not always) provide an extra layer of limited asset protection. Anyone who retains my service to form one or more business entities has access to my Land Trust documents at no extra charge!
  • If you finance property into your LP or LLC, or even into your own name, Federal law allows you to transfer it into a Land Trust without triggering the “due-on-sale” clause that is almost certainly in your loan agreement.[7] Essentially, a due-on-sale clause is a provision which states that if you finance property and then transfer it to another person or entity, the lending institution reserves the right to call the entire loan due immediately. Failure to pay the loan immediately means the lending institution could then foreclose on your property. Although the lender may not exercise this option, don’t take this risk! That’s exactly why you shouldn’t finance a property in your name and then place it into an LLC, LP, or other entity. However, you may safely transfer properties into Land Trusts.
• Because of lingering liability, it is a good idea to properly dissolve a business every few years, and then form a new entity and start anew. That way, if a lawsuit happens a few years down the road, the entity being sued may no longer exist! Instead, all of your assets are in a newer entity that had nothing to do with the transaction that gave rise to the lawsuit. The litigant is stopped dead cold.
  • It is very important to properly dissolve a company. If you just stop using it, the company will still be liable for franchise taxes, which will build year by year. Furthermore, ignoring a company means it may fall out of favor with the State, which means it may lose its limited liability, which means that when you’re sued several years down the road, the litigant may be able to sue you directly, instead of being forced to only sue your company!
• Unless you’re an extremely experienced and savvy investor, it’s usually not a good idea to set up LLC’s, LP’s, and/or other business entities by yourself. In this complex field I often see even attorneys and CPAs make big mistakes, because very few of them specialize in this field like I do. The tax, liability, risk management, and legal aspects of this type of structuring are simply too complex for the average layman. I’ve seen many incidences where the “do-it-yourselfer” put together a program wrong and lost many thousands of dollars or as a result. For an example of an LP set up wrong, by an inexperienced attorney who didn’t specialize in LPs, Strangi v. CIR, or read the article Entanglement Theory, which discusses 4 cases (2 in California) wherein improperly structured LLCs failed to protect assets.

[1] See AB 2065.

[2] See California form 100 tax booklet, p. 6.

[3] See California form 100S tax booklet, p. 5.

[4] See California form 568 tax booklet, p. 4.

[5] See California form 565 tax booklet, p. 5.

[6] The designation “C” and “S” for corporations is due to the subchapter of the Internal Revenue Code used to tax the particular corporation. Typically, “C” corporations are large, often publicly traded companies subject to tax as a corporation, and again when dividends (profits) are paid to stockholders. “S” corporations are small businesses where only the stockholders pay tax on company profits.

[7] See Title 12 U.S.C. §1701j-3(d), commonly known as the Garn-St. Germain Act.