Asset Protection

There are many ways to “asset protect” the property that you own. No one option fits every situation. Some common methods for asset protection include Limited Partnerships, Family Limited Partnerships, LLCs, and some types of Trusts such as the Beneficiary Defective Inheritor’s Trust or the Domestic Asset Protection Trust. The best way to determine the right method of asset protection for you is to discuss your objectives with a qualified asset protection attorney.

Domestic Asset Protection Trusts

Just what is a Domestic Asset Protection Trust, or what is more commonly referred to as a DAPT? It’s a type of irrevocable trust that is self-settled and acts like a spendthrift trust which doesn’t allow for the appointment of the trust assets to your creditors and permits you to be a beneficiary. In more plain English, it’s a trust you can set up in certain states to protect assets from your future creditors and lawsuits against you.

There are presently 13 states (14 if you include Colorado’s limited state statute) that allow for self-settled Domestic Asset Protection Trusts. California is not one of them. However, that doesn’t mean that you can’t set one up in another state that allows them such as Nevada, Delaware, South Dakota, or Alaska, just to name a few.

Although this asset protection device has been around for a decade and a half, it has yet to be rung up the Court system except in the case of a bankruptcy. Most cases settle out of court for some lesser negotiated amount due to the expense in litigating to get to the assets. Other than in the case of a bankruptcy, DAPTs have proven to be quite effective bargaining chips for settling debts for a lesser amount and protecting assets from the reach of creditors and lawsuits.

There are various state statutes for DAPTs across the country that govern how the trust needs to set up and how and from whom the assets can be protected. Most DAPT state statutes allow the DAPT to be a “Grantor” trust. This means among other things that the Grantor of the trust can pay the income tax on the income that the trust generates. Many types of assets can be transferred to a DAPT including cash, securities, real estate, and business interests, just to name a few.

So just who is a good candidate for this type of planning? Liability concerns doctors, lawyers, high risk professionals, and other people of high net-worth. The best protection is to set this structure up far in advance of any creditor problem. This is because each state has a statutory waiting period until the assets are protected. You also don’t want to get caught in the snare of a fraudulent transfer. A court could consider the transfer to a DAPT fraudulent if you transferred property to the trust after the threat of a creditor action or lawsuit has arisen. Each state has its own statutory waiting period from the date the asset is transferred to the DAPT and when the asset is protected from a creditor’s claim. For example, Nevada’s statutory waiting period is two years.

Today there is a definite increase in liability exposure. We live in a victim mentality world where the revelation that someone has deep pockets can spur on a lawsuit or a threat of one. The plaintiffs’ attorneys are partly to blame in this regard as well with their TV commercials making it appear to be the norm to sue sue sue! Many professionals are fearful of malpractice lawsuits today because of the notoriety of malpractice and errors and omissions legal actions. For instance, in 2006, there were over 633,000 malpractice claims against physicians and surgeons alone! This was reported by the Physician Insurers Association, 2007 Report.

There is also a statute of limitations that differs depending upon whether the creditor is a preexisting creditor or a non-preexisting creditor. If there is a preexisting creditor, there is a tolling of the statute of limitations period in order to protect those creditors.

Nearly all of the states that allow for DAPTs also have exception creditor statutes. These statutes protect certain classes of creditors by allowing them access to a DAPT’s assets. One common exception creditor is a divorcing spouse. There is one state that doesn’t have exception creditors and that is Nevada.

Even though just implementing a Domestic Asset Protection Trust would stifle most plaintiffs, there are additional asset protection strategies that can be utilized to significantly increase your asset protection if used in conjunction with the DAPT. By adding one or more Limited Liability Companies (LLCs) to the mix, you can limit a creditor’s remedy to a “charging order” in some jurisdictions. A charging order, as discussed in Chapter 9, limits the creditor to the LLC member’s share of distributions and doesn’t confer any voting or management rights to the creditor in the LLC. This charging order protection offers an additional barrier when it is combined with the DAPT in a well-crafted asset protection plan.

Asset Protection Planning for Commercial and Rental Real Estate

The basic idea behind asset protection planning for commercial or residential rental real estate is the use of business entities to create a legal separation between you and certain assets.  These entities, typically Limited Liability Companies, can also be great vehicles for privacy, tax and estate planning objectives. The more properties you acquire, the more likely you are to become the party to a lawsuit on one or more of the properties from financial predators. Putting an asset protection plan in place should be of paramount concern as soon as you begin to own commercial or residential rental real estate.

There are a variety of ways in which a property owner can lose their hard earned assets to even just one successful lawsuit. Some typical causes are bad tenants, delivery people, guests on the property, neighbors, criminals, children wandering on to the property and getting hurt, or even a city repairman. All it takes is one devastating event, and you could be wiped out.

A person on the property could slip and fall or a balcony could collapse. Not to mention that buildings do catch on fire and mold can grow in the strangest places and cause extreme damage not just to the property itself but to its inhabitants. You can be sued not just for things you are aware of but also for things you “should have” been aware of. Or something you should have known to do to repair the property to prevent the harm that resulted. 

It is not uncommon for a new client to come into my office owning real estate either outright in their name or directly in the name of their revocable trust. The problem is that if they are successfully sued, the whole of their assets are subject to satisfy that claim or judgment. So when I see a situation like this, I immediately inquire as to the sufficiency of their liability coverage on the properties, whether they have an umbrella policy and if they know the value and benefit of setting up a Limited Liability Company (LLC) to shield their other assets from a possible future claim or lawsuit.

Ideally, for the best asset protection, you want to place each rental or commercial property in its own separate LLC. The reason is that if a claim arises against one property, it will not take them all down. If they are all in the same LLC and a major judgment against the LLC occurs, all of the assets of the LLC may be subject to satisfy the judgment. This however is a matter of law which will depend upon the jurisdiction that you form your LLC under. Some states have better LLC statutes that better protect the owners of the LLC. For example, some state statutes limit the creditor’s remedy to a charging order.  A charging order limits the creditor to the LLC member’s share of distributions, without conferring on the creditor any voting or management rights in the LLC. For example, if the member decides not to make any distributions, then the creditor would not get any either.

After the LLC is properly formed, you will want to change the title to the property to the name of the LLC. Although some lenders on commercial and residential rental property may have due on sale clauses buried in their mortgage contracts, most rarely exercise them. Most banks are very familiar with the reasons their borrowers want to hold title in the name of an LLC and a simple call to the lender can clear up any questions. The bank will likely want to make sure that the LLC is owned by the same parties that are the parties to the loan on the property. When the deed to transfer the title to the LLC is prepared, you will also need a proportional interest statement and a preliminary change of ownership report so you don’t trigger an Assessor’s Office transfer tax or reassessment. After the transfer is recorded at the Assessor’s Office, you will want to assign your right, title and interest in the LLC to your revocable trust. If you are in need of estate tax reduction strategies, you may even want to set up an Intentionally Defective Grantor Trust and transfer a portion of the LLC to that legal entity. However, that is a very complex discussion and goes beyond the scope of this chapter.

Once the property is moved into the LLC, your other assets will be shielded from future claims and lawsuits arising from the property. Only the assets of the LLC could be at risk to satisfy the lawsuit.

If you own the building that you operate your business out of, it’s critical that you set up an LLC just for that property. You will likely want to lease the building back to your company and pay the LLC rent. The income paid as rent to the LLC is passive and not subject to employment taxes. You should not title your business operating real estate in a corporation. Doing so will lead to great taxes when the property is eventually sold.

Without Asset Protection Planning

Here’s an example of what happened to two real estate investors who did not do LLC asset protection planning:

Bill and Cindy own two residential rental properties in San Diego. The rentals are owned individually in their names as joint tenants. One of the properties as it turns out had some bad wiring and it caused a fire in the home. A tenant was killed in the blaze. The surviving spouse of the tenant sued Bill and Cindy and was awarded a judgment of $1.8 million. Bill and Cindy have a $1 million liability policy on the property and the insurance company paid that amount to the surviving spouse of the deceased tenant. There is still $800,000 outstanding on the judgment. The surviving spouse started collections proceedings against Bill and Cindy to take their personal residence and all their bank accounts, the other rental property, and investment accounts. The only thing left untouched was their 401(k)s. In a nutshell, they are financially devastated.

With Solid Asset Protection Planning

By contrast, let’s look at an example where two real estate investors invested in proper asset protection planning:

Tom and Sam own two rental properties together. Originally, they purchased them as joint tenants. However, Tom’s attorney told Tom that he recommended that the properties be held in an LLC so that Tom’s other assets would not be at risk if a lawsuit was ever filed in relation to the properties.

Tom and Sam decided to set up two LLCs since they own two properties. They liked the idea that if something bad happened to one of the properties, it would not affect the other property and they liked the idea of protecting their other assets.

A heavy storm came through late in January and resulted in the roof collapsing in one of the properties. One of the tenants was killed when the roof collapsed. Tom and Sam didn’t know of any problems with the roof, but the court ruled that they should have known that the roof would likely collapse in heavy rain and wind conditions. The judgment was for $1.7 million, however, the plaintiffs settled for $1 million because they knew they were limited in recovery to the property insurance and the equity in the LLC.

The property and casualty insurance policy paid the first $100,000 and the umbrella insurance policy paid the next $900,000. The plaintiffs could not get at Tom and Sam’s assets outside the LLC.