In this two part article I want to begin by clarifying that I do not want the title to mislead you in two ways. First, when I say “debt” I do not mean getting yourself in hock or using phony liens just to protect your assets. Instead I will be discussing your own valid controlled debt which is still your equity but in a separate entity apart from your real estate; but more on this later. Secondly, I do not want you thinking that you should not use an LLC, a trust, and insurance. This is because there is an important fundamental of asset protection which I call The Roman Shield Strategy. The ingenious ancient Romans had a military formation where their entire army was covered by numerous shields protecting the soldiers on every side. It would look like one gigantic shield defending against the enemy. No one shield, by itself, would totally protect them; but collectively all of the shields together were virtually impenetrable, like an enormous wall. You need to do the same with your asset protection because no one shield will totally protect you. You therefore need multiple shields of colossal protection – an LLC entity, trusts, insurance as well as other shields including what I believe to be the most powerful shield of using controlled debt (Equity Stripping) to deter wrongful actions which is the central topic of this article. But while these shields are powerful, they also must be cost effective without the expense and administrative burden of a lot of unnecessary entities. This too will be a focal point of discussion.
It’s no secret that the equity in our investment real estate is generally our most valuable asset, but also very prone to legal attacks. This is because real estate is a physical appreciating asset subject to many regulations (such as landlord-tenant laws); exposed to potential hazards (such as environmental); and which interacts with many individuals or entities (such as tenants, buyers, sellers, real estate agents, contractors, suppliers, etc.) All of the above (regulations, environmental, tenants, buyers, sellers, contractors, etc.) could very well be the origin of legal actions.
I mentioned three shields of protection – an LLC, a trust and insurance. Let’s discuss what these shields protect, as well as what they do not protect (which is an important question that you should ask of all asset protection vehicles).
Let’s start with insurance which essentially protects against slip & fall and personal injury. However, liability insurance does not protect from environmental hazards, fair housing violations, tenants disputes, buyer disputes, seller disputes, contractor disputes, in fact any disputes which all could lead to lawsuits. Also, insurance does not cover judgments that exceed insurance coverage limits from slip & fall (including intentional self-inflicted injuries), personal injuries or death. Such judgments exceeding insurance limits are becoming more and more common even if you’re not at fault. And sometimes insurance companies even try to wiggle out of claims that should be covered. (The “fine print”)
How about trusts? There are many different types. The one most associated with real estate is a land trust which gives you important financial privacy by masking ownership of your properties. However land trusts do not give you the statutory corporate limited liability of an LLC. If the trust is unmasked, and you, personally, are the beneficiary, your assets are exposed. (In accord with The Roman Shield Strategy, you should use land trusts in combination with insurance; and with an LLC which, as a statutory entity, would then be the beneficiary of the trust instead of you personally).
And how about an LLC? With the proper formalities, an LLC gives you corporate limited liability by protecting your assets outside of the entity, such as your home, second home, stocks, personal savings, expensive jewelry, art collection and other personal valuables. However, while it protects your personal assets outside the entity, an LLC does not protect the property equities within the entity. Such equity essentially comes from appreciation, upgrading and mortgage amortization. So before you know it, you can have significant equity that you need to preserve. Also remember that with multiple properties, we are talking about each property’s equity that we need to protect from not just a legal action on that property, but from a legal action of another property in the same LLC.
An example of unprotected equity (and a target for claimants) is six properties below in a real estate LLC.
| Total Value | $1,000,000 (6 properties) |
| - Mortgage loan | - 400,000 (first mortgage; bank’s equity) |
| = Your RE equity | $ 600,000 (target for claimants) |
Now in reviewing the above, the bank loan of $400,000, is that a target for claimants? NO! Because who wants to sue for debt. Lawyers want blood, not stone; they want deep pockets, not empty ones.
However, the bank loan of $400,000 is equity, not your equity, but the bank’s equity in a separate company not reachable by a potential claimant of you. So, why not do the same with your $600,000 equity – make that debt which would be equity in a separate company not reachable by a potential claimant of you. Only here the bank, with the $600,000 of equity, is your separately owned lender LLC which is a non-risk entity because it only would own the mortgage, a paper asset that is not the cause of legal actions.
This is known as Equity Stripping .
The end result is that the real estate LLC will have publicly recorded debt completely stripping out the property equity, along with avoiding a lawsuit target and avoiding the courtroom. In the above example this debt would be the bank’s first mortgage of $400,000; your lender LLC’s second blanket mortgage of $600,000 (plus accrued interest every year) or a total of $1,000,000+ recorded debt against the $1,000,000 value, with NO or even negative equity as seen in the public records. Believe me, this will ward off claimants along with their money-hungry lawyers, the way a cat scares off rats (no pun intended).
In part II of this article (next issue) I discuss how equity stripping works and its overwhelming advantages.
Author's Products:
August 29th, 2010 at 10:32 pm
Very good articole.
I would like to know also how you transfer a property ( comercial or residential), which has a mortgage held by a bannk, after the LLc has been establised. A typical example will be very much appreciated.
Thank you
Nick