Posts under: Real Estate

Legal Tips for Wholesaling Real Estate

July 18, 2017 Business planning, Real Estate Comments Off on Legal Tips for Wholesaling Real Estate


Many real estate investors regard wholesaling as a way to learn how to evaluate deals and develop your real estate network.  It is also a method to profit from investing in real estate without requiring significant up front capital.  Wholesaling is a strategy whereby the wholesaler enters into a purchase contract with a seller of real estate and then assigns the purchase contract to another third party who will typically rehab the property and flip it for a profit (at least that is the goal).

Although most investors regard wholesaling as involving less risk than, for example, the flipper who is rehabbing and selling the property, there are always risks in any transaction, and so the purpose of this article is to identify some of the common legal issues to look out for in your wholesale deals.  This article is not designed to teach you the strategies for being a successful wholesaler, such as how to find properties, how to approaching homeowners, etc., but instead, focuses on some of the legal aspects of wholesaling that investors should be aware.

Licensing Issues:  Be aware of potential licensing requirements for your state:  Different states define the scope of activities that require a license differently and so you should be aware of what activities are regulated by your particular state and act accordingly.  For example, California generally defines a real estate broker as someone who sells, buys or negotiates for another with the expectation of compensation.  If your activities in California meet these elements, then be advised that you may need to be licensed as real estate agent.   Any questions regarding state licensing requirements should be directed to an attorney with knowledge of the requirements of that state.

LICENSING ISSUES

Understand the Rules & Procedures Governing Real Estate Transactions in your State:  Many states have unique laws, forms or disclosure requirements for real estate purchase transactions.  For example, in California, a seller is required to provide a transfer disclosure statement and if the property is in foreclosure, there are additional required disclosure requirements.  Failure to abide by the rules that are required in your state could cause legal issues down the line in your transaction.  You don’t want to have a seller or your end buyer come back later raising an issue with the transaction that could have been avoided had you followed the proper procedures for real estate transactions in your state.

DISCLOSURE & TRANSPARENCY

Be Transparent as to your Role in the Deal:  If your intent is to wholesale the property during escrow, the homeowner should be well aware in writing that your intent is to assign the deal to a third party for profit, and the contract language should give you a unilateral right to assign without requiring the consent of the homeowner.  Most standard form purchase agreements you get from realtors do not have this language and so an amendment or specially prepared form may be necessary.   On the buyer’s side, you should be very clear in your written agreement with the end buyer as to what you will be responsible for and what will be the responsibility of the end buyer.  For example, are you going to do an analysis of after repair value (e.g. running comps and estimating repair costs)? Run title?  Do an inspection?  What happens to your earnest money deposit once you assign the contract to the end buyer?   Your agreement should clearly specify in detail what your specific obligations are in the deal, where your obligations in the deal ends, and what the end buyer is expected to do to close the deal.  It is better to have these details on who does what expressed clearly in writing rather than rely on assumption.    Most importantly, you should include language that fully releases you from any further obligations or liabilities in the deal to ALL parties once you complete the assignment to end buyer.

CONTINGENCY CLAUSES 

Make Sure Your Contingencies are Clear.  This should go without saying, but depending on the specifics of the particular deal, it is important to properly set the expectations early for all the parties involved.   I typically advise clients who wholesale properties to have a good understanding of what their potential end buyers want in a deal in terms of location, spread, contract language, due diligence items, etc.  I also encourage individuals wanting to pursue wholesaling to develop relationships with rehabbers as early as possible, preferably before getting a property under contract, so that they have a good idea of whether they will be able to successfully complete the assignment as intended.    It is highly recommended to have your team of professionals such as realtors, contractors, appraisers, etc. in place to provide accurate feedback as you analyze the merits of your deal.  Finally, have an attorney’s fees clause in your agreements so if you have to pursue legal action to enforce the agreement or your contingency clause, you preserve the right to seek your attorney’s fees.

Of course, making sure you are covering yourself legally is just one detail for successful wholesaling.  Finding the right properties, learning to negotiate with homeowners, and developing a network of professionals to assist you during the wholesaling process are all necessary aspects for successful wholesaling, but making sure that you are covering your bases legally will help ensure that your wholesale deals proceed smoothly with minimal possibility for conflict.

How to Donate to Charity and Beat the Tax Man

June 20, 2017 Estate Planning, Real Estate, Tax Planning Comments Off on How to Donate to Charity and Beat the Tax Man

I have a close relative who works in fund-raising for a fairly large university.  While he loves receiving large charitable donations in the form of immediately available cash or other marketable assets (such as real estate and publicly-traded stock), he knows that such donations are often simply not possible or practical for the average person.  This is why a huge buzzword in the world of fund-raising for non-profits is “Planned Giving.”

What Is “Planned Giving”?

Planned Giving is the present day legal commitment by a donor to give some assets or property to a charitable organization or institution at a future date. The future date is usually the death of the donor.

There are several types of planned gifts. Some people make outright gifts of assets such as appreciated securities or real estate.  Some planned gifts are payable upon the donor’s death such as a life insurance policy where the beneficiary is a charitable organization.  Still other planned gifts provide a financial benefit, as well as a tax deduction, for the donor.  Examples of this are: 1) Charitable Remainder Trusts, which provide an income stream for the donor, and at the death of the donor, the charity receives what is left in the trust; and 2) Charitable Lead Trusts, which essentially do the opposite and produce a stream of income for a charity, and the donor’s heirs receive what remains in the trust when the donor passes away.

What Is a Charitable Remainder Trust (“CRT”)?

A CRT is a tax-exempt irrevocable trust designed to reduce the taxable income of individuals by first dispersing income to the beneficiaries of the trust for a specified period of time and then donating the remainder of the trust to a designated charity. If you have a highly appreciated asset (e.g. real estate), the CRT will avoid capital gains taxes that would otherwise be due if you or your company sold the asset.

Who Should Be Thinking About a CRT?

People who:

  • Have a highly appreciated marketable asset (usually real estate or stock);
  • Want to save on taxes (i.e. they don’t want to take the capital gains tax hit);
  • Want an income stream over the rest of their life or over a certain number of years;
  • Want to make a donation to charity; and
  • Want to totally or partially disinherit their children. This isn’t the case if you structure it correctly!

How Does a CRT Work?

The diagram below goes through the steps involved in a CRT.  However, in a nutshell:

1)   A tax-exempt trust is created with the help of a professional.

2)   The donor places the asset in the CRT.  Are taxes due here?  No – and the donor gets a charitable deduction for making the donation that he/she can carry forward for up to five years!

3)   The property is sold to a third party and the proceeds are deposited into a CRT-owned account.  Are taxes due here?  Not if the property is owned free and clear!  These proceeds are then invested, and no taxes are owned when those investments appreciate in value!

4)   Payments in a set amount or set percentage are made from the CRT account to the donor on a regular basis (quarterly, annually, etc.).  Payments are either made for the life of the grantor or for a term of years.  Are taxes due on this income?  Yes, but the charitable deduction gained when the donation is made can be used to offset at least some of this income!

5)   The donor can use some of the income from the trust to buy a life insurance policy in order to make sure their heirs aren’t left out in the cold.  Do beneficiaries owe tax when they receive life insurance proceeds?  No!

6)   In some cases, the life insurance proceeds may be in the multiple millions of dollars, and could cause an estate tax problem for the heirs.  This issue can be taken care of by the proper use of an Irrevocable Life Insurance Trust (“ILIT”) – which is another subject for another day.

7)   At the death of the donor, or at the end of the term of years, whatever remains in the CRT is donated to the charity.  Does anyone owe taxes here?  No!

 

 

Who Are the Winners and Losers in a Properly-Structured CRT?

1)   The Donor – Winner!  Because he or she gets to avoid the capital gains hit on selling a highly appreciated asset, gets a tax advantaged stream of income, and gets to make a charitable donation that gives them warm fuzzies – and may end up helping to get their name on a building at their favorite university!

2)   The Charity – Winner!  The charity gets an irrevocable promise from the donor to donate assets at some point in the future.  With good investment of the funds in the CRT, the final donation to the CRT can end up being significant.

3)   The Donor’s Heirs – Winners!  Instead of inheriting a piece of appreciated real estate that they need to market and sell, they get tax-free life insurance proceeds, and will avoid possible estate tax issues if an ILIT is used.

4)   The IRS – Loser (for once)!  When properly structured, the only taxes paid in all of these transactions are those owed by the donor when they receive payments from the trust.  However, the charitable deduction will offset at least some of this income.

Now, there are plenty of details to sort through, but please give me a call if you’d like to discuss the CRT further and find out if it is something that might make sense for you.

6 Tax and Legal Tips When Investing in Real Estate

June 6, 2017 Real Estate Comments Off on 6 Tax and Legal Tips When Investing in Real Estate


Sir Francis Bacon put it best when he said, “knowledge is power”.  Not only does he have a great last name but he gives good advice that applies to all facets of life including investing in real estate.  Whether you are new to real estate investing, or a seasoned investor, before you rush off to make your first/next real estate investment, consider the following tips all of which are to help you be strategic about investing in real estate the right way for your situation, i.e. knowledge is power.  With that in mind, here are six tax and legal tips / questions to ask yourself when investing in real estate:

  1. Will you invest directly in real estate by yourself / with a small number of business partners OR invest indirectly alongside many other investors in a company that invests in real estate? For example, let’s say you invest $200,000 for 5% ownership of a company that will take your funds and, along with the funds of other investors, probably in the millions of dollars, invest in real estate. In this situation, you typically have very little control or decision-making authority, such that you are basically “parking” your money and somebody else will make decisions regarding the real estate investment such as what to acquire, how to manage it, when to sell, etc.    There is nothing wrong with this type of investment, you may actually desire that, but you want to understand this going into the investment and not have false expectations. You should consult with an attorney before signing documents to invest in real estate through a company, particularly one in which you are a minority owner.  Contrast that with a situation in which you invest $200,000 along with a friend or business partner to buy an investment property.  In this situation, you have a lot more control over the real estate investment, but that comes with more responsibility and potentially more liability.  Again, you should consult with an attorney to make sure you are setup properly from a tax and liability perspective and also to make certain you have the appropriate documentation between any business partners you may have in addition to the proper documentation to make your real estate investment.  Neither option is better than the other one – they are just different so before making your investment, you should consider which scenario makes more sense for you / which situation you are dealing with.
  1. Does your real estate investment require financing? There are many benefits that come with investing in real estate with financing/loans, such as minimizing the amount of out-of-pocket cash you have to provide.  However, anytime you have a loan, that means you have a lender, and if you have a lender, that means you have to play by their rules.  Sometimes having a lender is like dealing with a big gorilla on your back.  They have a legitimate interest in the property and want to make sure their interests are properly protected.  So by financing a property, you tend to lose a bit of control.  You should have an attorney review any loan documents so you understand the rules of the game with that particular lender as it will affect your deal.   Without involving a lender in your deal, you get a bit more flexibility and control of the deal but of course this assumes you have all of the cash necessary to complete the investment.  Further, if you own properties outright i.e. no financing, that typically means there is a sizeable amount of equity which may require some additional consideration and structuring in terms of asset protection.  Again, neither option is better than the other one – they are just different which is why before making your investment, you should consider which scenario makes more sense for you.
  1. Are you going to invest in real estate inside your retirement account OR outside your retirement account? For the average person, they probably have no idea they have the option to invest in real estate inside their retirement account. But for most of our clients, it is a large part of how they invest in real estate.  In fact, many of them invest in real estate inside AND outside their retirement account.  Knowing the difference between the two and the impact it has is crucial.  If you invest in real estate inside your retirement account, the income is typically either tax-deferred or tax-free.  This is probably the biggest benefit to investing in real estate inside your retirement account.  However, there are a few more restrictions when investing in real estate INSIDE your retirement account versus outside your retirement account.  For example, inside your retirement account, you need to be aware of matters such as “disqualified persons”, “prohibited transactions”, “unrelated business income tax”, and “unrelated debt financed income tax”.  Such matters don’t exist when you invest in real estate OUTSIDE your retirement account.  Long story short, there is a ton of upside to investing in real estate inside your retirement account, but you should counsel with an attorney before doing so.  Yet again, neither option is better than the other one – they are just different so before making your investment, you should consider which scenario makes more sense for you.
  1. Is your real estate investment a long-term deal OR a short-term deal? This is especially important if you are simply one investor in a company that invests in real estate alongside a number of other investors because if the investment is long-term real estate, such as owning a commercial property, an apartment building, or even a single-family residence, your capital is typically “locked up” for a longer period of time as opposed to a short-term real estate deal such as a 12 month development project for immediate re-sell. Either way, you may be taxed on the income differently with a short-term deal than with a long-term deal, which is why it is important to understand before making your investment how you will be taxed on your income from your real estate investment.  Again, neither option is better than the other one but you should consider which scenario makes more sense for you.
  1. Understand the different ways to acquire investment properties. Besides cash deals and traditional financing deals, there are other ways to acquire investment real estate, such as seller financing, or “subject to” deals.  There are pros and cons to some of these less conventional forms of acquiring real estate.  One of the biggest benefits is, like traditional financing, it requires relatively little out of pocket cash.  However, when acquiring a property via seller financing or subject to existing financing, you should consult with an attorney to make certain the purchase contract properly reflects this type of financing.
  1. Understand the various ways to sell your real estate investment (Exit Strategy). The more you consider your exit strategy before making your investment, the better situation you will be in.  This is similar to #5 above, you might decide to sell via seller financing, or an installment sale, or a 1031 exchange.  These are some of the strategies you might consider to defer the capital gain income tax that would otherwise be due when you sell your real estate investment.

In sum, just because you have a friend or a relative who invested in real estate a certain way does not mean you should invest in the same manner.  For example, there is a big difference between someone who invests outside their retirement account as an investor in a company alongside a number of other investors in a short-term real estate deal versus someone who is invests inside their retirement account in a two-man partnership on a long-term real estate deal that is financed/has a loan.  These are two situations that will have different outcomes from a decision-making perspective during the life of the investment, the liability exposure, and the tax consequences.  So before you rush off to invest in real estate, please contact our office.  We can properly advise you and also make certain you have the right paperwork, contracts, entities, etc., for your particular real estate investment(s).

Feds Make Change to Help Entrepreneurs Raise More Money

May 9, 2017 Business planning, Real Estate, Small Business Comments Off on Feds Make Change to Help Entrepreneurs Raise More Money

Your federal government has modified rules making it easier to raise more money from so-called “unaccredited investors”. Under the updated rule, known as Rule 504, you can raise up to $5 million from unaccredited investors in a 12-month period. Prior to the 2017 update, you could only raise $1 million from unaccredited investors. The updated $5 million cap is available under Rule 504 offerings and should only be used when the offering is a private placement memorandum offering (“PPM”), where you aren’t marketing the offering to the general public but privately to know persons and contacts. The new $5 million cap will make it easier to raise larger amounts of money from unaccredited persons and we expect to see an increase in persons using Rule 504 to raise money for operating businesses and real estate investments.

Background to Securities Offering Exemptions

At some point in its lifespan, just about every business needs an infusion of capital, whether to buy equipment or inventory, hire more employees, make additional investments or something else.  Obtaining that capital can be accomplished in several ways – maxing out credit cards, getting a business line of credit, tracking down private money loans, bringing on partners who invest money but also participate in the decision-making process of the business, or maybe even having a bake sale!

However, sometimes it makes sense to raise cash by bringing on investors – silent partners who have funds to contribute, but who would rather not (and maybe who you would rather not) participate in the business.  These are the type of folks who want to invest their money, step away, and then have you make the hard decisions and put in the blood, sweat and tears to produce a return on their investment.  When you bring on an investor of this type, whether you know it or not, you have sold that investor a “security” and you are now under the purview of the Securities and Exchange Commission (the “SEC”) – perhaps the only federal agency with a less developed sense of humor than the IRS.

Created by FDR and Congress while the country was in the throes of the Great Depression in 1934, the SEC exists to make sure the excesses and outright frauds that created the 1929 Stock Market Crash do not repeat themselves.  The intervening decades have seen the number and complexity of SEC regulations wax and wane, but in 2017 we are left with a multi-layered, multi-faceted system that those seeking to raise capital should not attempt to navigate without expert guidance.

Regulation D and the 2017 Federal Securities Exemption Options

One of the most popular tools for small businesses looking to raise money is something called “Regulation D.”  In a nutshell, under Regulation D, the SEC allows businesses to raise capital through the sale of securities without requiring those businesses to register said securities with the Commission (an extremely expensive and time-consuming process).  For the past 35 years or so, there have been three separate and distinct sets of hoops to jump through to comply with Regulation D, called Rule 504, Rule 505 and Rule 506.

Rule 506 has been the most popular of the three.  For all intents and purposes, Rule 506 only allows businesses to offer and sell securities to “Accredited Investors” – people with a net worth over $1 million, or whose annual income exceeds $200,000 (individually) or $300,000 (jointly with a spouse).  In exchange for only dealing with Accredited Investors, issuers of Rule 506 offerings get to raise an unlimited amount of money from an unlimited amount of investors over an unlimited amount of time.  In some situations, they may also be eligible to solicit their offerings to the general public (think email blasts and radio and TV ads).  Rule 506 offerings are also simple at the state level – where only the same short document filed with the SEC (the “Form D”) has to be filed (and a fee paid) in each state where Rule 506 securities are sold.

2017 Update

The recent SEC change that will help entrepreneurs raise money comes in Rule 504 of Regulation D.  The nice part about Rule 504 has always been that it allows the company raising the funds to accept money from both accredited and non-accredited investors – a huge advantage if you don’t have contact info for a bunch of super-rich folks in your phone.

The main problem with Rule 504 has always been that you can’t raise more than $1 million in any 12-month period, and $1 million doesn’t go quite as far today as it did in 1988 (which is when the $1 million cap was instituted).  Well, apparently late last year the powers that be at the SEC woke up one morning and realized that 1988 was almost 30 years ago, so they decided to increase the cap from $1 million to $5 million in any 12 month period.  This increase became effective January 20, 2017.  The increase is a potentially significant change, so let’s recap the parameters of the new Rule 504 Offering:

1)   You may offer up to $5 million in securities in any 12 month period.

2)   You may offer securities to an unlimited number of both accredited and non-accredited investors.

3)   Unless you jump through some pretty onerous hoops, you may not “generally solicit” your offering.  You will still need to rely on “word of mouth” marketing.

4)   You can’t play in the Rule 504 sandbox if you have run afoul of the SEC previously and have been branded a “Bad Actor” under their rules.

5)   You still have to comply with state-by-state “Blue Sky” laws.  This can be tricky.  Unlike with a Rule 506 offering, state law compliance is not always as simple as filing the SEC Form D and paying a fee.  In some blessed states (let’s give a shout out to Colorado and South Dakota) the process is exactly the same as a Rule 506 offering.  In others (I’m looking at you California and Texas) the rules are restrictive and complex, and you will be very limited on the number of folks you can accept money from (or even solicit) without “qualifying” the offering in that state.

The bottom line is that if you want to bring on investors and raise up to $5 million in capital, but you are worried about only being able to take money from “accredited investors” then the Rule 504 Offering absolutely needs to be on your radar.  It’s going to take a bit of heavy lifting on the state compliance side of the coin, but depending on the states involved, it could be a very attractive option.  Please speak with an experienced securities attorney to see if a Rule 504 Offering could make sense in your specific situation.

What Do I Need to Know About Title Insurance

April 4, 2017 Real Estate Comments Off on What Do I Need to Know About Title Insurance

We all know that title insurance is a necessity when purchasing real estate, but many do not have a sufficient understanding of what title insurance is really for and steps we can take to deal with title insurance companies to prevent being embroiled in a title dispute. Litigating title disputes can often be long, expensive, and often difficult to predict the outcome with any certainty. For that reason, having a solid grasp of what title insurance can do and cannot do is important for any would be purchaser of real estate.

The condition of title is one of the most important due diligence items for a buyer of real estate.   Purchasers usually want title to real estate to be clean, or as lawyers describe it to be “marketable.” Marketable title does not mean title that is completely free from any liens or claims, but merely title that is sufficiently free from doubt that an informed and reasonable buyer would accept it. For example, some legal descriptions for properties will exclude mineral rights, or contain easements for sewer, gas, or other utility lines. Technically, these are claims or “encumbrances” against title, but most would not consider these types of claims to be a sufficient “cloud” on title to render it unmarketable since those types of claims typically do not affect a buyer’s right to enjoy the property.

WHAT IT A PRELIMINARY TITLE REPORT?

Title insurance does not remove defects nor does it guarantee marketable title, but merely provides a means of recovery if title does prove unmarketable for a reason that is covered under the policy. In a typical real estate transaction, one of the initial first steps in escrow is that the title insurer will issue a “Preliminary Title Report” (“Prelim”). This is a crucial document for buyers to understand as part of their overall due diligence.   Contrary to popular belief, a Prelim is not a guarantee of the condition of title and title companies are generally not liable for errors appearing on the Prelim. I’ve seen cases where title insurance companies made mistakes on the Prelim, but unfortunately there was no recourse against the title insurance company because the Prelim is merely an offer, not a binding representation of title.  Therefore, although Prelim is a good starting point for conducting due diligence on the condition of title, but depending on the property, additional due diligence may be needed above and beyond what appears on the Prelim. Additionally, following a Prelim the Title Company issues a commitment for title and issues their title policy off of this commitment. It is the terms of the actual policy that comes from the Title Commitment that you need to be most certain about as the Prelim is not binding on the insurance company.

UNDERSTAND THE EXCEPTIONS TO YOUR POLICY

The most important part of reading the Prelim and the Commitment that follows is understanding the exceptions. The Commitment will list the exceptions which are items that would not be covered under the policy. Exceptions may be specifically listed, such as existing mortgages, unpaid taxes, federal tax liens, recorded easements, etc.   There are also general exceptions that are typically listed as an Exhibit to the Prelim or Commitment as a “Schedule B” Exception. These exceptions are usually described very generally and in legalese (i.e. most purchasers don’t pay attention to it). However, it is important for the purchaser to have a general understanding of these general exclusions so that if there is a potential issue on the property that is possibly excluded under these general exceptions, the purchaser can consult with the right professionals (lawyers, inspectors, surveyors, etc.) to determine what are the risks, and what steps can be taken to fix the defect (or else re- negotiate the price or cancel the deal).

For example, boundary disputes and encroachments from neighbors are typically not covered under a title policy. If the physical inspection of the property shows some doubts as to the boundary lines (e.g. no walls or physical marker showing the boundary lines or trees along the property line that create doubt as to whose side of the property it is on), then further due diligence, hiring professionals, or conducting a survey would be recommended. Even though standard policies may not cover certain risks, additional coverage might be available to cover these types of claims for an additional fee if you inquire.

Furthermore, standard title policies typically cover only matters in the public record (recorded liens, easements, judgments, etc.) and do not cover issues not shown in the public records.

As such, the Prelim and Commitment should not be the sole resource for determining whether there are issues with title, but if there are any doubts, these should be independently researched, or any doubt should be addressed directly with the seller and/or title rep.   For example, if the seller has been sued, or owes taxes to the IRS, these issues may not appear on the Prelim or Commitment if nothing has yet been recorded, but those issues could definitely affect your interest in the property, and so consider confirming with your seller that they are not aware of any unrecorded interests that could affect title or conduct your own independent due diligence. In addition, Prelims and Commitments may disclose the existence of a lien, but fails to provide specific information about its details, and in those cases, actual copies of the lien documents should be obtained from title or the seller.

GETTING A SPECIAL ENDORSEMENT

Any questions regarding the condition of title should be discussed with the title officer and/or attorney so that further investigation can be done to determine what can be done with respect to any title issues that arise during escrow. Sometimes a title insurer may be willing to issue a “special endorsement” to cover a particular title issue that would not otherwise be covered under the policy, but it is incumbent on the buyer as part of his/her due diligence to inquire about these issues, and of course, preferably during the due diligence period while the buyer still has the right to negotiate or cancel the deal. These types of inquiries should be made in writing so there is a record documenting the discussion.   I have experienced situations where a title insurer initially denies coverage for a claim stating that they were not aware of the issue, but then had to reverse course when presented with written evidence that the issue was discussed with the title company during escrow.

Finally, as with any insurance company, it is important to make sure you are working with a reputable company that will be there for the long haul. Getting a policy on the cheap from an unknown company will be useless if that company goes out of business. Choice of title companies are negotiable, although if the seller is paying for title insurance, they will usually insist on their own title company. Make sure that company is legitimate and has an established history and track record.

Fortunately, most homeowners will never need to make a claim on their title insurance. However, anyone who has experience litigating these types of disputes knows that the outcome is frequently hard to predict, and is often determined by which party has the most resources. If a claim ever arises requiring litigation, you’ll want to have the resources of an insurance company defending your interests, and in order to maximize that possibility, it is important to perform your due diligence on the property, on the title insurance company, and the details of the policy they propose to issue for your property.

Real Estate Investor Escapes Criminal Charges: Legal Factors When Raising Money from Others with Promissory Notes

February 28, 2017 Business planning, Real Estate Comments Off on Real Estate Investor Escapes Criminal Charges: Legal Factors When Raising Money from Others with Promissory Notes

Thousands of real estate deals/projects involve the use of promissory notes as a way to raise money to fund the project.  If you are raising capital for a real estate project using promissory notes and you assume incorrectly that securities laws do not apply to your deal/project, you could be fined or possibly end up in an orange jump-suit.

In a recent California case called People v. Black, the California Court of Appeals was asked to whether a promissory note in the real estate deal (an investment in land in Idaho) was a security.  Needless to say the project/deal did not go as planned.  Once the lender felt that he was getting the “run-around” from the borrower, he hired a private investigator which eventually led to a criminal investigation of the borrower.  Please note that this was a criminal case, which is important to mention because it highlights the fact that certain actions when raising capital can result in criminal charges, i.e., fraud, etc.  Also, although this case is from California, it is instructive for many real estate venturers and investors even outside of California because the court used many securities law cases from the United States Supreme Court to reach its conclusion.

The court in Black concluded that the promissory note at issue was not a security.  It used the “Howey Test”, to reach its conclusion, which derived from the famous securities case, SEC v. Howey Co., 328 U.S. 293 (1948).  The Howey Test is this:  If the funds were invested with the promoter/manager with the expectation of receiving a profit from a business enterprise, which profit wholly depends on the managerial efforts of the promoter/manager, then the promoter/manager has issued a security.   The analysis of WHY the court reached this conclusion with respect to promissory notes and securities law is very instructive.  Here are the “take-aways” from the case:

  1. Avoid Profits Sharing in Notes, Split of Profits v. Straight Interest / Promise to Pay. The promissory note in the Black case stated that the amount of interest paid to the lender would be either a percentage of profits from the sale of the underlying real estate, or two lots from the property if it is held for development.  There was also a provision that whether the property is sold or developed, the principal amount plus 10% interest would be due one year from the date of the note.  This last provision was a very important fact that the court seemed to place a lot of emphasis.  However, it also conceded that “the promise of a fixed return does not in itself remove the transaction from securities laws” because as the United States Supreme Court stated in a case called Edwards, (SEC v. Edwards, 540 U.S. 389 (2004)), “unscrupulous marketers of investments could evade securities laws by picking a rate of return to promise.” In other words, the court in Black was careful to not “hang its hat” on just this one factor.
  1. Give Investor Control or Protections, Control of the Investment / Split of Profits. If the note is a profit-sharing note where the borrower has total control of the investment and there are not protections to the lender, the investment will look more like a security.  The court relied on a United States Supreme Court case called Marine Bank, involving a profit-sharing arrangement involving loans between the parties.  The U.S. Supreme Court held that the loan in that case was not a security because the lender in that case has a measure of control over borrower regarding the investment/project despite the fact that the borrower’s obligation to repay was based in part on the success of the venture/project.
  1. Avoid Bringing in Multiple Parties Without Proper Legal Documents, Negotiated One-on-one v. Offered as a Uniform Instrument to the Masses. The lender and borrower in this case knew each other for six years.  They had appeared to individually negotiate this promissory note with each other as opposed to the lender simply taking the same promissory note and offering it to multiple investors especially in a public manner through public advertising.  The court also used the Marine Bank case mentioned above in this context.  As opposed to many deals/projects that involve promissory notes that are issued to many investors, another reason the U.S. Supreme Court held in the Marine Bank  case that the profit-sharing loan arrangement was not a security was because of the one-on-one nature of the investment.  The court in Black was careful to state that this is not the only factor but is simply one of a number of factors.
  1. Give Security for the Loan, Is the Promissory Note Adequately Secured. The lender in this case had secured the promissory note with his separate / personal property.  This was a factor in the court’s conclusion but it is important to note that the security must be adequate.  The court was careful to make this point and it did so by mentioning a case called Shock, (People v. Schock, 152 Cal.App.3d. 379 (1984)), in which the California court of appeals found that the public sale of fractional interests in secured promissory notes were securities, in part, because of the inadequacy of the collateral together with the investors’ dependency on the promoter’s success for a return on the investment subjected the superficial loan transaction to security regulation.   Similarly, In a California case called Miller, (People v. Miller, 192 Cal.App.3d. 1505 (1987)), the promoter issued notes to multiple investors in connection with a luxury home purchase “scheme”.  The court determined the notes and trust deeds were securities because the loans, i.e., the funds obtained by Miller were so far in excess of the value of the secured interest that no resale or foreclosure could recoup more than a few cents on the dollar to the individual lenders.  Also, it should be noted that investors were solicited from the general public and had no control over the success of the venture.  Likewise, in a 9th Circuit case called Wallenbrock, (SEC v. Wallenbrock, 313 F.3d 532, 9th 2002), the court found that promissory notes sold to the public which were secured by the accounts receivable of Malaysian latex glove manufacturers were securities.  The court determined that if the receivables existed at all, the investors had no way of reaching the assets. If you are planning to invest and your investment is secured by the receivables of Malaysian latex glove manufacturers, it’s probably not a good investment.  Nothing against the Malaysian latex glove industry, I’m just saying.

In summary, some promissory notes are securities and some are not.  Each deal/project must be analyzed by looking at the substance rather than just its form. The details matter as does careful legal planning. In this case, the promissory note (a) was an actual promise to repay regardless of the success of the underlying venture/project, (b) was adequately secured, and (c) was negotiated one-on-one i.e., individualized versus a uniform document to be used by the mass investors.  These facts were persuasive enough for the court to conclude the promissory note in this case was not a security.  If you’re using promissory notes to raise money in real estate deals, please carefully consider the points in this article and call our office to discuss your situation.

Just “Having” an S-Corp May Not be Enough

February 21, 2017 Business planning, Law, Real Estate, Tax Planning Comments Off on Just “Having” an S-Corp May Not be Enough

Just “having” an S-Corporation may not be enough. It’s important you make sure to reap the tax and legal benefits of your S-Corp if you’re going to set one up.

If you routinely read articles in this space or have heard any of our attorneys speak around the country, you are probably aware that we are big fans of the S-Corporation structure as a way for folks who own and operate small operational businesses (i.e. ones where they are selling goods or services and are not someone else’s W-2 employee) to get some limited liability protection and (probably more importantly) to save on self-employment taxes.

When self-employed folks don’t incorporate and instead operate as a sole proprietorship, their entire net profit from the business is subject to self-employment taxes. If you don’t do anything about them, self-employment taxes will eat up about 15.3% of your income – before we even talk about income taxes. So, on a net profit of $100,000, a self-employed person will pay about $15,300 in self-employment taxes

If instead, a self-employed person operates as an S-Corporation, they can do a “salary/dividend split” on the net income from the business. In a salary/dividend split, the business owner will pay himself a “reasonable” salary from the S-Corporation’s profits. A general rule of thumb is that roughly 1/3 of the company’s net profit is considered a reasonable salary. Self-employment taxes are paid on the amount of the salary, and the rest of the income flows through to the business owner as a type of “dividend” from the S-Corporation. That dividend is not subject to self-employment taxes.

So, if a small business owner has the same $100,000 of net profit and operates as an S-Corporation, he will pay himself a “reasonable” salary of about $33,000 and pay self-employment taxes of about $5,000 (instead of $15,300). The remaining $67,000 flows through to the owner free of self-employment taxes. We love the S-Corporation structure for self-employed doctors, dentists, engineers, realtors, commissioned salespeople, certain types of real estate investors, and others whose income would otherwise be subject to the 15.3% tax.

Right now, you’re probably either thinking: “Yep, Jarom, you’re preaching to the choir. I already have my s-corp and I’m saving a bunch on my self-employment taxes!” OR “Man, I need to look into an s-corp right away!” Either way, please keep reading because establishing an s-corp and doing the correct tax filings is only part of the equation.

The recent U.S. Tax Court Case of Fleischer v. Commissioner (2016 T.C. Memo. 238, filed 12/29/16) demonstrates that just having an S-Corporation may not be enough to save on self-employment taxes. Mr. Fleischer is a financial consultant who signed on as an independent contractor representative for a couple different brokerage houses. He also established an S-Corporation, and funneled his income through that entity to save on self-employment taxes in roughly the same way I described above.

So, why was Mr. Fleischer in Tax Court? Well, the IRS sent him something called a Notice of Deficiency. The Notice basically said that his use of the S-Corporation to save on self-employment taxes was invalid, and that he owed roughly $42,000 in back taxes, plus penalties and interest. Mr. Fleischer disputed the Notice, and the case went before a Tax Court judge.

The IRS argued that the Notice they sent was proper because the income at issue belonged to Mr. Fleischer, personally, and not to his S-Corporation. In support of this argument, the IRS presented evidence (which was unrefuted by Mr. Fleischer) showing: 1) Mr. Fleischer signed both independent contractor representative agreements in his personal capacity, not on behalf of his S-Corporation; and 2) Payment for Mr. Fleischer’s work went to Mr. Fleischer personally, not to his S-Corporation’s bank account.

Mr. Fleischer’s primary argument in response was that he had to sign the agreements and receive payment in his own name because he, not his S-Corporation, is licensed and registered as a financial advisor, and it would cost him millions of dollars to get the same required licenses for his company.

The Tax Court wasn’t impressed with Mr. Fleischer’s arguments, and ruled that he was indeed on the hook for all the taxes, penalties and interest the IRS asked for in the Notice. While the Tax Court’s decision in Fleischer isn’t necessarily binding on other cases, it is instructive for those hoping to use the S-Corporation to save on self-employment taxes – and have that use stand up under IRS scrutiny. Namely, it drives home two important points:

1)   To the extent possible, all of your S-Corporation’s contracts – especially those where it will be receiving income – should be in the name of your S-Corporation. This is crucial. One of the huge factors the IRS looks at when determining whether income belongs to a corporation is the existence “between the corporation and the person or entity using the services [of] a contract or other similar indicium recognizing the corporation’s controlling position.” A contract between your S-Corporation and the person or entity paying it will satisfy this factor. Besides, entering into contracts in the name of the S-Corporation also helps from a limited liability standpoint if the other party wants to sue for breach of that contract.

2)   Again, to the extent possible, all payments for goods or services provided should be made to the S-Corporation directly. Such direct payments may serve as “other similar indicium recognizing the corporation’s controlling position.” At the very least, these direct payments will save you from being in a position where you have to explain to the IRS why income being reported through you S-Corporation went first to you personally.

The S-Corporation is a wonderful and legitimate tool to save on taxes. Please just take the time to make sure you are using and operating it correctly. Doing so will save you time, money and headaches if you are ever audited by the IRS (or sued in your business).

Who’s Liable- The Landlord or the Tenant?

February 14, 2017 Asset Protection, Business planning, Litigation, Real Estate, Small Business Comments Off on Who’s Liable- The Landlord or the Tenant?

We have many clients that own residential rental and commercial properties and lawsuits involving landlords continue to happen throughout the country, and will continue so long as someone is willing to ‘rent a room’ and someone is likely not to pay or damage something.

However, the question then becomes…who’s liable when something goes wrong.  As you can imagine a lot of finger pointing takes place and it can oftentimes be difficult to see who is in the right.

Thus, history has taught one of the most important lessons of all- “learn from the past”.  As such, I have compiled a brief snapshot of a few recent court cases throughout the country that have dealt with landlord liability.  Hopefully learning from one of these difficult situations will help you avoid the some of the same mistakes.

In a case called Lipp v. Ginger C., LLC (W.D. Mo., 2016), the tenant threw a party. Surprise…Surprise!!! And as you would expect, one of the guests, who had been drinking at the party, went onto a second floor deck to urinate. While on the deck, the wooden balcony broke, causing the guest to fall 18 feet onto the driveway. He then died a few days later. The landlord knew that the balcony had been temporarily repaired by a prior owner, but the landlord had not permanently repaired the balcony as of the date of the party. The family of the deceased guest sued the landlord.

In a case called Ortega v. Murrah (Tex. App., 2016), the tenant broke her leg after slipping on water that had leaked from a broken pipe under the rental property’s kitchen sink. The tenant sued the landlord for personal injuries.

In a case called Moore v. Parham (Ariz. App. 2016), the landlord owned a residential property in Lake Havasu that he leased to a tenant. A satellite dish installer came to the property to install a satellite dish for the tenant. The installer was injured when he attempted to access the roof by climbing on a shade structure attached to the house. The installer sued the landlord for personal injuries.

Lastly, in a case out of California last year called Ramos v. Breeze, 2016, the tenant tripped and fell in the parking lot of the apartment complex in which she was living.   The tenant sued the landlord for personal injuries.  The landlord was held substantially liable for the injuries.

These are just a few of many recent cases involving landlord liability and a landlord being sued. Most of the cases above are still working themselves through the court system in terms of being resolved on the merits, but the point is that if you’re a landlord, you need to consider your exposure to liability and consider what steps you can take as a preventative measure, including the following:

  1. Have your landlord-tenant agreement reviewed. Whether you’re a landlord of commercial real estate, or investment residential real estate, you need to make sure you have a strong “landlord-friendly” agreement. Have you had it prepared or at least reviewed by an attorney?
  1. Review your rental property insurance policies and applicable limits. If a landlord is subject to a legitimate claim, hopefully it never ripens into a lawsuit because the claim is a covered event under the appropriate insurance policy. But make sure you know exactly what claims are covered and what claims are not covered under your insurance policy(ies) so that you know what is and what is not covered under the policy(ies). Do you know what policies you have and what events are covered and what events are not covered?
  1. Consider how you’re managing your rental(s). You want to make sure you utilize best practices and procedures for managing your rental(s), whether you can and are managing them yourself or you have someone else manage them for you.
  1. Consider how you’re vetting your tenant(s). Are you being careful to properly vet/screen your tenants? A little extra time on the front-end to make sure the tenant is properly qualified will save you a lot of time later on.
  1. Consider an entity(ies) for your rental(s). Certainly having an LLC own your rentals is not the end-all, be-all, and it won’t in of itself prevent a lawsuit. However, it can, unless abused, prevent you from personally being named in the lawsuit, and thus exposing your personal assets in the event the plaintiff obtains the judgment against you.

Even in cases in which the landlord “wins”, the time spent and the costs involved to defend the lawsuit can be enormous. An ounce of prevention is worth a pound of medicine, particularly when it comes to landlord liability. This type of liability can arise in a number of ways, including failure to comply with statutory requirements, a breach of contract, premises liability, or negligence.

Each one of these liabilities requires a state-specific analysis based on statutes and cases in the particular state in which the property is located. Please contact our office at 888-801-0010 if you would like to schedule a consult regarding these matters.

Which State’s Law Applies in a Lawsuit?

February 14, 2017 Asset Protection, Business planning, Corporations, Law, Litigation, Real Estate, Small Business Comments Off on Which State’s Law Applies in a Lawsuit?

We frequently hear from clients who have been told by others that they should incorporate in Nevada (or other states outside of their home state) in order to take advantage of their favorable laws.   We have seen many individuals persuaded into incorporating in a state outside of their home, only to complain about the cost and complexity of the structure which ultimately had to be unwound.

This is not to say that incorporating an entity in Nevada or Wyoming should never be considered as part of an asset protection strategy. One primary reason for incorporating a Nevada or Wyoming entity is arguably due to their strong “charging order” protection.   The charging order is a concept protecting an LLC owner who is sued and held liable for something unrelated to and “outside” from the LLC from then being able go and take that LLC interest or the asset held by the LLC.   For example, if you’re cruising on the highway over the weekend and get into a major accident causing serious injuries, the charging order could prevent or hinder the injured plaintiff from seizing your assets held in your LLC.

However, the myth that we often hear from clients is that because states like Wyoming or Nevada have strong asset protection laws, they should take advantage by incorporating these entities into their structure even if they don’t own assets or do business there. What is often omitted from the conversation is whether Nevada or Wyoming law will actually be applied if there is no connection between the lawsuit and Nevada or Wyoming.

Since we are a union comprised of fifty states with different laws, there is an incentive to try and take advantage of states that have more favorable laws. Courts generally discourage this type of “forum shopping” where people try to use the favorable laws of one state even if they have no actual connection with that state.

One of the ways courts deal with these types of cases is by applying a set of rules called Conflicts of Laws. It is an area of the law that allows a state to determine which laws will apply to a case when the laws of multiple states could potentially apply.

For example, lets say a California resident is driving in Nevada on his way to Vegas and collides with a Colorado resident causing catastrophic injuries. Where should this type of lawsuit be filed and which of these three state’s laws should we apply? Because these types of circumstances can be so varied depending on the residency of the parties and the location where the events resulting in a lawsuit occur, it is sometimes difficult to predict where a lawsuit should be and what state’s laws should apply. This is further complicated by the fact that states have different Conflicts of Law rules.

Here are some general rules that courts will usually apply depending on the type of case. Examples include the following:

  1. Personal Injury or Fraud: Generally the law of the state where the wrongful act causing the injury or fraud occurred will be the law that should be applied. For example, if the accident or fraudulent conduct occurred in Nevada, that is an indicator that Nevada law should be applied;
  2. Personal Property (damage or theft): Where the personal property was located when the act causing the theft or damage occurred may determine which state’s laws should apply;
  3. Real estate: The state where the real estate is located will often determine which state’s laws will apply in a dispute relating to real estate;
  4. Contracts: Where the contract was entered or where the principal events necessary to form the contract occurs. Keep in mind that many contracts have provisions governing which state’s laws or courts will be used in the event of a dispute. These types of “forum selection” or “choice of law” clauses are often enforced by courts, unless there is no substantial or reasonable relationship with the chosen state. For example, if you are in California and you enter into a contract with someone else in California and all the activities relating to the contract occur in California, it is unlikely that a California court would enforce a provision that says Delaware law should apply even if you included such a provision in your contract.

These are just some very general guidelines as courts may consider additional factors in any given case. Hence, the outcome in any particular case is often difficult to predict with any consistency.

Therefore, before you decide to set up a structure that includes incorporating in a state which you have little or no connection with, make sure you understand not only the purposes for choosing that particular state, but perhaps even more importantly, its limitations.     Don’t assume that if you incorporate your entity in Nevada, that you will necessarily get the benefit of Nevada’s laws, especially if you do not live in Nevada.

What Is a “Holding Company” and When Could It Make Sense to Have One?

February 7, 2017 Asset Protection, Business planning, Real Estate, Small Business Comments Off on What Is a “Holding Company” and When Could It Make Sense to Have One?

We have lots of clients who come to us after dealing with promoters and would-be practitioners who have recommended elaborate (and usually expensive) entity structures for their businesses. This “up-sell” approach tends to happen whether the business sells cheeseburgers or invests in buy-and-hold rental properties.

One of the structures that is almost always included in these intricate structures (especially when real estate is involved) is something called a “holding company.” Simply put, a holding company is a business entity that exists solely to own other business entities. In our practice, we see this most often in the form of a holding company LLC, which owns one or more additional LLC’s, each of which, in turn, owns a single rental property.

At first glance, this structure may seem like overkill, and in many situations it is. Owning a rental property in the name of a single properly established, maintained, and operated LLC will provide the LLC owner with limited liability for the potential debts and obligations associated with that property.

In several states (but certainly still less than half), this simple structure also does a great deal to protect the rental property from the debts and obligations of the LLC owner. In these states, if an LLC owner has some sort of judgment against him or her, the sole remedy available that judgment creditor has to get at the LLC owner’s interest in the LLC that owns the rental (and the rental itself) is something called a “Charging Order.” Let’s call these states “Charging Order States.”

The Charging Order lets the judgment creditor step into the LLC owner’s shoes if and when the LLC makes a distribution of profit – but it doesn’t let that judgment creditor do much else. For that, and several other reasons, the Charging Order is a particularly weak remedy that many judgment creditors will simply decide not to pursue (or that they may be willing to walk away from for pennies on the dollar).

So, given the protections offered by a single LLC, when can a holding company, set up in a Charging Order State, actually make sense in the context of rental real estate? Here are a few:

1)         You work in a profession that tends to get sued a lot (think doctors and engineers), and your rentals (and their associated LLC(s)) are located in a non-Charging Order State. In this situation, the holding company can be an effective barrier between the people who might sue you for malpractice and your rental property assets.

2)         Even though you don’t work in a “high risk” profession, you are a bit of an asset protection junkie, so for you, because your rentals (and their associated LLC(s)) are located in a non-Charging Order State, the additional cost and paperwork of having another entity is worth the additional protection from personal creditors. Here, the holding company may have less practical effect than in number one above, but it will serve as that same barrier if you get tied up in a lawsuit you end up losing.

3)         You are a bit of an asset protection junkie, and you like the idea having two layers of limited liability protection between the liabilities associated with your rental property and your personal assets. In this situation, if a plaintiff in a lawsuit is for some reason able to pierce the corporate veil of the entity that owns the rental and get at the owner, they will find yet another corporate entity whose veil will also have to be pierced before they can access your personal assets to satisfy a judgment.

You’ve worked hard to accumulate the assets you have, and it makes sense to take steps to protect them. Don’t be fooled by those who say “you have to” do X, Y or Z. There is no one-size-fits-all-approach. The art and science of asset protection involves one cost/benefit analysis after another. Make sure you are seeking and following the advice of a knowledgeable professional who has your best interests at heart.