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4 Reasons To Use A Limited Partnership Or LLC For Real Estate Investments

After searching the market for the perfect piece of real estate, you have found property that will satisfy your needs and give you future opportunities. It is now time to be concerned about protecting yourself from the risks involved in property ownership. One way to reduce such risks is to hold the property through a limited liability entity. By choosing the entity best suited to your specific situation, you will ensure that you have the flexibility and control that you need.

Although other limited liability entities are available, for the following reasons, the preferred entities for real estate investments are the limited liability company (LLC) and the limited partnership (LP):

1. Protect your Personal Assets from Lawsuits by Tenants, Guests & Trespassers

Limited Liability– As in any business transaction, one of your primary concerns in real estate investment should be your vulnerability. Owning property as an individual or in a general partnership creates unlimited liability. Tenants, guests, and, in some cases, trespassers may sue you for real or imagined grievances. If they prevail, they may seek to use your bank account, home, and personal possessions to satisfy the court’s judgment. By using an LLC or LP for real estate investment, you may be able to avoid personal liability for accidents that occur on the property. Liability will be limited to the extent of the LLC’s or LP’s assets. If anything goes wrong on the property, you will appreciate the protection limited liability provides.

2. Flexible Management Structure, Estate planning and Gifting Opportunities Available

Beneficial Management Structure– Depending upon your specific situation, either an LLC or an LP may provide the management structure you need. An LLC provides a flexible structure that allows members to manage the entity or to elect a manager or a group of managers. All members of an LLC are provided limited liability. Additionally, many states allow one person to form an LLC. On the other hand, LPs require at least one general partner and one limited partner. The general partner is personally liable, but that may be handled by forming a corporation or LLC to serve as general partner, thus encapsulating any liability in a protected entity. When you use an LLC or LP for real estate investment, you may also benefit from estate planning and gifting opportunities available.

3. Avoid Double Taxation

Reduced Taxation on Appreciated Property– Although the structure of a corporation may be familiar, corporations are undesirable for real estate investments. If you hold real estate in an LLC or LP and later decide to sell the property to some third party, the tax benefits of using an LLC or LP will become apparent. Unlike a C corporation, LLCs, LPs, and S corporations allow flow-through tax treatment. Profits are only taxed once, while they are taxed twice in a C corporation. Appreciation on the property will result in less tax in an LLC, or LP. (Compare C corporations and LLCs here)

4. Property Transfers are Less Expensive

In addition, an LLC or LP will provide benefits if you transfer the property to your personal use or the personal use of one of your LP partners or LLC members. Such a transfer to personal use would not result in tax consequences. Although other entities may provide limited liability, the tax consequences of using other entities make an LLC or LP preferable.

Distributing LLC Money

You’ve set up your LLC. Now it’s time to make money, and flow the profits into your bank account. It’s time to think about how you will be distributing LLC Money between bank accounts. In the example we’ll use in this article, you have transferred title in a real estate rental property (a duplex) into your new LLC, which is called XYZ, LLC. You have also, as is required to follow the corporate formalities, set up a bank account in the name of XYZ, LLC. You haven’t hired a property management company yet as you are going to try managing the property yourself.

In the first month, your two duplex tenants pay the rent on time. You are thinking to yourself: “This is good. This is how it’s supposed to work.” You deposit the rent checks, which are properly made out to XYZ, LLC, into the new XYZ, LLC bank account. You have a mortgage and trash pick-up payment to make, so you write two checks against the new LLC bank account to cover those obligations.

Glory be, after those payments, at the end of the month you have a profit! What do you do?

You could pull some of the money out, transferring it from XYZ, LLC to your personal account, knowing that you’ll have to pay taxes on a portion of it at some point. More likely, you may leave the money in XYZ, LLC and build up a reserve of cash to be able to cover any unforeseen issues. Some owners may leave the money in the LLC account until near the end of the year. After speaking with their CPA to understand how much income is sheltered by depreciation and how much tax they’ll owe they will pull enough money out of XYZ, LLC to pay their tax obligation, if any, as well as take a profits distribution for themselves at the end of the year.

Things are working well and you decide to invest in another rental property, a fourplex. You’ve heard that by putting your new fourplex into XYZ, LLC you are creating a target rich LLC. If a tenant at the duplex sues XYZ, LLC for a faulty condition they could not only reach the equity in the duplex but also in the new fourplex. They have a claim against the LLC and on an inside attack they can get what is inside XYZ, LLC, which would be both the duplex and fourplex. You don’t want to do that.

So you set up ABC, LLC to take title to the fourplex. Following what you did with XYZ, LLC you set up a new LLC bank account for ABC, LLC and deposit tenant checks made out to that LLC into the new ABC, LLC bank account.

Along the way you come to appreciate that the state in which ABC, LLC and XYZ, LLC were formed offers weak asset protection for the outside attack. The inside attack, where a tenant sues the LLC directly, offers the same protection in all states. But the outside attack where, for example, a car wreck victim has a personal claim against you and is suing from the outside to get at your assets, varies from state to state. California, New York and Utah are weak states. The car wreck victim and their attorneys can get at your valuable real estate to satisfy a claim. Wyoming, Nevada and Delaware are strong states featuring charging order protection, which is briefly described in this short video. For more detail, see my book, Loopholes of Real Estate.

LoopholesRE Sutton.Front Cover.Final .HiRes .2019
For now, we want you to focus on distributing LLC money through this new structure. As before, the new holding LLC we form in Wyoming opens its own bank account under the name Padre, LLC.
How to Properly use LLC Bank Accounts

 The profits you generate from the two title holding LLCs on the top line will, whenever you want, be distributed to the new Wyoming holding LLC. We don’t want to directly distribute to your personal bank account moneys from XYZ, LLC and ABC, LLC because you don’t personally own them anymore. Instead, you own Padre, LLC, which in turn owns XYZ, LLC and ABC, LLC. So the money flows from XYZ, LLC and ABC, LLC to Padre, LLC. Whenever you want to take a distribution you will take it from Padre, LLC, which is the entity you directly own. XYZ, LLC and ABC, LLC are technically owned by Padre, LLC and not you. But that is good, because it provides excellent asset protection when a strong state is used. As well, Padre, LLC is a good place to hold money because it is asset protected in Wyoming. If you hold the money in your personal bank account you are not as protected.

Some people will complain that in the structure example above, a total of three bank accounts is not needed. Two points are critical here. First, it is useful to know that with online banking and fairly low minimum balance requirements the use of three separate accounts is neither burdensome nor expensive. Second, and more importantly, by not using separate bank accounts you run the risk of a creditor seeking to pierce the veil of your entity. You must not commingle money between personal and separate business accounts. There must be a clear line of money flows from duplex tenants into XYZ, LLC, from that entity into Padre, LLC and from the Wyoming holding LLC into your personal bank account. You cannot skip a step and risk being held personally liable for a claim.

Again, distributing LLC money correctly is not going to be a burden. And even if it was it is required for you to maintain your asset protection edge, so just do it. Work with your CPA on the timing of distributions and payment of taxes and all will be fine.

Besides, it’s how everyone else does it anyway.

New Laws Upend Property and Privacy Rights

  • You can’t do a criminal background check on a tenant!
  • You must rent out your property or pay a fine!
  • You must report all of your company’s beneficial owners!

Do these exclamations ring of an authoritarian bureaucracy? That bell is ringing louder in the last year as local, state and federal agencies have approved new restrictions on property and privacy rights.

In California, the Oakland City Council outlawed criminal background checks on prospective tenants. The stated purpose is to allow the formerly incarcerated to compete for housing and avoid homelessness.

Any housing provider and any person aiding a housing provider (i.e. a management company) face stiff penalties for doing a criminal check. Liability can be three times the greater of a) one month’s rent or b) actual damages, including damages for mental or emotional distress. A court may award punitive damages and attorney’s fees. Criminal penalties may also be asserted. Tenant’s rights attorneys could make hay with this ordinance.

If you own a rental property in Oakland you most certainly want it titled in the name of an LLC, shielding yourself from personal liability. And rather than screening tenants personally (for which the high penalties again apply) you will want to use an independent management company for that task. If there is an accidental criminal background check on a prospective Oakland tenant, the management company will suffer the consequences, not you.

But while the new law allows criminal offenders to rent in Oakland, it doesn’t change a duty that is required across the Country. Landlords have a duty to protect the neighborhood of the rental property from the criminal acts of their tenants. Landlords are routinely held responsible for their tenants dealing drugs on the property. Other tenants, or anyone in the neighborhood, can sue the landlord for the rental property being a public nuisance that threatens public safety.

So in Oakland you have to rent to criminals but you are still responsible if they engage in crime. If one of your investing guidelines is to avoid nonsensical Catch-22s, you may want to sell your Oakland properties and never invest there again. Please note that several other cities in the San Francisco Bay Area are also considering legislation to ban criminal background checks. Accordingly, you may need to reinvest farther away.

Across the Bay, San Francisco voters just approved two measures affecting real estate rights. The first one aims to deal with the “blight” of empty storefronts. The owners of retail spaces remaining vacant for six months or more will now pay a tax of $250 per foot of linear frontage. The tax can rise to $1,000 a foot in later years. New York City is considering a similar tax.

Supporters claim landlords don’t care about local neighborhoods and only want more rent. (Of course, leaving a storefront vacant for years does not really constitute more rent). Opponents argue the measure ignores current realities. San Francisco’s permitting process for tenant improvements and alterations, as well as new business approvals, is notoriously byzantine and can take a year or more to complete. Bank financing requirements for expensive neighborhood retail spaces feature covenants calling for only the most credit worthy tenants, limiting the pool of prospective users. And, the rise of e-commerce has certainly not benefitted anyone in the brick and mortar space. The unintended consequences of this ordinance will be interesting to watch from a distance.

San Francisco voters also passed a measure tying office development permits to affordable housing goals. The city builds an average of 712 affordable housing units per year. The new law asserts that 2,042 units must be built every year and if not the annual 875,000 square feet allocated for office uses must be reduced accordingly. So if 1,024 affordable housing units are built (which never happens) then using the same 50% figure only 437,500 square feet of office space can be approved.

San Francisco’s chief economist wrote:

“By tying future office development to an affordable housing target that the city has never met, the…measure is likely to lead to high office rents, reduced tax revenue, reduced incomes and reduced employment across the city’s economy.”

But that didn’t stop San Francisco’s voters. It is indubitable that Adam Smith is not taught in their schools. The invisible hand, as put forth by Adam Smith’s “The Wealth of Nations” in 1776, describes the unintended social benefits of an individual’s self-interested actions. If the market needs affordable housing and the government gets out of the way, affordable housing will be built. But government in San Francisco and in California are in the way. Some find it very easy to dismiss the ancient teachings of Adam Smith, but in doing so they never fully and critically examine why affordable housing is not being built. Virtue signaling is so much easier. It is certain that this new measure will only further clog the natural arteries of commerce.

The state of California has also inserted their own very visible hand into the real estate market. State wide rent control has arrived.

  • Properties older than 15 years are limited to annual rent increases of 5% plus an inflation rate or 10%, whichever is less. Owners cannot raise the rent above the new limits to cover capital improvements on these older buildings, which means the Golden State will now shine with deferred maintenance.
  • The new California law also restricts landlords’ ability to evict tenants. If a tenant has occupied a unit for at least 12 months evictions can be for “just causes” (where the tenant is at fault) and a limited number of cases where they are not at fault (such as the owner moving in or taking the unit off the market).
  • When evicting any tenant a landlord must now provide written notice and state whether it is an at fault or no fault issue. If there is no fault on the tenant’s part, the landlord must provide one month’s rent money to cover the tenant’s relocation expenses.

Will even more people reinvest further away from California?

No matter where you invest it is important to take title to real estate in the name of a limited liability company (or LLC). As I wrote in my book “Loopholes of Real Estate” there are too many legal loopholes allowing tenants and others to sue property owners. You can close that loophole of unlimited personal liability by holding real estate title(s) in one or more LLCs.

We always recommend taking title in an LLC or, in some cases, a limited partnership (LP). But the two main benefits of forming such entities, limited liability and privacy, are under attack by certain governments.

The attacks come under the nobility of expanding virtue and punishing evil. Who can argue that employees shouldn’t be paid what they are owed? Of course they should. But this must be balanced so that employers want to hire workers.

California and New York now hold corporate owners responsible for wage and hour law violations. In California, corporate officers and managers can now be held personally liable for civil penalties resulting from minimum wage violations. Personal liability gets your attention. Either the company follows the rules or, with personal liability hanging over your head, you quit.

New York has gone even further. And in further we mean it has upset the balance between productive employment and limited liability protection. The top ten owners of an LLC can now be held personally responsible for violating New York’s wage and hour laws.

Consider the following example: You invest $10,000 into an LLC doing business in New York. In exchange, you receive a 1% interest in the LLC. Nine other investors hold the remaining 99% and three of them conduct the LLC’s business operations. You are a passive investor with no management control or authority. You like it that way. You invested into a limited liability company because your liability is limited to the $10,000 you invested, and nothing more.

But New York has now changed the rules. If the three managers don’t pay, for example, $100,000 in wages, you are now on the hook for the payment. Even though you only own 1% of the LLC and had no management authority you are now ‘jointly and severally’ liable for the money. This means that if the other nine owners flee, or are bankrupt, you now owe the entire wage claim amount. What if people turn in their shares and all of a sudden, without your knowledge, you are a top ten owner? You are responsible for the whole claim.

New York’s law totally upends the concept of limited liability. Attorneys will be counseling clients to think long and hard about doing business in New York. Mind you, all this disruption is in the name of protecting workers.

The District of Columbia is also demanding more from LLCs. Their government, with the stated virtuous goal to “expose bad landlord(s) hiding behind an LLC”, now wants ownership information on all LLCs (whether for real estate or business) formed in D.C. or doing business in the District.

Now, in all filings, the name, state of residence and business address of every person with either a 10% or greater ownership in the LLC, or who controls day to day operations of the entity, must be provided.

It is not hard to visualize the next step from this collection of information. Plaintiff’s attorneys will be suing not only the LLC, but also the LLC’s individual owners. In some cases, the courts will dismiss any personal claims when the liability rests with the LLC. But in many cases the suing of individuals will be used to gain leverage in the litigation. And again, the limited liability protection of the LLC will be diminished through government regulation.

At the federal level, the U.S. House of Representatives recently passed the Corporate Transparency Act of 2019. The bill, which requires the disclosure of beneficial owners of corporations and LLCs, is now before the Senate. If enacted, every entity filing under “the laws of a state or Indian Tribe” shall file a report with FinCEN containing the name, date of birth, address and passport or personal ID number of every beneficial owner.

FinCEN stands for the U.S. Treasury’s Financial Crimes Enforcement Network. Founded in 1990 and broadened under the Patriot Act in 2002, the agency tracks suspicious currency activities and other illicit financial activities.

Congress justifies the need for beneficial ownership information under the following finding:

“Criminals have exploited State formation procedures to conceal their identities when forming corporations or limited liability companies in the United States, and have then used the newly created entities to commit crimes affecting interstate and international commerce such as terrorism, proliferation financing, drug and human trafficking, money laundering, tax evasion, counterfeiting, piracy, securities fraud, financial fraud, and acts of foreign corruption.”

If the Senate passes it, the bill would also require entities to file an annual report containing the current owners and any changes in beneficial owners during the previous year. As well, the law would prohibit the issuance of bearer shares, whereby the owner is not identified as a shareholder on a share or membership certificate.

The act defines beneficial owner as a natural person who directly or indirectly owns 25% or more of the entity’s equity, or who exercises substantial control or who receives substantial economic benefits from the entity. As to the last standard, the Treasury Secretary gets to determine what percentage of ownership equates to substantial benefit. Conceivably, every entity owner, no matter how small their ownership, could be required to disclose their personal information.

Would criminals provide false beneficial ownership information anyway? Perhaps. The penalty for doing so is a fine of up to $10,000 and prison time of up to three years. But an offshore straw man with no U.S. contacts could certainly, for the right price, put forward their passport and personal information for the benefit of a real bad guy.

Of course, as a consequence of trying to catch some criminals, every single American business, every single entrepreneur and real estate investor using a corporation or LLC, millions and millions of them, must now file initial and annual reports – forever!

  • Can FinCEN handle that much reporting?
  • Can they handle the responsibility to keep all that information private?
  • Should you ask your U.S. Senate candidates if they support this bill?

The Electronic Frontier Foundation in San Francisco has questioned the benefits of FinCEN compared to the loss of individual privacy. They question the effectiveness of FinCEN’s “Suspicious Activity Reports”, and why no studies have identified how many reports are filed on innocent people. If the Senate passes the Corporate Transparency Act of 2019, the Foundation’s long-time concerns of Fourth Amendment protections against unreasonable searches and seizures will come again to the fore. Any government investigator will be able to use FinCEN’s database to investigate people instead of crimes.

Governments offer less protection and want more information about LLCs and corporations. Where does it lead?

The Four Dangers of Series LLCs

There’s a lot of talk about Series LLCs. More and more people are wondering if they’re a smart idea. The short answer is – they aren’t. They haven’t been tested, giving them limited applications if they have any at all.

The series LLC is different from a traditional Limited Liability Company (LLC). In fact, the series LLC is not not available in all states and has only been adopted in Delaware, Nevada, Illinois, Iowa, Oklahoma, Tennessee, Texas and Utah.

The California series LLC is a rarer entity as California does not allow for series LLCs to be formed under state law, but series LLCs formed in other states can register with the state and do business in the state.

What is the difference between an LLC and a series LLC? Why should series LLCs be avoided?

What is an LLC & What’s it Good For?

First, some background. LLCs alone are an excellent structure for many different uses. For instance, they work well as a method of holding high dollar assets like real estate. If you own commercial or rental property, it’s important that you hold title to that property in an entity.

If this entity (most likely an LLC) is run and managed properly, it can protect you from any personal liability. (Learn the top 12 advantages and disadvantages of an LLC)

Many people own a number of different investment properties. They want to protect both their investments and themselves by placing them into one or more LLCs. The task then, is that in this scenario, every investment is held under a different LLC.

That’s not a popular answer for people who have lots of investments, but it’s built on sound reasoning. Think of LLCs as giant shoeboxes. As many investment items as you like can be placed inside, but they’re all at risk if something happens to the box. If a lawsuit happens, every investment you’ve placed into that LLC will be in danger.

Keep Your Assets Separate

The solution is to separate your investments. Ideally, you should use a separate LLC for each one. If you can’t, be sure to examine the equity you have at stake in every investment along with its liability potential. Then group them in LLCs accordingly.

As an example, it’s not a good idea to include a single family beachfront rental in Maui in the same LLC as a duplex on the wrong side of town. You may have several hundred thousand dollars of equity stored in the house on Maui, which is placed at risk by including it in the same LLC as the rough-edged duplex. Keep them separate.

However, if you own three single-family homes in Idaho, each within about twenty thousand dollars of equity, you might feel that placing them together is an acceptable risk.

But the segregation strategy can get expensive. If you have ten properties, using ten different LLCs might seem confusing and costly.

How is a Series LLC Structured?

Series LLCs seem to provide a solution as statutes in certain states allow you to create separate series within a single LLC, the debts and liabilities of which are only enforceable against that series.

These laws allow LLCs to establish separate series of interests, members and managers, giving them separate duties, powers and rights. Those include the rights to profits and losses with respect to specific property and obligations.

In states that have this kind of enabling legislation, each series within the LLC works as a separate entity under state law. This is why many people are attracted to series LLCs – they theoretically have the ability to shield property in different series from liabilities incurred in or against one another without paying state fees for multiple entities.

This means that an LLC containing two properties can choose to place each into a separate series, so that liabilities from one can’t cause problems with the assets of the other. (Remember the same effect can be created using two different LLCs to hold these two properties.)

Reasons to Avoid the Series LLC

1. Series LLCs are Deceptively More Expensive to Set Up

Many people prefer series LLCs because at first glance they appear to be cheaper to set up. However, this assumption is false. It’s actually more complicated to set up a series LLC, making it more expensive than the basic type.

In California you might find a series LLC appealing because the Franchise Tax Board charges an annual fee of $800 for each entity. Many people think that setting up a single series LLC means paying only one fee in California.

However, the Franchise Tax Board takes the position that each series counts as its own LLC for fee purposes, meaning you’ll have to pay the same whether you set assets up in series or in their own separate LLCs.

2. Legal Uncertainty Surrounds Series LLCs

The biggest problem with series LLCs is that many states (including California) don’t have series legislation and may choose to ignore the laws of the state where the series was created. That’s because you’re subject to their rules when doing business in their state.

The example of the attitude of the California Franchise Tax Board applies to fees, but liability protection is also an issue. Since series LLCs are so new they’ve never been tested by courts, even in the states that permit them. That means there’s no guarantee that limited liability protection will be extended to each series until every state rules on the subject.

It’s hard to see how a court would choose to grant this kind of protection inside one entity, and only time will tell if courts will do this. But do you want this type of uncertainty when you are trying to protect your assets?

3. Difficulties with Series LLCs Across State Lines

Again, one should be concerned about how series LLCs will be treated by the states that don’t have laws permitting them. If you set up a series LLC in Nevada then register it as a foreign entity conducting business in the state of Massachusetts, each series in the LLC own a separate piece of property.

If there’s a lawsuit in regards to one of these properties you can’t be sure that the Massachusetts court will honor the series structure of the LLC, applying Nevada’s law to the real estate and activities that are located in Massachusetts.

If they do, the claimant can collect only against the property in that series. If they don’t, the claimant can collect against the properties in other series as well. States are expected to give full faith and credit to legislation of other states, but the answer is uncertain. Exceptions do happen.

4. The American Bar Association Does Not Endorse Them

It is also important to note that the American Bar Association did a review of series LLCs and declined to endorse them. You can be certain that future court cases will take note of this development.

Since the laws about creating series LLCs are different in every state that permits them, it might take a long time before enough case law is accumulated to give us any level of comfort about using them.

If you want to make sure your assets have good, solid protection, it’s a much better idea to avoid corporate structures that don’t provide reliable protection. Avoid series LLCs as a form of protection until a definitive case law is established and rely instead on known, tested entities such as individual LLCs.

Corporate Direct can help you set up your protective structure without using a series LLC. 

Six Ways Joint Ownership Could Cost You

Many people use joint ownership (the holding of title by two or more people), without really thinking about it. It is often used as a substitute for estate planning because it is cheaper, which is why some call it the “poor man’s will”. It may seem like a simple and inexpensive way to avoid probate (the costly court review of your transfers at death), but it is not a good idea in most cases, and can be fraught with unexpected peril. Joint property ownership disputes can really cost you.

What Is Joint Ownership?

Joint ownership occurs when the names of two or more people are placed on bank accounts, stocks, bonds, or deeds to real property. Then, when one of the joint tenants die, the surviving joint tenants own the entire property automatically by operation of law, meaning it happens without going to court or requesting any change. When the first joint owner passes, the survivors own it all regardless of the will of the deceased joint tenant.

The Disadvantages of Joint Ownership

  1. Vulnerable to Creditors
    Joint ownership property is subject to the claims of a joint owner’s creditors. If one joint owner experiences financial difficulties, then his creditors may be able to reach into his interest in the joint ownership property, creating an unexpected co-owner. This new co-owner could, if they wished, file a partition action to force a sale of the property.
  2. Unexpected Use of Joint Ownership Property
    There is nothing to prevent one joint owner from unexpectedly using the joint ownership property for his or her own benefit, thereby eliminating or reducing the value of the joint ownership property to the other owner. For example, you may show up to your vacation home one day and find some unsuspecting B&B guests had it rented to them by the other owner.
  3. Unequal Distributions Among Children
    If the parent of three children adds the name of one of her children to a joint ownership property before passing away, the entire property will pass solely to that one child. What starts out as a matter of convenience (i.e. being able to sign on a bank account), could lead to a family battle royale.
  4. Reconveying Joint Ownership Property is Difficult
    In order to convey joint ownership property back to the original owner, both joint owners must agree, and must be willing to sign the deed and all of the paperwork. If one owner refuses to do so, then reconveying the property to one owner may require a court order.
  5. The Incapacitation of a Joint Owner Could be Devastating
    If one joint owner becomes sick or mentally incapacitated, then it may not be possible to sell the property without the appointment of a guardian and the approval of a probate court. If the sale is approved, the probate court could order that the incapacitated joint owner’s share of the sale be placed in a separate guardianship account to pay for their care, effectively leaving the seller with only one half of the sale proceeds.
  6. Divorce Divisions
    If a joint owner is married, then it is possible that a divorce court might regard the joint ownership property as marital property and award all, or a portion of it, to a joint owner’s soon-to-be ex-spouse.

Examples of Joint Ownership Gone Awry

Case No. 1

John and Martha had been married for many years, but John was in the early stages of dementia. He and Martha began drifting apart. They both agreed that John would live in their marital home for the rest of his days and that Martha would live in another state until John died. Then, after John died, Martha would come back to live in their home. This might well have worked out all right for John and Martha, except that, after Martha was gone, John’s neighbor, Willie, saw a way to make some easy money.

Willie befriended John, and eventually talked John into divorcing Martha. Willie kindly helped John fill out all of his divorce paperwork, and convinced John to swear (falsely) in his affidavit that Martha had deserted him and that he did not even know where she was. The divorce court accepted John’s (Willie’s) lies and granted John a divorce from Martha. John was awarded all of the parties’ martial property, including John and Martha’s marital home.

John’s health steadily deteriorated, and a few weeks before John’s death, Willie convinced John to make him a joint owner of his home, so that he could better help John take care of it.

When John died, Willie became the sole owner of the home automatically, and, being the weasel that he was, Willie immediately borrowed $100,000 from a local bank by mortgaging John and Martha’s home, which was now his.

You can imagine Martha’s surprise when she returned to her marital home and discovered that not only was Willie it’s sole owner, but he was now living in it.

Case No. 2 — The Bad Actions of One Joint Owner Costs Both

After Joyce’s husband passed away, her son Dan offered to help her take care of her home. She made him joint owner of the property so that he could do things like pay utilities. Well, Dan was an idealistic man and held many strong beliefs, including that federal income tax was unconstitutional. True to his convictions, and unbeknownst to Joyce, Dan had not paid any federal income tax for the last ten years. Unfortunately for Joyce, the Internal Revenue Service (IRS) got around to investigating Dan’s finances and discovered his joint property interest in Joyce’s home. The IRS asserted a tax lien against Dan’s interest in the jointly owned property and Joyce was forced to pay back all of Dan’s back taxes to the IRS, together with interest and penalties, in order to continue living undisturbed in her own home.

Case No. 3 — The Need for Guardianship Costs Both

Bill and Mary had been married happily for 58 years. They had always owned their home jointly with the understanding that when one of them passed away, the other would receive the home. Unfortunately, a little after her 87th birthday, Mary was diagnosed with Alzheimer’s disease. Bill wanted to do what was best for his wife, so he decided to sell their home so he could provide care for Mary. It would not be that simple. Because Mary was considered mentally incapacitated, Bill had to hire a probate attorney to set up guardianship for Mary and her estate, and appoint himself as the guardian. He then had to hire the attorney again so he could sell the house. When the house was sold, the probate court ordered Bill to set up a separate account for Mary’s half of proceeds, and every time he wanted to use that money for something, he had to hire his expensive probate attorney and petition the court for approval. This was certainly not what Bill and Mary had in mind for their last few years of life.

CONCLUSION

Although joint ownership seems like a simple and inexpensive way to avoid probate, it is littered with traps. Luckily, there are other options such as using a living trust or an LLC for asset protection. Call 800-600-1760 to learn more about protecting your property the right way.

IRS Liens Don’t Die

Beware of Purchasing Real Estate with Unpaid Liens on It

Can the Internal Revenue Service (“IRS”) collect a prior owner’s delinquent federal income taxes from the subsequent purchaser of real property?

Yes.

In Shirehampton Drive Trust v. JP Morgan Chase Bank, N.A., 2019 WL 4773799 (D.Nev., Sept. 29, 2019) (unpublished decision) (Case No. 2:16-cv-02276-RFB-EJY), the United States District Court for the District of Nevada concluded that the IRS was entitled to enforce its federal income tax liens against the new owner of real property.

The Course of Proceedings in Shirehampton

Plaintiff Shirehampton Drive Trust (“Shirehampton”) sued Defendant, United States of America Treasury Department, Internal Revenue Service (“IRS”), and Defendant, JP Morgan Chase Bank, N.A. (“Chase”), seeking a declaration that from the Court that a Las Vegas property that it had obtained at a foreclosure sale in 2013 was not encumbered by Chase’s deed of trust.  To that end, Shirehampton asserted claims for injunctive relief, quiet title, and declaratory relief.  The IRS removed the case to federal court, and answered and counterclaimed against Shirehampton, and crossclaimed against Chase and other Defendants, to enforce federal tax liens pursuant to 26 U.S.C. §§ 6321, 6322 and 7401.  Chase answered the complaint and asserted counterclaims for quiet title under NRS 40.010, declaratory relief under NRS 30.010 and 28 U.S.C. § 2201, and unjust enrichment.  Shirehampton answered the counterclaims, and the Court dismissed the other Defendants without prejudice.  All three remaining parties then moved for summary judgment.  The Court administratively stayed the case pending the Nevada Supreme Court’s decision in SFR Investments Pool 1, LLC v. Bank of New York Mellon, 134 Nev. 438, 422 P.3d 1248 (2018), but then lifted the stay.

The Facts in Shirehampton

This matter concerned a nonjudicial foreclosure on a property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (the “property”).  The property was located in a community governed by a homeowners’ association (“HOA”) that required its community members to pay dues.

Louisa Oakenell (“Oakenell”) borrowed funds from MetLife Home Loans, a Division of MetLife Bank, N.A. (“MetLife”) to purchase the property in 2008.  To obtain the loan, Oakenell executed a promissory note and a corresponding deed of trust to secure repayment of the note.  The deed of trust listed Oakenell as the borrower, MetLife as the lender, and Mortgage Electronic Registration Systems, Inc. (“MERS”), as the beneficiary.  In May, 2013, MERS assigned the deed of trust to Chase.

Oakenell fell behind on her HOA payments.  The HOA, through its agent Red Rock Financial Services, LLC (“Red Rock”), sent Oakenell a demand letter by certified mail for the collection of unpaid assessments on June 26, 2009.  On July 21, 2009, the HOA, through its agent, recorded a notice of delinquent assessment lien.  The HOA sent Oakenell a copy of the notice of delinquent assessment lien on July 24, 2009.  The HOA subsequently recorded a notice of default and election to sell on October 21, 2009, and then a notice of foreclosure sale on September 18, 2012.  Red Rock mailed copies of the notice of default and election to sell to Oakenell, the HOA, the IRS, and Metlife Home Loans.  Red Rock did not mail a copy of the notice of default and election to sell to MERS.  On January 28, 2013, the HOA held a foreclosure sale on the property under NRS Chapter 116.  Shirehampton purchased the property at the foreclosure sale, and a foreclosure deed in favor of Shirehampton was recorded.

In addition to falling behind on her HOA payments, Oakenell also stopped paying federal income taxes.  The IRS subsequently filed notices of federal tax liens against Oakenell at the Clark County Recorder’s office on May 1, 2009, and June 24, 2009.  As of October 1, 2018, Oakenell had accrued $250,953.37 in income tax liability plus daily compounding interest.

The Decision in Shirehampton

The Court concluded that the IRS was entitled to enforce its federal income tax liens against Shirehampton, the new owner of real property, but that Shirehampton acquired the property free and clear of Chase’s deed of trust.

The Rationale of Shirehampton

Chase Deed of Trust.

The Court first addressed whether Shirehampton purchased the property subject to Chase’s deed of trust, and concluded that it did not.

Chase argued that the foreclosure sale was void because the HOA, through its agent, did not comply with the notice requirements of the version of NRS 107.090 in effect at the time by serving a copy of the notice of default and notice of sale on MERS, its predecessor-in-interest.  See, NRS 107.090(3)(b) (requiring that any person recording a notice of default mail a copy of the notice within ten days of recording to “[e]ach other person with an interest whose interest or claimed interest is subordinate to the deed of trust.”). The Court disagreed, and found the facts to be substantially similar to the Nevada Supreme Court’s decision in West Sunset 2050 Trust v. Nationstar Mortgage, LLC, 134 Nev. 352, 354-55, 420 P.3d 1032 (2018) (concluding that “Nationstar’s failure to allege prejudice resulting from defective notice dooms its claim that the defective notice invalidates the HOA sale”).

The Court next considered Chase’s argument that the HOA did not intend to foreclose on the superpriority portion of the lien, because the assessment lien notices did not specify that the sale was a superpriority sale.  The Court disagreed, and distinguished the Shirehampton case from the recent decision of the Nevada Supreme Court’s in Cogburn Street Trust v. U.S. Bank, N.A., as Trustee to Wachovia Bank, N.A., 2019 WL 2339538 (decided May 31, 2019) (concluding that HOA properly nonjudicially foreclosed on subpriority portion of lien after bank’s tender satisfied superpriority portion of the lien).  The Court concluded that Chase’s evidence was insufficient to find that the HOA intended to foreclose on the subpriority portion of the lien as a matter of law, and did not establish fraud, oppression, or unfairness sufficient to void the sale.  In addition, the Court noted that it had previously addressed Chase’s further argument regarding the facial unconstitutionality of NRS Chapter 116, and thus incorporated by reference its reasoning in Carrington Mortgage Services, LLC v. Tapestry at Town Center Homeowners Association, 381 F. Supp. 3d 1289, 1294 (D.Nev. 2019).  Thus, the Court finds that Chase’s deed of trust was extinguished by the HOA foreclosure sale.

IRS Tax Lien.

The Court next addressed the priority of the IRS tax lien versus that of the HOA’s lien, and concluded that, because the HOA lien was not perfected at the time that the IRS recorded its notice of tax liens, the IRS tax liens had priority over the HOA lien

The Court initially noted that, when the IRS assesses a person for unpaid federal taxes, a lien is created in favor of the United States as a matter of law, citing, 26 U.S.C. § 6321.  While the lien is automatically created when the assessment occurs, the lien is not valid against purchasers, holders of security interests, mechanic’s liens, or judgment lien creditors until notice of it has been filed, citing, 26 U.S.C. § 6323(a).  Federal tax liens do not automatically have priority over all other liens.  Absent a provision to the contrary, priority for purposes of federal law is governed by the common-law principle that the “the first in time is in the first in right”; and a competing state lien exists for “first in time” purposes when it has been perfected, meaning that the identity of the lienor, the property subject to the lien, and the amount of the lien are established, citing, U.S. v. McDermott, 507 U.S. 447, 449, 113 S.Ct. 1526, 123 L.Ed.2d 128 (1993).

Applying these principles to the Shirehampton case, the Court observed that the IRS first assessed Oakenell for lack of income tax payments on November 7, 2005, and July 3, 2006; and that the IRS then recorded its notice of tax liens with the Clark County recorder on May 1, 2009, and June 24, 2009.  The Court further observed that Oakenell first became delinquent on her HOA dues on March 1, 2009; that the HOA recorded its notice of delinquent assessment lien on July 21, 2009; and that the HOA mailed Oakenell a copy of the notice of delinquent assessment lien on July 24, 2009.

Despite these facts, Shirehampton argued that the HOA lien was first in time.  Shirehampton claimed that, because the notice of delinquent assessment recorded in July, 2009, incorporated delinquent assessments that had been owed since January, 2009, it was technically first in time.  Shirehampton pointed to the language of NRS 116.3116 at the time, which stated that the “association has a lien…from the time the…assessment or fine becomes due.”  Oakenell did not become delinquent until March 1, 2009, so Shirehampton argued that the HOA lien was perfected on March 1, 2009.  The Court disagreed, and found that the HOA lien was not perfected until the notice of delinquent assessment lien was sent to the unit owner, citing, In re Priest, 712 F.2d 1326, 1329 (9th Cir. 1983) (“[A] lien cannot arise prior to the taking of any administrative steps to establish the lien.”).  The Court emphasized that the Nevada Supreme Court has held that the mailing of the notice of delinquent assessment lien to the delinquent homeowner pursuant to NRS 116.31162(1)(a) “institutes proceedings to enforce the lien,” quoting, Saticoy Bay LLC Series 2021 Gray Eagle Way v. JPMorgan Chase Bank, N.A., 388 P.3d 226, 231 (2017) (“A party has instituted ‘proceedings to enforce the lien’ for purposes of NRS 116.3116(6) when it provides the notice of delinquent assessment.”).  Thus, the Court stressed that providing notice of delinquent assessment is the first administrative step to perfecting a superpriority lien, because “no action can be taken unless and until the HOA provides a notice of delinquent assessments pursuant to NRS 116.31162(1)(a),” quoting, Saticoy Bay LLC Series 2021, supra, 388 P.3d at 231.  The Court pointed out that the notice of delinquent assessment also establishes, pursuant to NRS 116.31162(1)(a), the amount of the lien as is required under federal law before a lien can be perfected, citing, Loanstar Mortgagee Services, LLC v. Barker, 282 Fed.Appx. 572, 573 (9th Cir. 2008).  While assessments and related fees may be delinquent prior to this mailing, they are not set until the mailing, citing, NRS 116.31162(1)(a) (explaining that notice must contain a set “amount” for the delinquency).  The Court reasoned that the mailing of the notice of delinquent assessment was the first administrative step to establish a superpriority lien, and was the first time that the amount of this lien was fixed and set.  Thus, the Court found that an HOA lien cannot be perfected under federal law until at least the notice of delinquent assessment lien has been provided to the unit owner.  The Court stated that, it is only with this notice that the identity of the lienor, property subject to the lien, and, most significantly, the amount of the lien are sufficiently established.

Applying these principles to the Shirehampton case, the Court observed that Red Rock sent the notice of delinquent assessment lien pursuant to NRS 116.31162(1)(a) to Oakenell on July 24, 2009, which was after the IRS recorded its notice of tax liens.  As such, the Court concluded that, because the HOA lien was not perfected at the time that the IRS recorded its notice of tax liens, the IRS tax liens had priority over the HOA lien, citing, LN Management LLC Series 31 Rue Mediterra v. United States Internal Revenue Service, 729 Fed.Appx. 588 (9th Cir. 2018) (finding no record evidence that identity of HOA lienors, property subject to lien, and amount of lien were established before notice of federal tax lien was recorded).  The Court concluded that was IRS was entitled to enforce its tax liens against the new owner of the property, citing, U.S .v. Bess, 357 U.S. 51, 57, 78 S.Ct. 105, 42 L.Ed.2d 1135 (1958) (noting that “[t]he transfer of property subsequent to the attachment of [a federal tax lien] does not affect the lien”).

Thus, the Court held that the IRS could enforce its tax liens against Shirehampton, but that Shirehampton acquired the property free and clear of Chase’s deed of trust.

BRIEF DISCUSSION

            This case is fairly straightforward; however, it does illustrate the potential difficulties that may ensue from purchasing real property at a foreclosure sale.  Obviously, a purchaser of real property at a foreclosure sale must be careful in doing so, because the IRS potentially can collect the prior owner’s federal income taxes from the subsequent purchaser of the real property. 

            It should be noted that Shirehampton filed a Notice of Appeal to the Ninth Circuit on November 5, 2019.

CONCLUSION

Under some circumstances, the IRS can collect a prior owner’s delinquent federal income taxes from the subsequent purchaser of real property.