As the next economic downturn approaches, interest in hiding recorded ownership increases. This article explains two different trust arrangements owners use to attempt this, and the ramifications of each.
Would you ever consider allowing another individual to hold title to your property for you?
This is not an uncommon situation, and typically occurs in recessionary periods when owners are interested in hiding property ownership to avoid creditors — including lenders holding mortgages — and mortgage alienation clauses.
But does it work? Is it considered fraudulent? And does this practice actually keep an owner’s name off public records and help them avoid the consequences of money judgments and ‘due-on’ calls?
An LLC holds title in trust
The purpose of a trust vesting arrangement is to keep one’s name from appearing on record as owning a parcel of real estate. Limited liability companies (LLCs) are the most straightforward way to complete this type of vesting and allow the owner to maintain full control over title to the property.
However, the use of an LLC to hold real estate assets was neither designed nor intended to be employed as a place to permanently hide an individual’s personal wealth from creditors. Rather, use of an LLC allows real estate vested in the LLC to remain undisturbed in the face of an individual member’s financial adversity, and vice versa. Thus, the “ownership” of the property is not hidden and no fraudulent transfer of property is involved since it is vested with title in the LLC and the debtor is the owner, solely or partially with others, as a member owning the LLC.
Creditors seeking the location of a debtor’s assets held in an entity such as an LLC need to look beyond the public records to determine if the debtor has any ownership in an LLC. This information is needed to obtain a court-issued charging order to attach the debtor’s interest in the LLC. Again, the creditor cannot attach and foreclose on the property vested in the LLC, they may only attach and sell/acquire only the creditor’s membership interest in the LLC.
Consider an owner of real estate who transfers title to a property into an LLC they created. The owner receives a percentage or all of the ownership interests in the LLC as a member for the conveyance — fair value for the transfer since they became an owner/member of the LLC which now owns the real estate. In this instance, the conveyance is not fraudulent. The owner has merely exchanged their interest in the real estate for an interest in the LLC of equal value. Full value is received and no tax liability is incurred on this tax-free exchange. [26 United States Code §721]
In essence, the owner has substituted their real estate vesting for a stock-like membership position in the LLC. The owner still owns a value equal to the equity in the real estate they transferred, just in a different form. The nature of the owner’s ownership interest merely changes from one of real property to one of personal property (shares in an LLC).
Further, this simple change in vesting inherently makes it much more difficult for creditors to locate, attach and judicially sell the debtor’s assets to satisfy a claim for money.
When vested title is in the name of an LLC, the individual named as the debtor on a recorded abstract of judgment is not the vested owner of any real estate. Further, the change in vesting makes the real estate, now the asset of an LLC, much more difficult — but not impossible — for the creditor to reach due to:
- the charging order and judicial sale process;
- nonvoting status of the creditor if they do foreclose on the LLC interest held by the debtor; and
- the buyout provisions in the LLC operating agreement.
As the creditor attempts to locate and attach the debtor’s assets, the LLC is able to continue its business of renting, selling or encumbering the property. On attaching the member’s interest via a charging order or appointment of a receiver, the LLC distributes net proceeds from operating income to the judgment debtor under the LLC operating agreement. On foreclosure of the debtor’s membership share in the LLC, the debtor becomes a nonvoting member in the LLC.
In an LLC vesting, there is an annual cost of maintaining the LLC as an entity in California, usually around $1,000-$1,500 for annual taxes and filings. Whereas, vesting title in trust with another person incurs no expense.
An individual holds title in trust
A property owner may be tempted to ask an individual (or entity registered to do business in California) to hold title to the property in trust for the owner, vested in the individual’s name as trustee to avoid the extra steps and costs of forming and maintaining an LLC. But this requires a certain bit of, well, trust in that individual.
One way this is sometimes done is through a revocable inter vivos (living) trust, usually carried out with a family member.
A living trust agreement is a title holding arrangement which is not operative and has no legal, financial or tax consequences until death. [See RPI Form 463]
Further, it’s a popular misconception that owners may use revocable living trust vestings to avoid their creditors. This is completely unfounded — a trust vesting is not a debt shield or an asset preservation vesting. Creditors can directly reach property vested in the owner’s revocable living trust, both during the owner’s lifetime and after their death.
Living trusts do provide a benefit: their ability to perform the same functions as a will while avoiding probate procedures. Given the nature of California probate proceedings, the advantage of the alternative trust vesting is substantial, both in conveyance time and handling costs.
But using a living trust with the goal of avoiding creditors does not attain that objective.
Trust vesting today
At the start of 2019, very few individuals are pursuing alternative vestings such as trust arrangements or LLCs to deter or avoid creditors or existing mortgage lender ‘due-on’ enforcement. However, as we head into the next recessionary period — forecasted to arrive in 2020 — expect to see greater interest in these types of arrangements.
But avoiding debts or ‘due-on’ clauses by hiding ownership is not foolproof. Placing title to a property in trust simply kicks the can down the road. Thus, it becomes more difficult for the creditor to locate the owned asset held in another person’s name and eventually attach the property and judicially foreclose, or the existing mortgage lender to determine whether their ‘due-on’ clause has been triggered.
Still, this hide-and-seek activity will pick up in the coming years as the economy slows and creative owners seek ways to avoid losing their properties when they can no longer pay their debts and frugal buyers seek ways to take over low interest rate mortgages on property listed for sale. Consider the LLC entity as the most practical and proper way for an owner to distance creditors from their assets — if that is the objective.
Very good explanation and by reading this article one could save up to $2K in fees from a Bankruptcy expert. However if the case is juicy enough people will spend time and money to discover all the theatrics and this could be tied up in court for years. Meanwhile time goes on and the experts’ fees will continue accumulating, the real estate values of the property in question will go up and there will be more time for negotiations.
In summary, the objective is to hide assets from the creditors allowing one to buy time to negotiate and let the values go up.
Well Carrie, you left a lot of stuff out of the article. There is the loss of preferential gains tax treatment on the resale of your residence if you put it in an entity. Then you must exit with an IRC 1031, which is really only a postponement tool. There is also the reality that a debtor hiding behind hidden ownership may ultimately need to lie under oath in a debtor’s interview to continue the protection, or worse yet, conceal in a bankruptcy. And why the complexity of a LLC (needed for the conduct of business) when a simpler LP will work just fine? Owning real estate is not a conduct of business, unless there is some ruling I am unaware of. There is also the problem of needing a lawyer for some of the simplest legal matters because the court will not usually permit a principal in an entity to essentially practice law on behalf of that entity. This is a legitimate concern for small or beginner investors. (Non-corporate Brokers can get around this by maintaining a property management contract with the LP/LLC/Corp. The property manager has a superior right of possession to the tenant and, therefore, can bring Unlawful Detainer actions and bring/defend some other related actions without an attorney.)
If you seek asset protection, you best have a plan that will continue to function even if everything hidden becomes exposed. I have studied asset protection since the 70s beginning with Fred Crane’s One-Man Limited Partnership. I experimented with various modifications until I found something that really does work. If I were not retired, I wouldn’t be sharing it here.
Rather than to hold title, the entity should be used to hold a lien against the property. As an asset protection method, form an LP or an LLC in the state where the property exists, then provide that entity with a long-term Option to Buy for the real estate you wish to protect. The strike price of the option should strip out the remaining equity in order for it to be fully protective. You must also execute and record a Deed of Trust to secure the optionor’s performance in the option. A DOT for performance in any contract is permitted in California. Some other states using recorded mortgages require a Trust Indenture, which is usually not a fill-in form. Instead of a dollar amount on the DOT, just show “performance in a contract dated xx/xx/xxxx”. Nobody knows from public record what that contract is, yet it has established its seniority to future creditors by its recording date. Subsequent creditors out in the cold.
This method overcomes all the typical problems with using a note/DOT to strip out the equity. That method fails for two reasons: A creditor can show that no funding occurred behind the sham note. Also, property appreciation will diminish the protection a note provides, eventually creating feasibility for a creditor’s attack. An option to buy continues its “net equity” protection no matter how high the property value rises. The option method preserves the residence status for gains taxes and any property tax preferential treatment. An option is not a sale. It is a contingent liability of the property owner. It is contingent, not upon any future choice of the property owner (optionor), but entirely upon the day-to-day choice of the optionee (LP or LLC), who can execute the option at any time. In some states where I have used this method, Montana for one, I have been excused from filing annual tax returns for the LP because merely holding an option to buy is not a conduct of any business and produces nothing to distribute on K1 to the partners. California wants their annual fees, which they erroneously call a prepaid non-refundable tax. So don’t try it there.
If the optionor wants to sell his property, the DOT can be reconveyed with a $0 demand concurrently with a typical sale. Alternatively, if the optionor is in trouble with creditors, the demand can be for net proceeds to the LP/LLC. If the creditors won’t get out of the way, the optionee can foreclose under the DOT and leave the creditors as a sold-out junior.
These concepts are versatile and can also be used to buy any property “subject to” without triggering a “due on” provision. Here is the method I have used for over forty years. Excuse any redundancy from the above-stated use. The method uses a long-term prepaid lease for possession and a long-term Option to Buy as a substitute for a Grant Deed. Then use a recorded Deed of Trust to secure the optionor’s performance in the lease and the option. You do not record the lease or the option agreement itself. You only record the DOT and, instead of a dollar amount of the lien, you write “for performance in a contract dated xx/xx/xxxx”. Long-term leases and options to buy will trigger the typical “due on” clause because too many rights in the “bundle of rights” have been conveyed. But the lender cannot foreclose because the public record is insufficient to establish a breach to a foreclosing trustee. A mere DOT for performance in some unknown contract is not a “due on” breach. If a trustee tries to proceed, its easy to make them stop with just a phone call. Also, Prop 13 reassessment does not occur by granting of an option.
So how does the optionee get title on demand or sell the property? The option will contain the method of execution, such as “send a $100 check to optionor at 1234 XYZ street with a demand for a Grant Deed”. Of course, this will usually get no response from the long-gone optionor. Now the optionee can foreclose under the DOT while claiming net equity as the foreclosure demand because the option (an interest in real estate) really does place ownership of the net equity in the hands of the optionee. Third party bidder interference at the trustee’s sale is unlikely and should be welcomed as an opportunity to sell over market value.
These are the basics only. I don’t want to over-simplify it. There are many other complexities to deal with in the option agreement like authority and agreement to pay any underlying debt payments, taxes, and insurance. There must be sub-leasing rights. Insurance provisions must keep a policy in the name of the optionor while it protects the optionee’s interest and all while keeping any lenders requirements satisfied. Insurance can be the biggest problem in a deeded “subject to” sale because it tips off the lender to a transfer if the policy is in the name of the grantee. If the grantee leaves the policy in the name of the grantor, the grantee is uninsured for any future claims. Insurance in the option scenario is easy to deal with. Just add the optionee to the policy as an additional insured mortgagee. Nothing else changes and the lender knows nothing. Clearly, the optionee owns equity from appreciation. But you must deal with who owns accruing equity from principal reduction of the underlying loan, which can be done by corresponding adjustment to the option strike price. The consideration for the lease and option can be up front payment, perhaps precious metals, or the optionee’s performance in paying all ownership costs. Fatcola, and probably others, will issue a policy or just a prelim, for the state of title upon recording of the DOT. Protecting it thereafter is done by the seniority of that DOT and the demand behind it. The lease and Option to Buy should be non-transferable to prevent an optionee’s creditor from seizing that lease option itself. Alternatively, lease and option should be transferable if the optionee wants to convey his interests without taking deeded ownership. Carefully crafted conditions on transferability can protect from perils in both scenarios.
My intent here is to demonstrate that all elements of a fee simple ownership transfer can be alternatively conveyed using a lease and an option. And it can be done in a very safe and secure way that prevents “due on” triggers or a vanishing optionor. Again, there are many details that must be covered. You cannot just use some Option to Buy fill-in form.
The use of a lease/option to avoid compliance with Equity Purchase laws remains risky. The law does define the Equity Purchaser as “any person who acquires title to any residence in foreclosure.” To any reasonable person, that would exclude lease and option agreements, particularly because of how easy it would have been for the legislature to include them. But the Equity Purchase law is sloppy and ambiguous, not by carelessness or mistake, but by design so it can be liberally construed in favor of the troubled homeowner. I wouldn’t take the risk. But then, just how would an option buyer comply with the equity purchase law? Too much speculation is needed as to what the compliance requirements would be if options were addressed in the law.
In summary, what we call ownership is really just a bundle of rights. There is nothing physical involved with the ownership of real estate. There is more than one way to convey ownership of those rights. I hope I have demonstrated one such alternative. Perhaps too far outside the box, but this lease/option/DOT method of transfer can be envisioned universally replacing fee simple Grant Deeds as it can be chained just like deeds.
Very informative post. Thank you for sharing. Hopefully Carrie listens and opens her mind to alternatives.
I forgot to include that the lease/option/DOT method also escapes all transfer taxes and other escape taxes and misc ‘per transaction’ fees for the usual variety government pillaging.
Interesting, thank you. I do have two questions for the author:
“exchanged their interest in the real estate for an interest in the LLC of equal value. Full value is received and no tax liability is incurred on this tax-free exchange. [26 United States Code §721] ”
Does such a reconveyance
1) trigger a new property tax bases ?
2) truly insulate an owner from a judgement if they are sole owners of the LLC
Thank you,
Dear Kelly,
Thank you for your questions. When the owner’s interest in the property transferred into an LLC remains the same in the LLC as under their prior ownership of the property, tax reassessment does not occur. [Rev & T C §64]
A creditor seeking an owner’s interest in an LLC will meet the same challenges to locate, attach and judicially sell whether the LLC has multiple members or is a “one-man” LLC.
Best,
Editorial Staff