Co-Authored By: Courtney M. Hills, Esq. and Anthony A. Marrone II, Esq.

If you are a real estate investor, chances are you have purchased liability insurance coverage for personal liability for injuries to others or property damage. But what happens when a claim exceeds coverage limits, or an insurer does not cover a claim due to an exclusion clause in the policy?  As a real estate attorney, I am frequently asked by my clients what they should do to protect themselves should a situation like this arise. To answer your questions I have teamed up with my colleague Anthony A. Marrone II, Esq., who has extensive experience in the area of trusts and estate planning.  Together we will provide you with a well-rounded approach to asset protection planning.

Asset protection refers to the way in which your property is arranged such that exposure to lawsuit risk and liability is reduced. This differs from strategies aimed at tax savings or mere disputes about being a landlord. Instead, asset protection centers on formulating a plan to fully insure your property and own such investments in a manner so that they become less vulnerable to the claims of others.

First, it is important to understand the difference between “inside” and “outside” liability. Inside liability is a lawsuit risk that is produced by the property itself.  That is, something associated with the property may cause you to be sued.  A tenant can be injured on the property or you might have a dispute with a buyer or seller. A lawsuit over these types of claims can put your assets at risk, including other properties and personal savings.  The first part of the asset protection planning therefore is to insulate and shield you from any liability arising out of the property itself so that you do not expose your other assets to this lawsuit risk.

Outside liability on the other hand is the risk associated with your other activities unrelated to the property.  This can include unrelated business dealings, motor vehicle accidents, and the like.  A lawsuit from any one of these sources poses a potential threat to all of your holdings, including the equity in your properties. Therefore the second objective of the planning is to protect the properties from any outside risks.

Protection from Inside Liability

If you own rental property, there is likely a fear in the back of your mind that you will one day be sued by one of your tenants.  And if there is not – there probably should be!  Real estate investors and landlords are often prime targets for lawsuits, both valid and frivolous. 

The law itself creates a presumption that property owners become the guarantors of the safety of tenants, employees, vendors, and anyone else that lives, works on, or visits the property.  Owners will often be held responsible for injuries sustained on the property, regardless of fault.  Real or alleged injuries to tenants and their guests are regular occurrences, and serious injury to even one person might create a potential liability exceeding the amount of your liability insurance coverage.  Other types of problems might not be even covered by insurance at all, such as being sued by a buyer for undisclosed defects in the property.

The good news is that the threat of a lawsuit from a tenant, visitor, buyer, seller or lender, can usually be contained by using the correct legal structure to hold (or shelter) the property.  Almost always, this is accomplished with a type of entity known as a Limited Liability Company (“LLC”).  Many times, an investor owns real property in his or her personal name.  While sole proprietorships (owning assets in your name) are the most common and simplest form of property ownership, they provide no asset protection for property owners.  When owning real property in your personal name, all of your assets, even those unrelated to the property, can be used to satisfy a judgment when sued. If structured and managed properly, an LLC entity can provide excellent asset protection because it allows the owner to protect his or her personal assets. If judgment is rendered for a plaintiff against the property owner, only the LLC’s assets will be accessible to satisfy the judgment.  This is crucial because it permits an individual to hold a series of assets, and compartmentalize those assets without exposing all of the assets to the risk created by any one asset.  With that said however, investors owning multiple investment properties should create separate LLC entities for each property. When an LLC is sued, all of that entity’s assets become available to creditors.  By placing each property in a separate LLC, an investor can protect his or her other properties from being subject to the judgment related to only one of the properties.

Protection from Outside Liability

At this point we can see that the LLC itself will protect you from any liability associated with the property, but what happens if there is a lawsuit against you from your other business dealings or matters unrelated to your property?  Can a successful plaintiff take away the property or your interest in the LLC?

The answer is generally yes.  A membership interest in an LLC is similar to other types of assets. If there is a judgment against you, the creditor may be permitted to either foreclose on your membership interest or he or she can ask the court for a “charging order” which allows him or her to collect your share of any distributions from the LLC. Either remedy can cause you to lose a valuable property interest so additional planning to complete your asset protection should be considered. There are many different strategies available for protecting these LLC interests.   

One of the best ways to shelter the value of your membership interest in an LLC is by using an irrevocable asset protection trust. These types of trusts are almost always irrevocable and may be formed in New York State or in other states that have favorable creditor protection laws, like Delaware, Nevada or South Dakota. Before we dive too deep into a discussion on asset protection trusts, it will be helpful to understand some key differences between revocable and irrevocable trusts.

Revocable Trusts vs. Irrevocable Trusts

A revocable trust is primarily a substitute document for your Last Will and Testament. What does that mean?  In New York, if you have a revocable trust that owns, for example, your membership interest in an LLC, your revocable trust dictates to whom those assets will be distributed when you pass away, not your Last Will and Testament.

The major difference between revocable and irrevocable trusts is that revocable trusts exist merely as will-substitutes, they do not provide any kind of asset protection. The right type of irrevocable trust can provide the ability to protect assets from creditors, divorce, the costs of nursing homes, and other long-term health care expenses.

Use of Irrevocable Trust for Asset Protection

In New York, we primarily use irrevocable, income-only trusts that provide an income right to the creator of the trust to protect assets titled to the trust.  In the example of your LLC owning real estate, we would assign your ownership interest in the LLC to the trust. If the real estate generates rental income, you are entitled to retain all of the income. The major restriction for this type of trust, and what makes it work as an asset protection vehicle, is that you cannot withdraw principal from the trust itself.

An example may be helpful to illustrate this principle. Let’s say you place your rental properties into an LLC and assign ownership of the LLC to an irrevocable, income-only trust.  You will receive all of the rental income generated from those properties. However, if you decide to sell one of the properties, you will not be able to withdraw the proceeds from the sale of the trust directly.  It is exactly that restriction that allows the trust to protect your assets from creditors in the first place.

The great thing about structuring ownership of your assets in this way, is that it not only protects your assets against your creditors and future creditors, but it potentially insulates them from your beneficiaries’ creditors as well.  Owning assets using this type of irrevocable, income-only trust would protect your assets in the event any of your beneficiaries goes through divorce, bankruptcy, has creditor issues or passes away before you.

Perhaps the best thing about using this type of trust is that you can retain control of the trust without giving up the right to manage the asset to someone else.  As long as you follow the rules of the trust, you can place your assets into the trust and continue to exercise managerial powers over the trust and the trust assets. This is a great option for clients not looking to give up control or total ownership of their assets just yet, but who recognize the need to protect the value of the assets from outside forces.

The combination of the LLC and irrevocable trust can work wonders to protect your real estate assets from both inside liability and outside liability. Through the proper structuring of these entities, you can achieve the best of both worlds, total protection, while maintaining full control. You will also be able to put a concrete plan in place now to pass ownership of these assets to your beneficiaries in a structured way in the future.