Forming an LLC to Purchase Real Estate

Limited liability companies (“LLCs”) are the entity of choice for most transactions involving the purchase and/or development of real estate.  There are many situations in which another entity may be used, as, for instance, when a company owns various assets, only one of which is real estate. Still, LLCs predominate. In this document we will discuss the reasons why LLCs work so well, the alternatives to their use, the types of LLC management structures, and other considerations affecting the use of LLCs for real estate transactions, such as asset protection considerations, environmental laws, and insurance coverage.

Forming an LLC to Purchase Real Estate Overview

Ownership of real property is a risky There are many ways in which users of real property can become injured, from tenants falling down stairs or being poisoned by pollutants oozing from the ground or walls, to children being injured by construction equipment, to an entire building collapsing from natural forces (hurricane) or faulty construction. Landowners almost always become defendants in lawsuits claiming damages from use of their property.

Because of the inherent risks of owning real property, owners limit that risk by holding the property in entities, such as LLCs, rather than in their personal names. Most entities, such as LLCs and corporations, provide some protection from liability to owners, although general partnerships provide less than others. The general rule for general partnerships is that a creditor can recover from the assets of partners once the assets of the partnership itself are exhausted.

With properly formed and maintained LLCs and corporations, the creditor can collect against the assets of the LLC or corporation, but not against the assets of the individual members of the LLC or shareholders of the corporation. In addition, LLCs offer additional protection, in that most state statutes provide that, if a creditor obtains a judgment against a member of an LLC, all he will obtain is a “charging order,” i.e., the ability to receive the percentage of profits allocated to that member. Since members and their managers determine how profits are allocated, the members can limit or thwart a creditor obtaining funds. In addition to forming an LLC as a basic form of asset protection, owners can increase that protection by taking the following steps:

1. Use Single Purpose A single purpose entity is an LLC or other legal entity organized for the express purpose of holding a single real estate asset. The purpose of single purpose entities is to lessen the likelihood that insolvencies or other negative circumstances of other assets held by the same or different owners will affect the assets held in the single purpose entity.  For instance, if an owner holds two office buildings in two different LLCs, and one faces a natural disaster, the creditors of the first LLC may not have the ability to foreclose on the office building held by the second LLC. Of course, an owner’s goals, in using single purpose entities, can be foiled by the owner cross-collateralizing the assets owned by both LLCs, or by giving personal guarantees on the loans affecting both properties. Lenders usually require that real estate projects be placed in single purpose entities because there is asset protection for the lender, as well as the owner, in that type of structure.
2. Seek Limitations on Guarantees. Each time an owner gives a guarantee, he/it is diminishing the owner’s asset protection, since a guarantee gives a creditor access to the owner’s personal assets to cover the real estate Some lenders are willing to place exclusions or time limits on guarantees, such as releasing the guarantee if the property is sold to a qualified buyer, or releasing the guarantee if payments are made under the loan for a certain period of time. Sometimes, the lender can be convinced to take guarantees from only some of the owners, such as owners holding above a certain percentage interest in the property.
3. Consider Use of Particular State’s Law. Many LLCs created for the purpose of holding real estate are created under Delaware The advantages of Delaware law include flexibility as to the terms of the operating agreement, increased asset protection against creditors (a creditor cannot acquire any portion of the LLC’s assets if a judgment is filed against a member), a statutory limitation on member personal liability (member loss limited to dollar amount invested in the LLC), no meeting or voting requirements, and an inclusive privacy policy (no owner information needs to be disclosed to the state of Delaware in order to form or maintain an LLC). Real estate owners should weigh the advantages of creating entities under Delaware law with the additional costs and administrative burden of creating and maintaining a company in a foreign state.
4. Hold Adequate Insurance. As in other business transactions, obtaining adequate, or even extensive insurance can protect an owner from liability in the event of casualty damage. If indemnities are included in loan documents or other business contracts, the owner should make sure that insurance covers the indemnity covenants. A good procedure is for the owner to provide its insurance agent with a copy of the insurance provisions of any contract it is entering into, as well as indemnity provisions, to make sure that coverage is available.
5. Carefully Draft the Operating Specifying duties and liabilities in the LLC Operating Agreement will also give protection to bother members and managers.

Questions? Call (305) 921-0440 or Romy@jflawfirm.com

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