Regardless of the value or use of your real estate investment property, insurance is always the first line of defense in protecting your assets once you have made an investment. Insurance is an effective tool to leverage against inside liability considerations. Determining the level and type of insurance that best suits your investment depends on the scale, use, location and type of real estate you have invested in. A rental property, for instance, will likely need a greater spread of insurance than a private vacation home owned by your family. For any property, it is essential to have hazard and fire insurance, liability insurance and sewer backup insurance. With those essentials in place, your additional insurance needs may be determined by your specific situation. Builder’s risk insurance may be necessary if you are planning on larger renovations or upgrades to a location. Loss of income insurance is important for investors who own rental real estate, but is not appropriate for family homes that are not generating revenue. Workers’ compensation insurance if you hire employees to work for your real estate investment business. Lastly, umbrella insurance is an excellent option to create greater protection against liability.
Complications of Prop 13
In California, Proposition 13 creates a fairly significant complication in the asset protection options available to real estate investors. Proposition 13—officially known as the People’s Initiative to Limit Property Taxation—was established in the late 1970’s in reaction to growing property taxes. The purpose of the proposition is to limit property taxes to manageable levels by maintaining real estate taxes between 1% and 2% of the cash value at the time of a change in ownership. So, when you purchase a house, the property tax is set and stays fixed. Any transfer in title or ownership, or any new construction, resets the taxed value of the real estate property up to the current, market value and the new market value will then be taxed at 1% and not to exceed 2%. New construction or additions to a property may or may not be reflected as a Prop 13 reset and will be determined on a case by case basis.
Generally, the guideline for protecting assets against judgements or lawsuits is to contain liability by creating some form of title transfer. The idea is that if an asset is titled under some other name, the liability associated with the asset will only affect the name of the titler and any outside liability will be safeguarded against. Unfortunately, this method will also trigger the retitle stipulations of Prop 13, thereby increasing estate taxes to market value. For example, if you are looking to retitle a vacation home that has been in the family for 40 years for protection under an LLC that is owned by you and your brother, the transfer of title will cause the taxable value of the house to update to the current market value, thereby increasing your taxes from a 1% cap on the 1979 value to a 1% tax on the 2019 value.
To navigate California law specifically, real estate investors must both find a way to contain liability without losing the benefits of Prop 13.
LLC’s and FLP’s
Limited liability companies (LLCs) and family limited partnerships (FLPs) are excellent protective tools for assets, but need to be carefully considered and utilized to work with Prop 13 restraints. Using this business entity without reinstating a title in another name requires that the property be owned in the same proportions and by the same owners as the LLC or FLP. California law will recognize the same ownership of property in the event of this transfer and Prop 13 will be upheld at the original tax rate on the original value of the real property. Any change in LLC ownership, however, will trigger the reevaluation of the property value and taxable amount.
While LLCs and FLPs can be challenging to navigate if the ownership does not align with the property proprietor, they offer excellent protection against lawsuits and judgements.
Private Retirement Plan (PRP)
To facilitate a long-term plan of protection for real estate, private retirement plans can be an important step after the use of an LLC. A private retirement plan or PRP is a unique alternative available to California residents. This type of trust is particularly interesting as an option for real estate protection because, unlike general IRA accounts, these accounts have no cap and few restrictions, as long as the assets residing in the trust are designated for retirement. This is also an extremely attractive option because it provides extensive protection against potential lawsuits and judgements. By clearly delineating beneficiaries, this type of trust can avoid the prop 13 criteria regarding non-exempt beneficiaries, while maintaining a safeguard against lawsuits and judgements, even in the event of bankruptcy.
It is important to note that in order for assets contributed to a PRP to be protected, they must be designated solely for use in retirement. This is a very strict requirement. If assets are not intended for use in retirement, they will be subject to seizure by creditors and court judgments. It is wise to work closely with a financial advisor and/or attorney to make sure your PRP is created and maintained properly.
Revocable vs. Irrevocable Trusts
Trusts are generally an excellent way to protect assets and different trusts create different levels of protection for assets. Two common forms of trusts include revocable and irrevocable trusts, the former being a Prop 13 friendly option. A revocable trust redeeds assets to the trust and can be dissolved within the lifetime of the grantor. Because a revocable trust can be disassembled in this manner, it does not ultimately protect against creditors and does not maintain the level of protection afforded by alternative choices. Revocable trusts, however, are exempt from Prop 13 stipulations and any assets placed in the trust will maintain the original owner’s tax rate.
Irrevocable trusts are unique in that they cannot be dissolved within the lifetime of the grantor. Like a revocable trust, assets are redeeded to the trust itself. Irrevocable trusts provide greater protection against creditors and liability, and are therefore a safer option for assets, but unfortunately, due to the stronger boundaries and separation afforded by these trusts, they are also subject to Prop 13 stipulations and will not maintain an owner’s tax rate. For this reason, it is important to consider which type of trust is better suited to your assets.
Personal Residence Trust
Another potential option for California residents is a personal residence trust. This trust can be designed to maintain ownership of an estate, thereby protecting from Prop 13 tax complications, while also imposing restrictions on the asset, which guarantees some level of liability protection. These trusts are generally most beneficial to family asset planning strategies that are incorporating long-term visions for title transfers to future generations. To avoid taxation appreciation through Prop 13, a PRT can name the asset as a gift to future family beneficiaries while granting the use and control of the property to its current grantor. This specific design is referred to as a Qualified Personal Residence Trust or “QPRT” and is a reasonable option for private residence estates that have appreciated and are currently titled to a family member.
Ultimately, safeguarding an asset will require a consideration of potential cost against potential risk, especially for investors in the State of California. While there are some easy ways to protect assets, like insurance and LLCs, other more robust options like trusts will require more contemplation. If you are in the planning period for the purchase of a real estate investment, placing the title of the property in a protective entity from the onset of your investment may be the smoothest and best option for a long-term plan. However, while distancing oneself from an asset is the safest way to protect and contain liability issues, this method may be complicated by tax considerations and a less protective path may be worth the risk due to the financially benefits they afford.
To determine the best planning strategy to protect your real estate investments, contact our experienced and knowledgeable team of financial advisors for a consultation today.
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Mr. Bowman is a Partner with Anderson Law Group in the firm’s Las Vegas office. He received his Bachelor of Science degree in business from Arizona State University. After spending five years in the computer industry, Mr. Bowman received his Juris Doctor from Seattle University School of Law and is licensed to practice in multiple states. His experience includes commercial and civil litigation, construction defect law, complex real estate transactions, and business law.