A frequently promoted “secret” of buying investment real estate with the intention of “turning around” ownership is, as usual, no secret at all. However, it’s worth reviewing here so you don’t end up in a relationship you don’t want. Many real estate investing aficionados promote the concept of buying real estate under the name of an organized legal entity rather than your own name. One of the purposes behind this structure is to facilitate the resale of the property. This goal is reportedly accomplished by selling the owning entity (LLC, Corporation, or Trust) and thereby also transferring the property you own without the traditional process of title search, title insurance, filings, etc. Sounds good, but is it really? I well understand the desire to make life easy for a buyer. However, there are elements involved in a typical “entity sale” that can make it problematic at best.
The first issue is the probable sale of the entity. Unless this is done correctly, the seller may be selling a security. Securities law is what governs people who sell securities. Stocks, bonds, and shares in an LLC are generally considered securities. In a case like the one we are discussing, the seller must comply with securities law. The penalties for breaking these laws are much more punitive than for violating most real estate laws. In addition to the securities ramifications, there are liability issues.
In order for all available real estate ownership benefits to be enjoyed by (transferred to) the owners must have personal liability for the debt. This means that the new owners will necessarily have to sign off on any underlying debt, assuming current lenders allow it, which is not a given. In addition, it will be difficult for sellers to obtain a release from lenders. It is important to note that this type of sale can still trigger an “expiration at sale” clause in the mortgage. This would allow the lender to claim 100% of the loan balance due and payable. Please read these clauses carefully.
There is also the issue of the entity’s operating liabilities. Simply put, if you buy an operating entity, you will inherit all of its operating liabilities. If the entity owes a debt when you buy it, you owe the debt. That’s true even if the debt isn’t directly related to the property you want to own. This may be the case with loans such as lines of credit, credit cards, and open accounts with vendors. In most cases it is difficult to know all the debts an entity owes, so if you buy an operating business, be careful to identify and document all the debts you take on and that the sellers indemnify you for any others.
As with many things in real estate, this concept comes across as a safe and easy-to-use tactic to facilitate business. In the real world, it usually isn’t. But, it is used with some degree of frequency. The reason you don’t hear more about this is that the parties involved usually never get to the point of litigating any of the issues. In most cases, according to Hoyle, things run their course. If money is earned, everyone is happy. If money is lost, most people take the hit and go on with their lives. However, just because you never get caught doesn’t make it okay to use this concept with impunity.
As with all elements in real estate, you have an obligation to be honest, open and direct with yourself and with those with whom you do business. You must understand as much as possible about a transaction and make your decisions wisely. If you are thinking of buying or selling an entity and therefore a property, be careful. The more you know the better. This tool is not as secure as some would have you believe, neither for the buyer nor for the seller. If we can help, we’d be happy to. Good luck.
