Real Estate Investment

Real estate investors like to concentrate their efforts on profitable acquisitions and positive cash flow operations. It is also important, however, to protect against liabilities. Even though real estate investment is generally a "passive" activity, accidents and injuries raise the issue of liability. Owners of real estate investments can protect their assets from these potential claims by having adequate insurance in place and by forming a legal entity to hold title to the property to separate the investor from the liabilities of the property.

Types of Legal Entities
History of Business Trusts
Forming and Maintaining a Business Trust

Types of Legal Entities

An investor has several options for the structure of the legal entity that holds the real estate, including limited liability companies, corporations, and business trusts. A limited liability company ("LLC") gives liability protection and is easy to form and maintain. A corporation provides liability protection like an LLC, but is not typically used to hold real estate because of unfavorable tax consequences. In either case, if an injury occurs, the victim's recourse is against the entity, rather than the investor, provided the entity follows the proper formalities.

Disadvantages of a Single LLC

Many investors choose to own their real estate investments in an LLC. However, if the investor owns multiple properties, liability protection can be more complicated.

Example: Investor owns three rental houses and transfers them all to his newly formed single member (wholly-owned) LLC. His tenant's guest is injured at house A, wins a lawsuit and obtains a judgment against the LLC. The guest records his judgment as liens against houses A, B and C. Under this scenario, until Investor clears the liens, he cannot sell house B or C and give clear title to the buyer.

Multiple LLCs

One solution to the problem in the example is to form separate, individual LLCs to hold each property. However, this solution can get expensive and unwieldy when investors own more than 3 or 4 properties. A common compromise is to hold no more than 3 properties in each LLC. While this does protect some of the Investor's real estate and assets, the other 2 properties in the LLC are still potentially at risk.

Virginia Business Trust

On October 1, 2003 the Virginia Business Trust Act became effective. This entity, though technically a "trust," resembles a corporation or LLC, and should not be confused with living or testamentary trusts that may be used in your estate plan. A business trust offers liability protection, like a corporation or LLC, and has the advantage of being extremely flexible. The law will give great deference to the governing instrument of the trust (the statute gives maximum effect to the principle of freedom of contract), so virtually anything that can be done using the corporate form can be accomplished with a business trust.

A business trust can include separate and distinct "series" or "classes" of ownership interest. Each series is like a sub-trust within the trust. Each holds the separate assets and liabilities assigned to that series. The key advantage of this structure is that liability is "quarantined" from the assets in the other series and from the trust as a whole. This means that any claims that arise from the ownership of an individual property cannot normally be satisfied from assets outside that series. Properly structured, a single legal entity holds multiple properties, each protected from liability as though it were held in its own entity.

History of Business Trusts

Massachusetts allowed the first business trusts in the early 1900s largely because corporations could not own real estate at that time. Delaware enacted a business trust law in 1988. Twenty-nine states now have business trust statutes. Many mutual funds operate as business trusts, as do many real estate investment trusts ("REITs").

"Series entities" like the Virginia Business trust are becoming more popular, and have been authorized by several states. For example, Nevada allows series to be formed in a Nevada LLC.

Forming and Maintaining a Business Trust

To form a Virginia Business Trust, Articles of Trust are filed with the SCC and a "Governing Instrument" (the contract that controls the trust) is drafted, as required by law. The trust is governed by "Trustees" who are similar to the board of directors of a corporation. The owners of a business trust are called "Beneficial Owners," and are like shareholders.

The Governing Instrument can create a separate series for each piece of real estate owned by the trust. This provides liability protection between each piece of property owned by the Business Trust.

The business trust must keep records of minutes of meetings of owners and all correspondence with owners. Also, under the statute, it is essential to keep separate books and records for each series. The Governing Instrument must specifically authorize the formation of separate series.

Like an LLC, a business trust can elect its tax treatment. A trust with a single owner can be taxed like any other real estate investment, and reported on the owner's individual Form 1040. If there are multiple owners, the trust will likely be taxed as a partnership. In either case, there is no requirement that each individual series be reported separately on the owners' tax return(s); but again, don't forget the state law requirement to keep separate books and records for each series.

The Virginia business trust can be a very effective way for investors in multiple real estate properties to obtain a high degree of liability protection while minimizing the administrative burden of forming and maintaining multiple entities.