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Do You Have an Unlimited Liability Company?
By George M. Megaloudis
It's been a long time since I've run into an investor who did not maintain a
limited liability company for investing in pre-foreclosure properties. Even
the most novice investor typically has some sense of the benefits in
separating personal assets and activities from investment assets and
activities.
That said, it's been even longer since I have run into an investor who fully
appreciated why such a limited liability company was created, and who
understood the potential areas of liability for a pre-foreclosure investor.
How Limited Liability Companies Offer Protection
Let's begin by reviewing why limited liability companies are established in
the first place. Generally speaking, investors create these to shield
themselves from personal responsibility for their investment activities.
For this reason, investors use the name of the limited liability company
during all stages of the pre-foreclosure investment including negotiations,
purchase, re-model/hold period and finally re-sale of the property.
* Next 37 17 investors only!
The important thing to understand however, is that while this method is
better than investing as an individual, simply operating in the name of the
company doesn't solve all of the investor's liability problems. To receive
maximum benefit from the limited liability company established, an investor
needs to take all necessary precautions to separate her personal world from
the world of the company. Failure to do so will allow a crafty lawyer to
look to one's personal assets - rather than those of the limited liability
company - to collect a judgment.
Several quick examples of failing to adequately keep things separate
include: not having a written operating agreement; not setting up separate
bank accounts for the limited liability company and the investor; not
keeping consistent records for the limited liability company; and, the
limited liability company being consistently under-capitalized.
Step one therefore, for any pre-foreclosure investor is to make sure that
the limited liability company behaves as a separate entity, in addition to
being established as such.
Three Main Phases of Liability for Pre-Foreclosure Investors
As a pre-foreclosure investor, you are exposed to liability during each of
the three phases of your investment, each of which has its own peculiar set
of risks (detailed below). The good news is that most of those risks can be
mitigated by thinking the process through and by maintaining a proper
distinction between personal and company activities as described above.
- Phase One: The negotiation stage, and up until the time the investor
takes title to the property.
A fact of life in pre-foreclosure investing is that for one reason or
another, the numbers tend to change after the negotiations with the
homeowners end. Sometimes the investor and the homeowner are able to modify
their terms and reach agreement, while other times, they simply walk away
from each other. Unfortunately, regardless of the outcome, the
pre-foreclosure homeowner always feels slighted and as a result, may decide
to sue your limited liability company.
Remember, the homeowner in this situation is saddled with both selling his
home via unconventional means (i.e. to you), while also facing the monetary
and emotional burden of homelessness and loss of his biggest investment.
Under these circumstances, suing the investor is always an option. All of a
sudden the homeowner's lawyer liens the property. The lien can last for
months if not years and the profits on the deal are eaten away by the
carrying costs of the property.
If however, the investor used a corporation to negotiate the entire deal
with the homeowner and just prior to closing assigned the purchase contract
to a limited liability company controlled by the investor and then had the
homeowner deed the property to a limited liability company or another
limited liability vehicle, the problem mentioned above would be much more
easily averted.
- Phase Two: Holding the property, up until the property is re-sold.
During the holding period of the property of course, many things can go
wrong. A worker rehabbing the property can fall off a ladder, a real estate
broker showing the home can trip on the front steps, or any one of a
thousand other things can occur on the property that you now own.
Here too, the limited liability company offers protection. Provided you
keep the property insured and hold title to the property in the name of a
limited liability company, your personal assets would likely be safe (unless
you personally caused the problem). Furthermore, and for several reasons
that are beyond the scope of this article, under these circumstances the
former owner would have a harder time trying to place a lien on the
property. Again, good news for you.
- Phase Three: Following the sale of the investment property.
After you sell a property, you are almost home free. Yes, every so often a
buyer comes back to the seller and claims that the seller hid a property
defect or lied about the condition of the property, however such occurrences
are rare. Furthermore, since you sold the property out of your limited
liability entity, you've again got a degree of personal asset protection.
(Having an "as-is" or "inspection satisfaction" clause in your purchase and
sale agreement is an important tool in your arsenal as well.)
Keep in mind by the way, that even if you have a great lawyer, multiple
layers of limited liability entities, and more insurance than your insurance
agent is willing to sell, the best defense against an after-the-fact
disgruntled buyer is to make sure your hands are clean in the first place.
It is never in your best interest to misrepresent a property for sale.
In summary, a limited liability company offers much protection and is a must
have for the pre-foreclosure investor. Equally important to understand is
that the protection offered through the establishment of a limited liability
company is as much a function of the way you operate that entity (i.e.
separate from your personal assets and activities) as it is of the company's
creation in the first place.
George M. Megaloudis is an attorney and holds an of counsel position with
the Boston law firm of Roach and Wise, LLP. He is admitted to practice law
in both Massachusetts and Rhode Island and focuses a portion of his practice
on real estate transactions and limited liability entities. Contact George
at megaloudis@roachwise.com.
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