By George M. Megaloudis
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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.
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.
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.
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.
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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