The New Way to Own Residential Real Estate Investments
The investor’s maxim is to always buy real estate investments in a Limited Liability Company (LLC). Using an LLC provides the dual advantages of shielding the investor’s non-investment assets from liability exposure, while also providing pass through taxation for the investor so such investor can be taxed as an individual, rather than double taxed as both a subchapter C Corporation and, then, as an individual upon receipt of income from such corporation. However, investors in residential real estate will be hard pressed to find a lender willing to extend credit to an LLC for the purchase of residential real estate investments, even with personal guarantees, and therefore the dual advantages of purchasing with an LLC are often functionally unavailable to residential real estate investors. Investors must often choose between leveraging financing in order to maximize returns or, alternatively, utilizing an LLC to insulate such investor’s non-investment assets from liability exposure.
This article explains why such choice is unnecessary, and investors can have the benefits of both financing and liability protection simultaneously. With proper structuring of a residential real estate investment, an investor can end run a lender’s illogical refusal to extend credit to an LLC by obtaining the requisite financing to purchase as an individual owner and, thereafter, such investor can ultimately rent the property to the end user by way of first leasing the property to an LLC as an intermediary master lease tenant (aka sublandlord) who will serve as the end user’s landlord. Most importantly, this ownership structure does not require lender approval or even lender knowledge.
The structuring of a residential real estate investment is necessarily complex because a linear transfer of ownership, post-funding, is functionally unavailable to an individual owner who purchased with a residential mortgage. In fact, a residential mortgage note’s due-on-sale clause would require lender approval for any such post-funding transfers and lenders rarely, if ever, grant such approval. A due-on-sale clause is a specific type of acceleration clause, which gives the lender the contractual option to demand full payment of the entire remaining loan balance when any interest in the property is transferred or sold without the lender’s prior approval. A typical due-on-sale clause reads as follows:
If all or any part of the property herein is transferred without the lender’s prior written consent, the lender may require all sums secured hereby immediately due and payable.
However, a federal law called the Garn–St. Germaine Act, preempts certain enumerated due-on-sale transfers on “residential property containing less than five dwelling units” and provides a path forward to optimally structure a residential real estate investment. Unfortunately, the federal law does not preempt the due-on-sale clause for an outright linear transfer of ownership. Consequently, landlord’s legal counsel must creatively leverage the Garn–St. Germaine Act, while structuring the investment, in order to obtain the benefits of an outright transfer of ownership to an LLC without actually transferring such ownership outright to an LLC. The solution is found in the fact that the federal law preempts due-on-sale triggers concerning “the granting of a leasehold interest of three years or less not containing an option to purchase.” Consequently, the individual owner can lease the property to such individual’s wholly owned master lease LLC for a period of three years without risk of such action triggering the due-on-sale clause in the mortgage note. Thereafter, the due-on-sale clause would also not prevent the master lease LLC from subleasing the same property to the subtenant end user (aka ultimate tenant). Under this structure, the individual owner can have an LLC serve as the landlord (here, as the sublandlord) while concurrently obtaining financing for investments in residential real estate as an individual owner.
Yet, this lease structure, without more, only enables the individual owner to end run seeking investor approval, but it does not shield the investor from personal liability exposure. Shielding the individual investor from personal liability exposure requires further creativity in drafting the lease between the individual owner and the master lease LLC tenant. The key to this lease draftsmanship is to limit the individual owner’s rights and duties in the lease so that such individual owner is defined as an out-of-possession landlord under the precedent found in New York State case law.
Ordinarily, a landlord is exposed to personal liability for injuries and other wrongs on such landlord’s property. But, according to case law, an out-of-possession landlord “owes no duty to maintain and make repairs upon demised premises unless it retains control of the property or is contractually obligated to perform such maintenance and repairs.” Not only is an out-of-possession landlord excused from common law exposure to liability, such a landlord is also excused for statutory exposure to liability. To illustrate, the Multiple Dwelling Law (MDL) renders an “owner” of certain residential real estate statutorily liable for failing to maintain the property “in good repair.”
However, case law has held that an out-of-possession landlord is not defined as the “owner” under the statute. This is because the term “owner” is defined as “the one in possession and control, exercising the usual functions of an owner,” not necessarily “the owner of the fee.” Consequently, an out-of-possession landlord can be shielded from liability arising both under statute and common law through creative draftsmanship of the leases, including draftsmanship of the lease between the individual owner and the master lease LLC tenant, and then, the lease between the master lease LLC tenant and the subtenant end user. In drafting the respective lease agreements, the master lease LLC tenant, but never the individual owner, can have express rights of access and duties to make repairs to the property. As a result, the master lease LLC tenant will be protected from statutory liability, such as the liability set forth in the MDL, because the individual owner will not be the “owner” under the statutory scheme and will be an out-of-possession landlord under the common law. Consequently, the individual owner is shielded from personal liability exposure, by way of leasing the property to a master lease LLC tenant, in a similar vein as if the owner had purchased the property through an LLC in the first instance while avoiding the need for lender approval.
Investors of residential real estate benefit from utilizing an LLC; albeit, not purchasing with an LLC. Apparent barriers only require creative structuring to overcome. As set forth above, creatively structuring the ownership, where the individual owner obtains the benefits of LLC ownership through leasing the property to a master lease LLC tenant who, in turn, leases the property to a subtenant end user, but never transfers ownership that would trigger a due-on-sale clause, is the best practice to structure investments in residential real estate.
Andrew M. Lieb, Esq., MPH, is the managing attorney of Lieb at Law P.C. and is a contributing writer for Behind the Hedges.
No legal advice is provided in this article, which is for informational purposes only. Before utilizing the information set forth in this article, the user should consult with an independent attorney.