An oft promoted “secret” of buying investment real estate with the intent of “flipping” the property is, as usual, no secret at all. It is however well worth reviewing here so you don’t end up in a relationship that you don’t want. Many real estate investment aficionados promote the concept of buying real estate under the name of an organized legal entity instead of their own name. One purpose behind this structure is to facilitate easy re-selling of the property. This goal is reportedly accomplished by selling the ownership entity (LLC, Corporation, or Trust) and thus transferring the property it owns as well without the traditional process of title searches, title insurance, filings, etc. It sounds good, but is it really? I understand well the desire to make life easy for a buyer. However, there are elements involved in a typical “entity sale” that may make it problematic at best.
The first issue is the probable sale of the entity. Unless this is done correctly, the seller may in fact be selling a security. Securities law is what governs people who sell securities. Stocks, bonds, and shares in a LLC are all generally considered securities. In a case like we are discussing, the seller must comply with securities law. The penalties for breach of these laws are far more punitive than for breaking most real estate laws. In addition to the securities ramifications, there are liability issues.
For all available real estate ownership benefits to be enjoyed by (passed through to) the owners they must have personal liability for the debt. This means that the new owners will of necessity need to sign on any underlying debt, assuming that the current lenders will allow it, which is no way a given. In addition, it will be difficult for the sellers to get a release from the lenders. It is important to note that this type of a sale may well still trigger a “due-on-sale” clause in the mortgage. This would allow the lender to call 100% of the loan balance due and payable. Read these clauses carefully.
There is also the issue of entity 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 is true even if the debt doesn’t pertain directly to the property you want to own. This may be the case for loans like lines of credit, credit cards and open accounts with vendors. In most cases it is difficult to learn of all the debts owed by an entity, and therefore, if you buy an operating company, be careful to identify and document all the debts you assume and have the sellers indemnify you against any others.
As with many things in real estate, this concept is presented as a safe, secure and easily used tactic to facilitate the business. In the real world, it typically is not. But, it is used with some degree of frequency. The reason you don’t hear more about it is that the parties involved usually never get to the point of litigating any of the issues. In most cases things just go along according to Hoyle. If money is made then everybody is happy. If money is lost then most people take the hit and get on with life. The fact that you may never be caught however does not make it all right to use this concept with impunity.
As with all elements in real estate, you have an obligation to yourself and to those you do business with to be honest, open and upfront. You need to understand everything possible about a transaction and make your decisions wisely. If you’re thinking about buying or selling an entity, and thereby a property, be careful. The more you know the better. This tool is not as safe as some would have you believe, for either the buyer or seller. If we can help, we’d be glad to. Good luck.