This is Part Two of a Two-Part Article on Land Trusts
Just Use What the Law Already Provides
There is really no substitute to a properly formed and maintained limited liability entity. Whether you choose to form a limited liability company, a corporation, a limited partnership, or a limited liability partnership as part of your asset protection planning, one of those entities should be part of your overall business plan. Trusts are merely optional, not necessary. Which entity is right for you depends on several factors. Principally, which form of limited liability entity to use depends on tax considerations, your investment goals, the number of investors in your operation and your estate planning goals.
Using both land trusts and limited liability entities may be the best of both worlds, and will be a good choice for almost all landlords and investors. Although there are always exceptions to these general rules, using a land trust alone as a means of limiting your liability and protecting your assets is never a good option, because it simply does not work. . . at least not in Indiana. In short, land trusts are overrated as a business and asset protection planning tool, and should be limited in their use to providing limited anonymity.
Land Trusts As A Means To Avoid Your “Due-On-Sale” Clause
There is an old claim that land trusts can be used as a means of avoiding the “Due On Sale” clause in the mortgage a borrower gives to a lender.
Before I explain how this “scheme” works, I should give some background information. First, a “Due-On-Sale” clause is a contractual provision in a note or mortgage that authorizes a lender, at its option, to declare due and payable all sums secured by the mortgage, whenever there is a transfer of the borrower’s interests in the mortgaged real estate, without the lender’s prior written consent. Most lenders require a “smaller” investor (i.e., someone who is not Donald Trump) to borrow monies in the borrower’s own name (i.e., John P. Smith), as opposed to the borrower’s limited liability entity (i.e., Smith Properties, LLC). Similarly, the lender requires the real estate’s title and the mortgage to be in the borrower’s own name, rather than in the name of the borrower’s limited liability entity. In order to take full advantage of the limited liability afforded through the use of corporations, limited liability companies, limited liability partnerships, etc., investors borrow money in their own names and grant the mortgage in their own names, and then later transfer title to a limited liability entity. That transfer may “trigger” the “Due On Sale” clause, allowing the lender to foreclose.
In nearly 30 years representing real estate investors, this author has only once witnessed a bank foreclosing on an investment property, simply because the borrower transferred title to the borrower’s corporation or LLC. That only occured because the borrower-investor called the mortgage lender and told he what he had done.
Banks want to be timely paid, and they want to avoid litigation. If a bank is getting timely loan payments, most banks show little interest in foreclosing on a good paying customer. Moreover, unless the lender has a reason to order a title search, the lender never learns about the deed transferring title of the real estate to the borrower’s corporation or LLC. Additionally, the lender’s security position is not affected by the deed transferring title of the real estate from the borrower to the borrower’s corporation or LLC. A first mortgagee-lender retains its superior priority to the borrower’s corporation or LLC. And, the borrower is still personally liable under the note.
So, why and how would an investor use a land trust to avoid the “Due On Sale” clause in the borrower’s mortgage?
Here’s the “scheme.” Under federal law, lenders cannot enforce a “Due On Sale” clause in certain types of, but not all, loans secured by mortgage on residential real property containing less than five dwelling units, if the “triggering” transfer satisfies one of several criteria. In other words, the “Due On Sale” clause in certain types of loans are unenforceable by a lender, under any one of these several statutory circumstances. One transfer which, under federal law, does not “trigger” the “Due On Sale” clause, is a transfer into an inter-vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property. The theory under this “scheme” is that a transfer to a land trust looks like a transfer into an inter-vivos trust in which the borrower is and remains a beneficiary and which does not relate to a transfer of rights of occupancy in the property. That might be true, if the borrower merely transfers title of real estate to an inter-vivos trust, and the borrower is the sole beneficiary of the trust. However, most real estate investors want asset protection and limited liability. And so, those investors who use land trusts (for anonymity purposes) ordinarily designate their corporation or limited liability company as the beneficiary of the trust, which fails the test described above. If the beneficiary of the trust is a corporation or limited liability company, or anyone other than the borrower, then the “Due On Sale” clause could be enforced.
Most investors would rather have limited liability through the use of a corporation or limited liability company, and are willing to bet that their lender will not foreclose on their mortgage on the slim chance that the lender ever discovers or cares about the borrower’s wise use of a limited liability entity. This author has even witnessed title companies, serving as agents for the lender, record first the mortgage and then the deed transferring title from the borrower to the borrower’s limited liability entity, as part of the loan closing! Banks are not (always) stupid. Banks are aware of the need for their investor-borrowers to protect personal assets and limit liability.
Is it a “triggering” event for an investor to transfer title to a limited liability entity in violation of the “Due On Sale” clause? Probably in most cases.
Do banks care, discover the transfer or act on it? This author has not seen it once, once only then because the investors called and alerted the bank to the transfer.
Avoiding Foreclosure Laws
There is another horrible suggestion by “legal gurus” selling land trust forms that a land trust will enable an investor to sell the beneficiary interests of a land trust on contract, as a substitute for a land contract, and thereby avoid the time-consuming and expensive mortgage foreclosure process. Firstly, it is a hard sale to convince a buyer that the buyer is purchasing a home by purchasing the beneficial interests of a land trust. Try listing that deal on the MLS. Good luck.
I have litigated real estate matters for 30 years. I assure every reader that most, and probably every, judge in Indiana will treat an installment of the beneficiary interests of a land trust as the purchase of real property subject to the equitable powers of the court. I seriously doubt that many courts will allow forfeiture or ejectment of a “land contract” purchaser, who is purchasing the beneficiary interests of a land trust. That transaction will be recharacterized by the courts as a land contract, and thus subject to the mortgage foreclosure statutes.
A land trust is not an inter-vivos (living) or testamentary trust. A land trust does not serve the same purposes of a true estate planning trust. Land trust are typically shorter, address a single parcel of real property, and do not contemplate all of the complexity of a standard inter-vivos (living) or testamentary trust. It is just bad planning to use a land trust as an important part of an estate plan. The proper approach is to use a last will with a testamentary trust or a living trust as your estate planning tools.
What State Law Applies?
As a final note, please remember that trust documents, leases, lease applications and other forms may be lawful in Georgia or Ohio or Florida or other states, but somehow violative of Indiana law. Your legal documents should conform to state and local law, and it is always dangerous to use a generic form marketed and sold to real estate investors all across the country. No single form fits every landlord, every investor or every property, and that is particularly true when using forms drafted or used in other states governed by other laws. Find a lawyer who understands