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Despite benefits, not all states recognize setup

Benny Kass
Inman News

DEAR BENNY: I read with interest what you wrote about putting rental properties in LLCs. What can you tell me about the new series LLCs for real estate investors? It appears they can be formed only in certain states, but would they be recognized in all states? --Elizabeth

DEAR ELIZABETH: The "series LLC" is a new, untested concept. Oversimplified, it is a "master" limited liability company, composed of two or more limited liability companies.

I have always recommended that real estate investors put their property into an LLC. But if you own two properties, each should be titled in the name of a separate LLC. Why? Because if a tenant in one of your properties decides to sue you -- and you do not have adequate insurance coverage, or if the lawsuit is based on a matter that is excluded from your coverage -- you could lose all of the assets in that LLC. So if you have two properties in the same LLC, both properties could be sold to satisfy any judgment against you.

On the other hand, if you have only one property in the LLC, the court -- and the creditors -- cannot go after those other properties. Of course, if you do not carefully follow all of the LLC rules (i.e., commingle funds, or sign legal documents in your name and not as "manager" or "member" of the LLC), then you potentially are exposing all of your assets.

Enter the series LLC. The concept began in Delaware, and to my knowledge, only seven other states currently allow the creation of such a legal entity. Those states are Illinois, Iowa, Nevada, Oklahoma, Tennessee, Utah and Texas.

In a series LLC, although each separate LLC (often referred to as "cells") can have separate assets, different members and managers, the series (or master) pays only one filing fee and files only one income tax return.

While this column cannot provide a complete summary of the pros and cons to this concept, you can get a lot more information on the Internet by searching for "series LLCs." But the most important questions are:

1. Will a state that does not authorize the series allow an entity that is legally formed in another state to be recognized and authorized to do business in that state? Recently, California has said "yes." However, California is still going to require filing fees and taxes to be paid by each of the various cells in that master.

2. Is it absolutely certain that the assets of each cell are individually protected in the event of a lawsuit against one of the individual LLCs? Recently, the American Bar Association issued a report questioning the viability of this entity. One of the ABA's concerns is whether the so-called "internal liability shield" would be recognized in those states that have not formally authorized series LLCs.

This is a new animal, and while intriguing, leaves a lot of questions unanswered. If you are an investor, discuss your situation with your attorney and your financial advisors before going down this uncertain path.

DEAR BENNY: I live in a duplex that has recently been listed as a short sale. Since it appears that my landlord has not been making the mortgage payments, what should I do with my rent payments? I have not been contacted by the landlord or the listing agent, so I'm not sure what I should do. Any suggestions? --Chris

DEAR CHRIS: I know it is tempting not to pay your monthly rent, but even though your landlord is not paying his mortgage (or at least that is what you suspect) and even though the property is being considered for a short sale, your landlord is still your landlord.

You are living in the apartment, and are legally obligated to pay your rent. What the landlord does with your money is his business.

More importantly, if the short sale does not happen, and the lender decides to foreclose on the property, there is a new law that can protect you. Congress passed the "Protecting Tenants at Foreclosure Act," which became effective on May 20, 2009. According to the law, a "bona fide" tenant in a foreclosed property has the absolute right to remain in the house for a minimum of 90 days. Note that if your state law provides a longer period of time, state law will apply.

But in my opinion, if you are not paying your rent, you may not be considered a "bona fide" tenant and may not be able to take advantage of this new law.

DEAR BENNY: We have a rental home and would like to exchange it for a rental home in another part of the state. What length of time does the new house have to be rented before we could move into it? My husband's mother (age 90) who is still living independently in another state will be moving in with us when we make the move. She is getting frailer and needs to move to a place without stairs. I need a knee replacement and also need a house without stairs, and the new property meets our needs. Do these medical problems affect the timing? --Kathy

DEAR KATHY: I am afraid that these medical issues are not relevant in an exchange. The current property is called the relinquished property and the new one is called the replacement property. Section 1031 of the Internal Revenue Code allows taxpayers to exchange one investment property for another. If done correctly, any capital gains tax that would normally have been paid when the relinquished house was sold is deferred to a future time. The technical term is that the tax basis of the relinquished property becomes the basis of the replacement property. This is known as a "like-kind" or "Starker" exchange.