In California, the preferred method for holding investment interests in real estate is through the use of an LLC because this form of ownership shields the owner of the LLC from personal liability and also provides the owner with pass-through tax treatment. This tax treatment means that the owner of the LLC is taxed only as an individual, and the LLC does not pay any corporate tax.
The LLC structure is not easy to use for investors in residential real estate because most lenders will not lend money to an LLC for the purchase of residential real estate. Unfortunately, the terms of most mortgages contain a “due on sale” clause, which means that if the investor obtains a mortgage to purchase residential real estate and subsequently transfers that property to their LLC, the loan will become immediately due and payable in full.
Real estate investors and their attorneys have found a way around this problem by creating a tiered leasing structure. The investor purchases the property in their name and then leases the property to the LLC via a master lease. The LLC, in turn, leases the property to the ultimate tenant. This master lease structure can be affected without any approval from the lender, and it won’t trigger the “due on sale” clause. Unfortunately, this master lease arrangement only helps with the tax treatment of the investment. It does not shield the investor from personal liability. However, careful drafting of the contract terms in the master lease so that the investor will be considered an “out of possession landlord” should shield the investor from personal liability.
Investing in real estate can be interesting and profitable, however, investors need to make sure that their investments are made in such a way as to limit their personal exposure and their tax liability. An attorney with a thorough knowledge of tax and real estate laws and experience in structuring a wide array of real estate investments can be an important advisor for real estate investors.