Clients who own or who are purchasing real estate often have concerns about the liabilities associated with investment real estate ownership. And with good cause. There are occasionally some very large judgments against property owners arising out of injury or death to tenants or their guests or invitees.

I should clarify that the liabilities discussed in this article are tort liabilities rather than contract liabilities; liabilities which result from some form or injury to a person rather than liabilities which result from a default under a contract such as a mortgage.

Most of the large settlements or jury awards against property owners for injury to a person are arise out of a legal body of law referred to generally as “premises liability”. Recoveries based upon premises liability hold a land owner responsible for injuries which occur on the land owner’s property.

Judgments or settlements can involve millions of dollars. It is difficult or impossible to cover premises liability risks with liability insurance. Often liability policies insuring property owners against premises liability risks have large gaps in coverage and do not provide enough monetary coverage.

For the reasons outlined above, I am often approached by clients to help insulate them from the risks associated with owning real estate. It is not possible, in any article such as this one, to address this subject in depth. However, I will discuss some of the basic pro-active steps a property owner may take to protect assets from potential creditors. A word of caution. Any attempt to protect assets from creditors must be initiated prior to the act creating liability. After the injury for which liability may arise has occurred and certainly after a suit is filed, it is usually too late to initiate action to protect assets from the claim.

There are some basic asset protection steps which anyone can and should take to protect assets from third party claims. These are, for the most part, non-invasive and free or very inexpensive. Most of the initial or basic asset protection techniques involve taking advantage of the laws which protect certain assets from creditor claims. The most well known of these laws in Texas is the homestead exemption.

By purchasing a home and paying cash or quickly paying down the debt, you can protect the cash invested in your home from all creditors other than the mortgage holder on your home, unpaid property tax on the home, and federal government claims (such as income tax liability).

Other less well known exemption laws protect funds held in IRAs, 401K plans as well as pension plans. Cash value of life insurance is also protected. Any one desiring to protect assets from creditor claims should maximize contributions to retirement and pension accounts.

If you are married, the second level of asset protection usually involves partitioning your community property into separate property. All property acquired during marriage is presumed to be community property. Community property is owned equally by both marriage partners. Community property, including the interest of both spouses in community property, may be taken by a judgment creditor of either spouse. Separate property may be taken only to satisfy the claims against the spouse owning the separate property. Thus by partitioning or dividing community property into separate property, one half of the property of a marriage may be excluded from the claims against one of the marriage partners.

While partitioning property does not change the percentage ownership of property (each party will still own one-half of the partitioned property) it may have estate tax ramifications and could have negative benefits in the event of divorce.

After maximizing use of exemptions and partitioning community property, the next level of asset protection usually involves the creation of entities to contain liability within an entity or protect other assets from creditor claims by placing those assets within an entity created for that purpose.

The issues involved determining whether this is a feasible approach and in selecting the type of entity can be very complex. Generally, there are four entity choices to choose from; corporations, limited liability companies, general partnerships and limited partnerships.

The general partnership can usually be immediately eliminated since all of the partners of the partnership are fully liable for any injuries arising out of real estate owned by the partnership. It provides no protection at all.

Corporations provide a liability shield but are usually not good choices to hold title to real estate, primarily because of negative federal income tax treatment. You should never form any entity to hold title to real estate without consulting your accountant to fully understand the tax consequences and you should certainly never form a corporation to hold title to your real estate without fully understanding the federal income tax consequences including the potential for double taxation when you attempt to extract cash from the corporation after the sale of real estate.

Limited liability companies are a good choice to hold title to real estate from a federal income tax perspective. You can elect to have the limited liability company taxed as a partnership, thus eliminating the negative federal income tax problems, while still retaining a shield, similar to the shield provided by a corporation, against claims arising out of property owned by the limited liability company.

Limited partnerships provide substantial benefits for owning and managing real estate, especially for larger projects. Provided it is properly established, it can provide a shield from claims arising from property held in the partnership, it is taxed as a partnership from a federal income tax perspective and does not risk double taxation. The primary negative of the limited partnership is that it is more expensive to create and maintain than a limited liability company. For small real estate projects, the expense can be prohibitive.

Effective January 1, 2007, corporations, limited liability companies, limited partnerships, business trusts, and business associations are subject to the Texas franchise tax. Sole proprietors and general partnerships of natural persons are not subject to the tax. All businesses with $300,000 or less in total revenue are also exempt from the tax.

The tax is based upon a taxpayer’s “taxable margin”. Taxable margin is defined as the lesser of (a) 70% of total revenue or (b) total revenue reduced by the cost of goods sold or the taxpayer’s employee compensation expense, capped at $300,000 per employee or owner. The tax rate is 1% of taxable margin with retailers and wholesalers taxed at only ½% of taxable margin.

Please view this article as a very basic primer. Due to space limitations, I have generalized some concepts. You are strongly advised to seek competent legal and tax advice before undertaking any but the most basic asset protection techniques.