Diversification of investments is typically thought of as the best strategy to grow wealth and protect an individual’s holdings from the vagaries of the economy. Real estate in particular has become an attractive option for high-net-worth individuals looking for investment options beyond having a stock portfolio. While from an investment standpoint this has significant benefits, ownership of rental properties can potentially increase the risk to an investor’s personal assets if ownership is structured without asset protection in mind.
Consider what is a fairly common scenario: An investor who lives in California starts out with local rental properties. When they have the funds to purchase more properties, however, they buy in other states, such as Tennessee and Texas, where real estate is more affordable, laws are landlord-friendly, and tax rates are lower. An asset protection plan in this case needs not only to protect the investor’s personal assets, such as their stock investment account, from liability arising from their ownership of real estate investments. It also should be structured to protect each individual property so that a lawsuit filed against one doesn’t impact multiple properties.
The Limits of LLCs
If the first thought is to create a limited liability company (LLC) for rental properties, it isn’t necessarily a bad one—but the asset protection an LLC provides on its own can be inadequate. One can protect personal assets from a lawsuit, but property held in the LLC may not be fully protected from pursuit by creditors if the owner is sued personally. (For more on the difference between inside liability and outside liability protections provided by LLCs, see our previous blog article here.) Further, each property should ideally be held in a separate LLC, to ensure that unrelated properties don’t become collateral damage if a lawsuit against another one is successful.
A better strategy can be to also use a Domestic Asset Protection Trust (DAPT) or hybrid Domestic Asset Protection Trust (hybrid-DAPT) to shield valuable investments from the grasp of potential creditors.
Understanding DAPT and hybrid-DAPT
A DAPT is an irrevocable trust in which the grantor (the person creating the trust) is also a beneficiary. While the grantor must name a third-party distribution trustee to distribute assets to the trust’s beneficiaries, they can retain control over how the trust’s assets are managed as the investment trustee. Legally speaking, the assets no longer belong to the grantor, making it more difficult for creditors to make a claim against them. (Keep in mind that no asset protection strategy will completely eliminate the threat of a lawsuit—the goal is to make it as difficult as possible for creditors to claim assets so it becomes much more attractive to settle claims on terms favorable to the person being threatened with a suit.)
A hybrid-DAPT goes a step further, because it does not name the grantor as a beneficiary (although they can be added as a beneficiary later). This provides extra protection against creditors because the grantor has no beneficial rights to the trust, giving them no grounds to pursue a claim. As of July 2024, 17 states allow the creation of DAPTs; for more details on how they work and why Nevada is considered one of the leading jurisdictions for establishing one, see our previous blog article here.
The most important thing to realize is that a DAPT must be established well before its protections are necessary. Assets that are transferred in as a dodge to avoid the claims of known or pending creditors will not be shielded. Further, distributions from a DAPT are not made regularly, so this strategy may not be suitable if beneficiaries are intending to live off the income of assets in the trust.
Creating Unique Asset Preservation Strategies to Protect Your Wealth
DAPTs and hybrid-DAPTs are just one example of possible strategies to protect your assets now and in the future. At Bridge Law LLP, our expert asset protection attorneys will create a customized approach based on your circumstances and goals. If you’re concerned that the property and accounts you’ve worked hard to grow are vulnerable to a lawsuit, don’t wait to get protection and peace of mind. Contact us here to set up your consultation.