In Texas, a “trust may be created for any purpose that is not illegal” (Tex. Prop. Code §112.031). There are many kinds of trusts and most of them can be adapted to hold real estate, whether investment property or the homestead. The difference between types of trusts revolves around their intended purpose, so one needs to be clear about goals before setting out to utilize a land trust. Is the trust being used to acquire and then flip property? Is anonymity a concern? Or is the primary purpose the transfer of property to a credit-impaired borrower? And what about duration-short term versus long term?
The scope of this article is limited to living trusts (meaning trusts formed during the lifetimes of the participants) for the purpose of holding investment real estate. Testamentary trusts, which take effect upon the death of the person creating the trust, are usually part of the estate planning process and can be substantially different, often because of tax issues-so consult an appropriate expert for advice on those. Living trusts designed specifically for the homestead are the focus of another article.
While land trusts can be used flexibly, there are certain basic legal principles that do not change:
(1) The trustor (sometimes called the settlor or grantor) is the current title-holder to the property. The trustor is therefore the person or entity who transfers property into the trust.
(2) The trust corpus (or trust estate) is the asset-in this case investment property-that is conveyed into the trust.
(3) The trustee controls the trust with authority to manage, maintain, lease, and sell the trust property. An LLC cannot usually be designated as trustee.
(4) The successor trustee serves if the trustee dies, resigns, or cannot otherwise serve.
(5) The beneficiary is the ultimate party in interest for whom the trust is being operated-the one with “ownership” to use that term loosely. An LLC can be a beneficiary.
(6) The contingent beneficiary or successor beneficiary acquires the beneficial interest if the primary beneficiary dies (Note that there would be no need for a contingent beneficiary if the beneficiary originally named is an LLC).
In order for an attorney to draft a land trust, the client needs to specify which persons or entities will be acting in each role. Note that “a trust terminates if the legal title to the trust property and all equitable interests in the trust become united in one person,” known as the doctrine of merger found both in common law and in Property Code Section 112.034. So the person or persons acting in each of the three main roles cannot exactly match. As a practical matter, particularly when dealing with lenders and title companies, it is better if these actors overlap as little as possible. This enhances the perceived legitimacy of the trust.
Once an investor identifies the persons who will be principals in the trust, then the next steps are to: (1) formally establish the trust by means of a signed trust agreement, and then (2) convey the property into trust by means of a warranty deed (usually a general warranty deed).
Duties of a Trustee
An examination of trusts of any type would be incomplete without mentioning the legal duties of a trustee, so we will pause our discussion for a moment to examine these. When serving as trustee for others, a trustee is a fiduciary and has certain duties with respect to both the beneficiaries and the property held in the trust, and these are significant, as is the potential liability for failing to perform these duties. Fiduciary standards may not be very important if the trustee is also the sole beneficiary of the trust (not a recommended set-up), but otherwise such considerations are very relevant indeed.
The duties of a trustee include:
(1) a duty of loyalty;
(2) a duty of competence;
(3) a duty to exercise reasonable discretion;
(4) a duty of disclosure with respect to the beneficiaries; and
(5) a duty to comply with the prudent investor rule contained in Prop. Code Section 117.003.
While a trust agreement can attempt to reduce or mitigate some of these duties, it cannot eliminate them entirely, at least not as to intentional, bad faith, or reckless actions by the trustee (Trust Code §114.007).
Law Applicable to Trustees
The law in this area is found in a mixture of that portion of the Property Code known as the “Texas Trust Code;” the Restatement of Trusts (second and third versions), a body of academic literature that states common-law principles applicable to trusts; and case law as it is reported from the Texas courts. All of these sources make it fearfully easy for a beneficiary to sue and win against a trustee for breach of duty, especially in cases of trustee self-dealing, which is a breach of the duty of loyalty.
Section 113.053 of the Property (Trust) Code provides that except in limited circumstances “a trustee shall not directly or indirectly buy or sell trust property from or to: (1) the trustee or an affiliate; (2) a director, officer, or employee of the trustee or an affiliate; (3) a relative of the trustee; or (4) the trustee’s employer, partner, or other business associate.” An old supreme court case puts this succinctly: “[A] trustee, or person occupying a fiduciary relation to another, is incapacitated, in equity, to buy from himself property committed to his care, or secure to himself an advantage in a purchase of such property by another from him.” Tenison v. Patton, 67 S.W. 92, 93-94 (Tex. 1902). Note that in cases where this duty is breached, it falls to the beneficiary (and really no one else) to raise the issue. Harvey v. Casebeer, 531 S.W.2d 206, 208 (Tex.App.-Tyler 1975, no writ).
As to real estate investing in particular, the law makes it clear that a trustee has an active duty to take reasonable measures to protect trust property and make it productive. The exact extent of this duty can be argued in any particular case; however, at the very minimum, a trustee is obliged to ensure that property belonging to the trust is not subject to unnecessary waste, loss, or other diminishment. Central to this is the “prudent investor rule” found in the Restatement (Third) of Trusts which sets forth core principles: (1) a preference for lower risk to achieve a beneficial rate of return, (2) applied as an overall strategy (which does not mean that any single investment needs to comply with this concept); plus (3) reasonable diversification to manage risk and avoid unnecessary loss; along with (4) a view toward increasing returns over time if that is reasonably feasible; (5) and, having said the foregoing, a trustee should nonetheless retain flexibility to actively take advantage of unique or special opportunities as they may arise.
A “Uniform Prudent Investor Act” is included within the Texas Trust Code (Chapter 117 of the Property Code). This law takes the general principles of the Restatement of Trusts and gets more specific, stating that “a trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.” Prop. Code §117.004(a). The same section goes on to list specific items that a trustee should consider: “(1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.”
Finally, note that if a real estate investor has considerable experience and knowledge of the business, then he or she will be held to a higher standard when acting as trustee for another: “A trustee who has special skills or expertise, or is named as trustee in reliance upon the trustee’s representation that the trustee has special skills or experience, has a duty to use those special skills or expertise.” Prop. Code §117.004(f). All of this should highlight the liability risk involved in anyone acting as trustee.
Lawyers are often asked to act as trustees for their clients’ trusts (for free, of course). Considering the extensive duties and liabilities outlined above, it is not surprising that lawyers are reluctant to do so without substantial compensation, especially since trustees are sued all the time. In fact, when the trust is sued, it is the trustee who is named as the defendant.
Types of Land Trusts
There is a wide variety of trusts that involve acquiring, holding, or selling real property. The following are the main categories:
entry trusts, used by an investor to acquire a property, usually with the intention of flipping using an assignment of beneficial interest;
exit trusts, used by an investor to transfer limited rights in a property to a buyer who is working to restore credit and obtain traditional financing;
living trusts for the homestead, principally for purposes of probate avoidance; and
anonymity trusts, which endeavor to conceal the principal or principals behind the trust.
Clients often ask attorneys for a “standard” trust (or worse, a fill-in-the-blank form they can use themselves) neither of which exists at any acceptable level of quality. There is no substitute for the analysis and drafting expertise of a competent professional in this complex area. Because trust agreements can be written in so many different ways, the challenge for the attorney is to discover what the client is trying to achieve and then tailor a custom document to suit specific needs.
The Entry Trust (Investor Acquisition of Property in Preparation for a Flip)
In the case of an entry trust, an investor coaxes a (usually) distressed seller into transferring property by recorded deed into an irrevocable trust. This is often done with a foreclosure looming. However, such trusts do not delay or stop foreclosure unless the investor is willing to promptly reinstate the loan and then continue payments until the property can be sold.
As for the trust itself, it has either been previously established by the investor or is created just for the specific transaction. In the latter case, there are two options: one names the seller as beneficiary, after which the seller immediately executes an unrecorded assignment of beneficial interest to the investor. Another version utilizes the seller as trustor (so the seller actually signs the trust agreement), the investor as trustee, and the investor’s LLC as beneficiary. The latter option is much better, since it does not allow the seller ever to be in a position of asserting the rights of a beneficiary, even if the window for doing so is brief. It is better for the investor’s potential liability if the seller is never given a beneficial interest at all. Why? Firstly, because courts tend to be sympathetic to trust beneficiaries and are more likely to go out of their way to preserve a beneficiary’s rights; and secondly, if the seller never holds a beneficial interest, then he or she can never argue that he or she was duped out it by a sly investor. It is thus preferable to arrange for the seller to transfer a 100% fee simple interest to the trust by general warranty deed and then be entirely dismissed from the investment equation.
An entry trust should always be a carefully-crafted document. And, as noted, the trust should be irrevocable, since allowing a seller the opportunity to experience remorse and revoke the trust is not a good idea. This is a bedrock principle, yet lawyers see revocable land trusts all the time.
Another bad idea is allowing the original seller to retain a beneficial interest that allows the seller to share in profits when the property is flipped. It is almost always the best policy to make a clean break so there is no further participation by the seller.
Other trust agreements permit the seller to have a power of direction over the trustee, an even worse idea.
Steps in the Process
The following are the steps involved in an entry trust if there is no trust in existence at the time of the transaction (i.e., if a new trust must be established for the transaction to take place):
1. the investor-buyer’s LLC enters into an earnest money contract for the purchase of 123 Oak Street;
2. the contract lists the buyer as the investor’s LLC and/or its assigns;
3. a trust agreement is executed showing the seller as trustor, the individual investor John Jones as trustee, and the investor’s LLC as beneficiary;
4. at closing, the seller conveys the property to The 123 Oak Street Trust.
The foregoing should be closed as a stand-alone severable transaction. Subsequent assignment of the beneficial interest to an end-user should also be structured as a separate, stand-alone transaction. Do not attempt to collapse these two transactions into one. The potential liability of the investor (or the investor’s LLC) goes up substantially if this is done. Courts are more inclined to pull apart a complicated collapsed transaction and find that fraud occurred somewhere in the process.
Note that using the investor-buyer’s LLC as trustee is not an option because of the burdensome regulatory requirements that must be complied with in order for a registered entity (corporation LLC, or limited partnership) to qualify as a trustee.
Sale and Assignment of the Beneficial Interest to an End-User
Transfer of the beneficial interest in the trust to an end-user can occur in one of two ways: (1) by means of an assignment, as discussed above, in which case the trust will continue to exist; or (2) by means of a warranty deed from the trustee to the end-user, after which the investor’s trust terminates. Again, this all depends on the circumstances.
If the assignment is for cash, then the document required is an irrevocable assignment of a 100% beneficial interest to the end-user, and that is all. To limit liability, the assignor should be the investor’s LLC. If the assignment to the end-user is financed, then the investor will need to ask the attorney to prepare the assignment plus a secured note for the amount financed and a security agreement that imposes a lien on the assignment, allowing it to be cancelled and revoked in event of default. It is also useful for the investor to require the end-user to execute an assignment back to investor’s LLC, to be held in reserve by the investor as security if the end-user defaults on the secured note. The “assignment back” should include full release language for the benefit of the investor.
Note that if the assignment is financed, it is advisable that financing be short-term only, in order to limit ongoing liability. The note can be amortized over a longer-term (even 30 years), but if so then it should balloon (all principal and interest due and payable) in no more than five years. One to three is better. This pressures the end-user to secure alternative financing.
Assignments of beneficial interest should be recorded in the real property records.
The Exit Trust (Transfer to a Trust Pending Credit Repair)
Exit trusts are created for the purpose of selling a specific property to an end-user. They involve a calculation on the part of the investor that it is better to utilize a trust than a wraparound, usually because there is some hesitation about giving the end-user a deed and fee simple title. The property is conveyed into trust by general warranty deed and the buyer takes immediate possession pursuant to a lease or equivalent document. The buyer is given either a beneficial interest (in some percentage, not necessarily 100%) or an option to purchase a beneficial interest when certain minimum requirements (often credit repair) are completed. Upon becoming beneficiary of the trust, the buyer can decide if he or she wants to keep the trust in place or take a deed outright.
The trust acts as a temporary parking place for title to the property while the buyer works to obtain financing in order to purchase the property outright at a specified price. Sound similar to an ordinary lease-option? It is, except that beneficial interests in a trust are personal property, not real property, and therefore one can plausibly argue that they do not fall under the executory contract provisions of the Property Code.
In the exit trust scenario, there is no deed, recorded or unrecorded, into the name of the buyer, since the buyer is not acquiring actual title to the property at the time the trust is created and the deal is closed-only the option to buy a beneficial interest. The only warranty deed being executed is the deed into the trust.
Creation of an exit trust is a private transaction except for the recording of the warranty deed. The trust agreement is not recorded. In order to achieve maximum anonymity, the name of the trust should be generic, e.g., “The 123 Oak Street Trust.”
There are no published cases on the success or failure of the exit trust as a long-term investment strategy, but there is an obvious degree of risk. A judge looking carefully at the transaction could use the sword of justice to slice through the trust verbiage and find a de facto executory contract that fails to comply with Property Code Section 5.061 et seq. For this reason, the best strategy is to keep the term of the trust as short as possible.
Are Exit Trusts a Form of Seller Financing?
The executory contract rules of Property Code Sections 5.061 et seq., the SAFE Act, and the Dodd-Frank law have combined to make seller financing of residential real estate a challenge for Texas investors. Is an exit trust a form of seller finance? The answer is debatable. If challenged, the investor will need to fall back on the argument that trust beneficial interests are personal and not real property; and even though an option is part of the trust agreement, the option is to purchase a beneficial interest rather than an option to purchase the real property itself. We make no prediction as to how that argument will fare before a discerning judge.
Use of an LLC in Combination with a Trust
Trust law in Texas falls under the Property Code while the law of business entities (LLCs and corporations) falls under the Business Organizations Code.
Trusts can hold property, of course, but there is no liability barrier against lawsuits as with registered entities formed under the BOC. Even if property is held in an anonymity trust, the trust-including the trustee as well as other participants in the trust-are still individually and personally exposed, an undesirable result given the propensity of plaintiffs’ attorneys to sue every name they can find that is connected to a transaction. Utilizing an LLC as beneficiary (and as assignor if a beneficial interest is transferred to an end-user) inserts a valuable layer of liability protection. One should recall that asset protection is about the combination and layering of incremental measures. Inserting an LLC into the transactional mix almost always helps.
The Anonymity Trust
Use of an anonymity trust (our term) is an edgy technique that must be implemented carefully and by planning ahead. The scenario goes like this: a trust agreement is executed along with a warranty deed conveying real property into the trust. The traditional way for a trust to hold property is by expressly stating the name of the trustee, e.g., “John Jones, Trustee of the 123 Oak Street Trust;” however, it is possible to list the grantee as only the trust-e.g., the “123 Oak Street Trust”-with no reference to a trustee. Anyone seeking to know who the principals are and what assets they have has their work cut out for them since trust agreements are generally private, unrecorded documents. County clerks will accept such a deed for filing in the real property records so long as it is properly executed and acknowledged by the person conveying the property into the trust. But filing is not the problem. Issues arise later when the investor decides to transfer the property out of trust, since no trustee was named in the deed who can now sign as grantor.
Accordingly, users of anonymity trusts should anticipate legitimate objections from a future title company based on the proposition that a trust is not a legal entity-which it technically is not, even though trusts often act as if they are in the real world. Texas subscribes to the entity theory of transactions, meaning that the grantee in a deed must be a legal entity or the conveyance is void.
A trust is actually a contractual relationship, not an entity. Accordingly, one should be prepared to record a second deed which properly includes the name of the trustee. A wise alternative would be to expect this obstacle and have such a deed already signed and notarized, previously held back in reserve (a version of the deed-in-the-drawer technique), but now ready to hand to the title company upon demand. Filing this second deed cures the “trust-is-not-an-entity” objection while having preserved anonymity in the interim.
Property Code Section 113.018
A development in favor of anonymity is Property Code Section 113.018, added in 2017, which permits a trustee to appoint an agent and grant the agent powers “to act for the trustee in any lawful manner for purposes of real property transactions.” The agent can be anyone so long as the appointment is in writing and notarized (there is no requirement that it be recorded). The appointment-or “delegation” as the statute puts it-can be supplied on demand to third parties as evidence of authority. It is valid for six months.
The Title Company and the Trust Agreement
When trust property is sold, it is likely that the title company will want to see the trust agreement, so expect that this will occur. A written trust agreement must therefore exist. It must also be properly drafted and executed so that it will be accepted as valid. Otherwise, a title company may choose to ignore the trust altogether (act as if it never existed in the chain of title) and require signatures from all persons having an actual or potential interest in the property. One should also anticipate a requirement that any assignments of beneficial interest executed along the way will have been recorded.
Be aware that since the real estate crash, title companies have become suspicious, if not outright hostile, to land trust transactions, so this is a factor that must be considered when considering the use of land trusts (anonymous or not) as a principal feature of an investor’s business model.
Certification of Trust
If for privacy reasons an investor is reluctant to show the entire trust agreement to the title company, then Property Code Section 114.086 provides for an alternative: a “certification of trust” (also commonly called a memorandum of trust) that is a concise summary of material trust terms. So long as the information required by the statute is contained in the certification, “A person who acts in reliance on a certification of trust without knowledge that the representations contained in the certification are incorrect is not liable to any person for the action and may assume without [further] inquiry the existence of the facts contained in the certification.” Tex. Prop. Code §114.086(f). A title company is not compelled under this law to accept a certification of trust in lieu of the actual trust agreement, but liability to third parties may be avoided if the title company chooses to do so.
It is widely advertised by seminar gurus that land trusts prevent a lender from exercising due-on-sale. However, Garn-St. Germain (the federal living trust exception) was intended to create an exception for transfers of property to family living trusts designed to avoid probate. It was not intended to provide a safe haven for investors seeking to use trusts as part of their business plan. The truth is that an investor land trust does not defeat due-on-sale because it invariably contemplates a transfer of rights of occupancy-so due-on-sale provisions remain effective and enforceable. Nonetheless, so long as monthly payments remain current, the discussion may be academic since lenders are generally hesitant to foreclose on performing loans. This could change, however, as interest rates rise and lenders perceive an opportunity to upgrade their portfolio of low-rate loans.
Not all land trusts are created equal. There are a myriad of trusts available on the Internet that purport to be good in all fifty states. This is false. A principal defect of trusts marketed over the Internet is failure to consider or comply with Property Code Section 5.061 et seq. pertaining to executory contracts. Construal of a trust transaction as an executory contract would be disastrous for an investor because of the various penalties for seller non-compliance.
Many Internet and guru trusts involve complex, exotically-named transactional documentation with fill-in-the-blank forms, a sure indicator that they are junk. The place to get a valid Texas land trust is from an experienced Texas asset protection lawyer who knows what he or she is doing in this area.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well, since we do not give tax advice.
Copyright © 2019 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.