In Texas, a “trust may be created for any purpose that is not illegal” (Prop. Code Sec. 112.031).
Trust law falls under the Property Code (the Texas Trust Act contained in Prop. Code Chaps. 112-117) while the law of LLCs falls mostly under the Business Organizations Code (BOC Sections 101.001 et seq.).
The scope of this article is limited to investment-oriented 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 probate process and can be substantially different, often because of tax issues—so consult an appropriate expert for advice on those.
Caution Regarding Liability Barrier
It is important to understand that a trust does not have a liability barrier as do registered entities such as LLCs and corporations. Placing investment properties in a land trust may therefore not be a sound asset protection approach unless the overall entity structure provides a liability barrier at some other point or interface with potential plaintiffs.
Caution Regarding Merger
It is also important to be cognizant of the doctrine of merger (Prop. Code Sec. 112.034). If the purported trustor, trustee, and beneficiary are all identical, then as a matter of law it is not a trust at all. Basically, the law does not allow you to convey your own property into trust to be managed by you for your own benefit. This rule frustrates many investors who want to do just that.
Types of Land Trusts
There are many kinds of land trusts. The biggest distinction is between those that are intended to own investment property versus those intended to hold the homestead. Assuming that the intended application is investment, what is the strategy? Will the trust being used to acquire and flip property? Or is the primary purpose the transfer of property to a credit-impaired borrower? Is anonymity a concern? And what about duration—short term versus long term?
The following are the main categories of investor land trusts (these may overlap):
holding trusts, which exist simply to hold real property for whatever purpose is intended by the trust agreement (probate avoidance, for instance);
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; and
anonymity trusts, which endeavor to conceal the principal or principals behind the trust (the beneficial owners), at least for a period of time.
A trust can hold any number of investment properties, but as noted above there is no liability barrier against lawsuits as is the case with registered entities such as LLCs and corporations. In fact, the existence of a liability shield is the defining characteristic of an LLC. It is essentially what one is paying for when an LLC is formed with the Secretary of State.
If the LLC is sued it is generally the case that members and managers are not personally liable for satisfying a judgment against the LLC—at least so long as those members and managers are not culpable of actual fraud. By contrast, a trust and its trustee are fully exposed. Property Code Section 114.087 makes it clear that “the trustee of a trust is considered for all purposes to be the named party [i.e., the true party in interest] to an instrument [a deed, for instance] that names the trust as a party. . . .”
The underlying basis for this distinction is the legal entity theory. An LLC is a distinct legal entity, a legal person with its own rights, duties, and remedies. “An LLC is considered a separate legal entity from its members.” Spates v. Office of Atty. Gen., 485 S.W.3d 546, 550-51 (Tex.App.—Houston [14th Dist.] 2016, no pet.). This is not the case with a trust, which is a contractual relationship among its participants, not a legal entity.
The absence of a liability barrier in a holding trust is a near-fatal flaw in terms of asset protection. For this reason, a trust (standing alone) is not the vehicle of choice for holding investment real estate for any substantial length of time.
Utilizing an LLC as beneficiary (and as assignor if a beneficial interest is transferred to an end user) can mitigate liability by inserting a valuable layer of liability protection. Asset protection is often about the combination and layering of incremental measures. Inserting an LLC into the transactional mix can be helpful (but not a panacea) in the context of an investor land trust.
Entry Trusts (Investor Acquisition 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 take over the 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 by general warranty deed and then be entirely dismissed from the investment equation.
An entry trust should always be 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 Entry Trust 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.
Assignment of 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 may be terminated. 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.
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 years is better. This pressures the end-user to secure alternative financing.
Assignments of trust beneficial interests should be recorded in the real property records.
Exit Trusts (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 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 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 in a deed 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 recording of the deed 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.
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. 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.
Deed in the Drawer
When using an anonymity trust, it is wise to anticipate the objections of a future title company and have such a deed already signed and notarized (a version of the deed-in-the-drawer technique) ready to hand to the title company when their objections are presented. Recording this second deed cures the title company’s trust-is-not-an-entity objection while having preserved anonymity in the interim.
Again, an anonymity trust of this type is edgy technique. In using it, one must be prepared for significant pushback and to respond promptly with a curative deed that properly names the trustee.
Delegation to a Trust Agent
A development in favor of anonymity is Property Code Section 113.018, added in 2017, which permits a trustee to appoint an agent and delegate certain powers to that agent “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.
Title Company View of Investor Trusts
Expect skepticism from a title company when using a land trust. Since the 2008 real estate crash, title companies have become suspicious, if not outright hostile, to investor 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.
It is likely that the title company will want to see the trust agreement, so a written trust agreement must therefore exist. It must also be properly drafted and executed so that it will be accepted as valid. Otherwise, the 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 before insuring the new owner.
One should also anticipate a title company requirement that any assignments of beneficial interest executed along the way will have been recorded in the real property records.
Investor Trusts and Due-on-Sale
It is widely advertised by seminar gurus that land trusts prevent a lender from exercising the due-on-sale clause in their deeds of trust. This is false. The federal living trust exception (the Garn-St. Germain Depository Institutions Act, 12 U.S.C. Sec. 1701j-3) was intended to create an exception for transfers of the homestead to family living trusts that are 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. An investor land trust does not defeat due-on-sale because it invariably contemplates a transfer of rights of occupancy away from the owner-occupant—so Garn-St. Germain does not apply. Due-on-sale provisions remain effective and enforceable.
Lenders have been historically hesitant to utilize due-on sale in order to foreclose on performing loans. This could change, however, as interest rates rise and lenders perceive an incentive and
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—and that is just one of many common defects. The place to get a valid Texas land trust is from an experienced Texas lawyer who knows what he or she is doing in this 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 (with asset protection in mind) tailor a custom document to suit specific needs.
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. The law changes. 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. 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.
Copyright © 2024 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.