An article circulating amongst real estate syndicates, investor groups, and developers purports that a Irrevocable Trust and that not a Limited Liability Company (LLC) is the ideal legal entity type to hold real estate investments. For the quick answer, generally LLCs are the ideal entity type to hold real estate investments; the law dictates that no two parcels are identical, and so it follows that every real estate investment is different, therefore some real estate investments are suited for Irrevocable Trusts. There are many investment entities that are suitable for investment including Limited Partnerships, Limited Liability Companies, and Corporations.

Real Estate Investment Trust (REIT) (semi-technical reduced for complexity, skim if necessary)
Some Irrevocable Trusts are REITs but not all REITs are trusts (irrevocable or otherwise). Internal Revenue Code (IRC) section 856 defines REITs as a “corporation, trust, or association” which is:

• managed by trustees or directors;
• beneficial ownership in the REIT is transferrable;
• would be taxable as a domestic corporation if not for this section (26 USC § 856);
• is not: (a) a financial institution described in (26 USC § 582(c)(2)): a bank or foreign ‘bank’; cooperative and mutual banks; licensed § 301 small business investment company (SBICs) (see Small Business Investment Act of 1958 for private equity and venture capital LLCs or LPs as amended post 2005); Business Development Corporation (see below bold titled); or (b) insurance company (see 26 USC Chapter 1, Subchapter L).
• ownership is held by 100 or more persons;
• (through reasonable diligence) is assumed to be not closely held under 26 USC § 542 meaning greater than 50% of ownership is held by 5 or less individuals; and,
• meets all 26 USC § 856(c) limitations, REITs must comply with all of the following:
  1. REIT election has not been terminated or revoked (see 26 USC § 856(g));
  2. (January 1, 1980 onward) 95% of its gross income is derived from: dividends, interest (see (G)(i)-(ii)), rents, sale of securities and real property (excluding 26 USC 1221(a)(1)), tax refunds, foreclosure income and gains, allowable transactions under 26 USC § 857(b)(6) (prohibited transactions), first year mineral royalties;
  3. at least 75% of its income is derived from: rents, interest (from real property mortgage) and (see (G)(i)-(ii)), sale of property (excluding 26 USC 1221(a)(1)), dividends, tax refunds, foreclosure income and gains, allowable transactions under 26 USC § 857(b)(6) (prohibited transactions), qualified temporary investment income; and,
  4. at least 75% of assets is in real estate, cash, account receivables, government securities; and not more than 25% is in other securities OR taxable REIT subsidiaries, EXCEPT no more than 5% of its total asset securities in any one issuer, the REIT does not hold more than 10% in any one issuer, and the REIT does not hold more than 10% of outstanding value of one issuer…

Business Development Corporation is a corporation created pursuant to State law “…for purposes of promoting, maintaining, and assisting the economy and industry within…” the “…State by making loans to be used in trades and businesses which would generally not be made by banks within…” the “State in the ordinary course of their business (except on the basis of a partial participation), and which is operated primarily for such purposes” (26 USC § 582(c)(2)(B)).

Even by skimming the above-summarized statute it should be obvious REIT should not be confused with a form of Trust or Corporation (that defeats one misconception).

Business Entities
A business entity is first (a) separate from an individual (legal personality), second (b) suited for business activity, third (c) it has more favorable taxation than several individuals, fourth (d) it has favorable liability protection for the torts of the entity, and five (e) ownership is generally transferable to another person.

Trust Entities
A trust entity is first (a) fiduciary relationship (duty to manage, invest, safeguard, and administer trust assets and income) in which the trustee(s) hold legal title for the benefit of designated beneficiaries who hold equitable title, second (b) may have favorable tax treatment compared with probate assets (think will vs. trust), third (c) is centered around a particular asset or assets owned at one time by the settlor (person who sets up the trust sometimes known as the grantor).

Why a trust may not be suitable for doing business.

• It is assumed that if the sole-Trustees are also listed as sole-beneficiaries, then legal and equitable title merge and the trust disappears (no trust exists) MCL 700.7402(1)(e). Someone (beneficiary) must exist to hold the trustee accountable to carry out the terms of the trust, and the same person cannot owe those duties to him or herself. However, the settlor can be the only beneficiary as long as the settlor is also not the only trustee.
• Trustees may only leave the administration of the trust by (i) providing 28 days notice, or (ii) through court approval (MCL 700.7705).
• Trustees may be removed if there is a serious breach of trust, lack of cooperation amongst co-trustees, persistent failure to administer the trust effectively, or substantial change of circumstances where removal of the trustee is in the best interest of all beneficiaries (MCL 700.7706). It is important to note there is no provision for payment to a removed trustee; in business if an owner is ejected he or she must receive a return on their interest in the business.
• Trustees are disallowed from following the purpose of the trust. The trust will fail if the purpose is to evade settlor’s creditors (see MCL 700.7404 for more information on trust purpose).
• An irrevocable trust without a spendthrift provision will allow creditors to reach the beneficiaries interest through garnishment or attachment (effectively defeating the only advantage a trust might have over a standard business entity). (see MCL 700.7502 for more on spendthrift and Fornell v. Fornell Equipment, Inc., 390 Mich. 540 (1973)). However, once the distribution has been made, the money is no longer protected MCL 700.7502(3) (procedurally creditors must move FAST after disbursement for obvious reasons).
• Property owners are not allowed to transfer assets (via spendthrift trust) for the property owner’s benefit to avoid creditors’ reach. Any interest retained by the settlor in any asset may be reached by the creditor in full. (see MCL 700.7506(1)(c) for more on settlor-beneficiary interests).
• Michigan disallows discretionary spendthrift trusts, whereby the trustee has complete discretion to disburse trust income to a class of beneficiaries (used to evade creditors). (see MCL 700.7505 for nuance in language of ‘pure discretion’).
• If more than 1 person or entity contributed to the trust, they are all settlors (MCL 700.7506(2)) and all retained interests may be reached.
• Additionally since settlors, beneficiaries, and trustees are typically individuals, unique situations arise in Michigan around dowery, divorce, and other familial legal actions.

Under most circumstances, the best method of administering and planning a real estate investment (or any other type of investment) is to incorporate under a business entity statute. The second step is to then place your personal assets into a trust revocable or irrevocable depending upon your needs. Speak with your trusted counselor for more information, it is important to explore new ideas and convey your intentions accurately to your lawyer.

Think about Real Estate.
Anyone who is selling a business or investment property should consider the benefits of a 1031 Exchange also known as a like-kind exchange. Internal Revenue Code (IRC) Section 1031 allows an investor who sells a property and reinvests the proceeds in a new property to defer all capital gain taxes. IRC Section 1031(a)(1) states:

“No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment, if such property is exchanged solely for property of like-kind which is to be held for productive use in a trade or business or for investment.”

To be eligible for a 1031 exchange the buyer basically must:
– Purchase property that will be held for investment or used in a trade or business;
– Purchase property of equal or greater value; and,
– Obtain the same or greater debt on the new property.

The Internal Revenue Service (IRS) does mandate that an investor:

(1) identify the new property within 45 days of the sale of the original property and close within 180 days;
(2) use a qualified intermediary (QI) to hold the proceeds of the original sale (a QI is a company that is in the full-time business of facilitating IRC Section 1031 Exchanges and is further defined under IRC Section 1031(k)-1(g)(4)); and,
(3) reinvest all of the equity from the sold property into the new property.

For example: if an investor buys an income property for $250,000 and later sells the property for $350,000, the investor has made $100,000 that would be taxed at the capital gains rate. If the investor reinvests the $350,000 in another income property this could qualify as a 1031 exchange and allow the payment of the taxes to be deferred.

In many instances 1031 exchanges are very useful in deferring an investor’s tax liability. The exchange should be contemplated before the sale of the initial property and structured to best benefit each investors unique concern. It is wise to consult an experienced attorney if you are considering a 1031 exchange.

General Information: Recent data analysis of business history suggests that somewhere around 50-90% of Michigan businesses will be engaged in a legal dispute over the next 10 years. And a large number of those disputes will involve contract litigation. Fortunately, if trends are cause for prediction, approximately 70% of filed business lawsuits are resolved out of court. Michigan allows 6 years to bring a general breach of contract claim (MCL 600.5807(8)), and 4 years to bring a ‘sale of goods’ breach of contract claim (MCL 440.2725(1)).

Better Estimate: It is safe to assume that there is an actual or probable breach of contract in 99% of all contracts formed. And 99% of those are likely (1) unnoticed, (2) minor, (3) not worth the money to litigate, or (4) not worth damaging the business relationship.

For example: Commercial Real Estate transactions are notorious places for all 4 types breach of contract events from the letter of intent (binding provisions) to purchase agreement to closing and beyond. (1) Typical areas of unnoticed breaches are notice provisions. Often times purchase agreements will call for a particular form of notice to be delivered to tenants or the manager of a property before performing inspections; for obvious logistic reasons these are overlooked. (2), (3), and (4) Noticed minor breaches, not worth the money, and not worth damaging relationships: take place most often during the due diligence period and timing provisions when one party fails to deliver a specific requested item of due diligence or fails to deliver it within a particular time period. The minor breaches take place when the party provides most of what is requested, and a lot of what isn’t requested, but the seller fails to deliver a document that the buyer would like to see, but won’t make or break the transaction.

Finally the breach may not be worth the money to enforce or not worth harming the business relationship; buyers often must weigh the benefits and costs of instituting such actions, such as:

a. whether or not the potential defendant is needed in the future for supplying or other business plans such as acquisition;
b. whether clients and customers will view the action as negative (such as subpoenaing a client, or bad publicity of appear litigious);
c. the loss of business hours spent on investigation;
d. the loss of business secrecy and value if it is in the public domain in unsealed court documents;
e. the actual ‘hard’ dollars spent on filing fees and lawyers.

It is not unheard of for the potential aggrieved plaintiff to direct its attorney to contact the potential defendant’s attorney to discuss a potential resolution outside of litigation and even settlement. Concessions and temporary price reductions made by the potential defendant allow business relationships survive and thrive.

Damages: Typically, specific performance, general, and special damages are the most common remedies for breach of contract in business disputes resolved in court.

As one might imagine since lending practices are so highly regulated, defaulting on such a loan is also highly regulated. From the creditor’s perspective, Michigan’s Uniform Fraudulent Transfer Act protects creditors from deceitful debtors (MUFTA). The MUFTA defines fraudulent transfers as any transfer that is made with actual intent to defraud, hinder, or delay either a present or future creditor; including transfers without actual intent if the debtor should have believed that he or she would become insolvent by failing to make the exchange for a reasonably equivalent value (see MCL 566.33 and MCL 566.34).

Fraudulent conveyances more broadly is defined as any transaction by which any property (real or personal) is moved beyond the reach of creditors, including a transaction that prejudices the legal or equitable rights of present or future creditors. Exchanges whereby a debtor accepts a value below a reasonable equivalent for property a creditor has a higher right to, happens every day. Consequences for purchasing or selling property in a transaction that triggers a fraudulent conveyance statute can harm both parties.

For example: Imagine if an individual named Mr. Tower purchases the Grand Rapids Plaza Towers for $100, and Morty’s Bureau Mortgage (mortgagee) helps Mr. Tower (mortgagor) complete the purchase through a loan secured by a mortgage. One of the terms of this mortgage–and almost certainly all mortgages–prohibits the transfer of any portion of the property, here the Plaza Towers, without authorization by the mortgagee Morty. If Mr. Tower and his good friend William Weasel sever a portion of the tower through a transaction not involving Morty to make a little extra money; they likely have committed a fraudulently conveyance, and several other legal issues may implicate Mr. Tower and William Weasel (such as, breach of contract, business tort, which we won’t get into in this article).

The simplest remedy a creditor may seek against a debtor and the transferee under civil law is to invalidate the transfer through a legal proceeding to void the transfer (MCL 566.37). Further, the transferee and transferor generally have not cause of action against each other, public policy and the law leave the parties in the position in which they have placed themselves. In plain english, the transferee (William Weasel) loses his interest in the Plaza Tower, and likely has no method of seeking relief from the consequences of participating in the fraudulent transaction against Mr. Tower. From William Weasel’s perspective, this is exactly why due diligence, and properly recording interests where typical, is so important in every transaction.

Michigan, like most other states in the country, view legal restraints on alienation (transfer of property) as void. Thus, (i) disabling restraints; (ii) forfeiture restraints; and (iii) promissory restraints are all void. Please keep in mind when reading this article that this is a very delicate area of law and is subject to several exceptions. Like all legal articles, be sure to read this one for broad-view purposes only.

Disabling restraints are created by a transferor (seller) preventing future transfers by the transferee (buyer / future seller).

Forfeiture restraints, whereby the transferor (seller) attempts to cause a forfeiture of the transferee, if the transferee ever attempts a sale themselves.

Promissory restraints, represents a clever method, whereby the transferor attaches a covenant preventing sale by the transferee in the future.

Nonetheless, all restraints will be rendered void. Public policy dictates that if you (or a group) are the full owner of a property, you should be able to sell it when and how you please. This allows a transferee to ignore restraints on transferability when they decide to sell. Restraints in time are however, when reasonable, enforceable.

Under the Fair Housing Act and the Fourteenth Amendment (XIV) of the constitution all restraints that are discriminatory are void.

Some examples of valid restraints on transfer of real property are those restrictions that are reasonable in (i) commercial transactions, (ii) first refusal, and (iii) on assignment or sublease of renters (landlord consent).