Matt Engel is our guest writer for today.  Matt is an attorney and a Minnesota Real Estate Show radio partner.

Q: “I have a new tenant who will pay the first and last months rent in advance due to bad credit.  If they are late on a month can you still evict or do you wait until the next month?  Do you use the advance payment if they are late or hang on to it and insist on payment for that month?  What is the standard use of this last month paid in advance?  How do you handle it if you get to the end of the lease and want to extend?”

A: I am not aware of a specific section of the landlord tenant statute that deals directly with advance rent payments.  However, Minn. Stat. 504B.178 deals with interest on security deposits; withholding security deposits; damages; and limits on withholding the last month’s rent.

The reference to the limit on withholding the last month’s rent is actually addressing the tenant’s withholding the last month’s rent in lieu of the security deposit, as opposed to an advanced rent payment.

I would argue that the advance rent payment is an exception to the application of this statute section per the following language in Minn. Stat. 504B.178:

Subdivision 1. Applicability. Any deposit of money, the function of which is to secure the performance of a residential rental agreement or any part of such an agreement, other than a deposit which is exclusively an advance payment of rent, shall be governed by the provisions of this section.

Therefore, I would argue that section 504B.178 does not apply to the last month’s rent payment because it is an advance payment of rent.

For learning purposes, let’s take a look at the provision that discusses withholding rent.  The relevant portion dealing with withholding rent states:

Subdivision. 8. Withholding rent. No tenant may withhold payment of all or any portion of rent for the last payment period of a residential rental agreement, except an oral or written month to month residential rental agreement concerning which neither the tenant nor landlord has served a notice to quit, or for the last month of a contract for deed cancellation period under section 559.21 or a mortgage foreclosure redemption period under chapter 580, 581, or 582, on the grounds that the deposit should serve as payment for the rent. Withholding all or any portion of rent for the last payment period of the residential rental agreement creates a rebuttable presumption that the tenant withheld the last payment on the grounds that the deposit should serve as payment for the rent. Any tenant who remains in violation of this subdivision after written demand and notice of this subdivision shall be liable to the landlord for the following: (1) a penalty in an amount equal to the portion of the deposit which the landlord is entitled to withhold under subdivision 3 other than to remedy the tenant’s default in the payment of rent; and (2) interest on the whole deposit as provided in subdivision 2, in addition to the amount of rent withheld by the tenant in violation of this subdivision.

Now that we know that a tenant is prohibited from withholding the last month’s rent on the grounds that the security deposit should serve as payment for that rent, let’s get back to the discussion on advance rent payments.

I found a Minnesota Supreme Court case from 1921 that discussed advanced rent payments – and it actually states that the landlord can retain an advanced rent payment if the tenant breaches the lease prior to the time when that advanced payment was to be used.  Here is the language from that case:

Where a lease is terminated for a default of the tenant after he has made an advance payment of rent, the landlord is entitled to retain such advance payment, although the lease was terminated before the beginning of that part of the term upon which such advance payment was to be applied.

Thomas Peebles & Co. v. Sherman, 148 Minn. 282, 283-84, 181 N.W. 715, 716 (Minn. 1921).

Although this case sounds promising to landlords, especially those landlords that collect the first and last month’s rent, I think its usefulness would apply more to a well briefed court battle as opposed to the simple confines of the housing court.  In other words, I don’t think a housing court referee will force a tenant out of their home when they have a month’s worth of rent on advance to the landlord.  What’s the trade-off?  The person making the Peebles argument is attempting to keep the last month’s rent, and risking the time, effort, filing fee, and service fees if the case is dismissed by the housing court.    Probably not a good investment.  It should also be noted that the tenant breach in the Peebles case was for violation of the non-subletting clause, not for non-payment of rent.

In sum, rarely do I see standard language in residential leases that require the first and last month’s rent, as well as the security deposit.  The last month’s rent is an advance rent payment.  Again, according to the 1921 Peebles case, it would appear that the landlord would be able to keep the advance rent if the tenant breaches the lease prior to the last month.  However, for all practical purposes, I don’t see a housing court referee signing an immediate Writ of Recovery  in favor of the landlord when a tenant has made an advance rent payment.  One could try to make the argument with 90 year old case law, and might be technically correct, but could also be wasting time and money (with having to re-file or appeal) by using this argument.  My recommendation?  I would use the advance payment as soon as tenant is late with rent.  If tenant makes payment in the meantime, you have your advance payment back.  If the next month comes and the advance payment is gone, then bring the eviction action.

Matthew A. Engel, Esq.
The Engel Firm, PLLC
www.theengellawfirm.com
612-373-7060

In a perfect world, banks and/or lenders would lend money to new investment property LLC with no income or credit history, thus allowing you to purchase your investment property in the name of your LLC.

Should you transfer the title of your investment property into your LLC?  You could probably ask 10 different people for their position on this issue, and receive 10 different answers.  My position is that I do not like to transfer title from the individual to the LLC – for a couple of reasons.  First, transferring the title when the mortgage is still in your name triggers a due on sale clause within the mortgage/note.  Second, if you ever go to refinance, you will have to transfer title back out of your LLC to you individually, creating a strange series of transactions for your lender and/or title company to sort through.

My position rests on the assumption that you have properly formed your LLC, complying with all of the statutory corporate formalities including organizational minutes, bylaws, appointing the Board of Governors, Managers, Membership Units, etc.  In addition, all of your business dealings are done in the name of the LLC – your lease with the tenant will be between the tenant and the LLC, the tenant should pay the LLC, and the LLC has a separate bank account and accounting records.

From a legal standpoint, the tenant’s contract is with the LLC, not with the investor as an individual.  If something goes wrong, they should sue the LLC, not the individual.  That is not to say that someone couldn’t try suing the individual – it is not uncommon for a litigious person to throw everything against the wall to see what sticks.  Even if your strategy was to transfer title from your personal name to the LLC in order to “tie” the property to the LLC, the mortgage would still be in your name anyway, thus leaving the same issue for that litigious person to throw against the wall.  In addition, if you completed all of the other steps to adequately form and operate your LLC, the argument to be made is that it would be bad policy if a court ruled that in order to receive liability protection from your LLC, that you should have violated the due on sale clause in your mortgage/note.

Again, every new business must start the ball rolling somewhere.  Every new business is started with the capital or credit of the owner.  Eventually when you have built your portfolio, built your LLC’s credit history and property equity, you will no longer need to purchase properties with your own credit and in your individual name.  Your goal will be to get loans through the LLC and thus title in the name of the LLC.

Remember, most banks do not make loans to brand new LLC’s, therefore you must start the ball rolling by purchasing your property personally.  Perhaps the bank/lender will allow the LLC to purchase the property with the individual’s personal guarantee or co-signature on the note.  If the bank will not accept the personal guarantee, there are several other options to consider.  Some strategies could include the individual leasing the property to the LLC, which would then lease the property to the tenant.  Alternatively, there could be a written agreement between the individual and his LLC whereby the individual pledges and confers upon the LLC the right to possession of the investment property.  All of these alternatives should be documented through company minutes of the LLC that acknowledge and authorize the LLC’s use of the investment property.  Having these added formalities can only strengthen the liability shield created by the LLC.

Please feel free to contact me at the number below if you need assistance, have questions or concerns with respect to properly forming your LLC or incorporating additional investment property ownership strategies to strengthen the liability shield created by the LLC.

Matt Engel

The Engel Firm, PLLC

Union Plaza

333 Washington Avenue North

Suite 300

Minneapolis, MN 55401

W: 612-373-7060

F: 612-465-6211

C: 612-385-0554

It is amazing how often I am asked by people starting in real estate investment: “What type of corporate structure is best for owning investment property“. I hear that question more often than I am asked how to find tenants or how to finance the property. Here is some information that I have compiled and learned over the years.

Disclaimer: Right up front I need to remind everyone that I am not an attorney nor do I play one on television. You should seek competent legal advice in your area, regarding this topic. These details are simply what I have learned through reading, executing, and talking with attorneys.

Best entity for Investment Property

Although there are many different business entities (LLC, C-Corporation, S-Corporation, partnership), the easiest to set up and cheapest to maintain, for real estate investments, is an LLC (limited liability company). Additionally, an LLC is very flexible and can have any number of owners (technically called ‘members’). Each member can own any percentage of the company (as long as the total equals 100%). Lastly, members can be other LLCs, corporations, and trusts. This flexibility allows you to customize the configuration to suit your tax situation and liability protection goals.

Tax Implications for the Investment Property LLC

C-Corporations pay taxes on profits generated by the corporation, first. The owners pay taxes again on the profits they receive as dividends. Although, S-Corporations avoid the corporate tax, their corporate structure and number/type of owners is severely limited (S-Corporations can only be owned by individuals, not LLCs or trusts). Fortunately, unlike corporations, LLCs do not pay any corporate tax. All profit and losses “pass through” to the member’s tax returns at the percent that they own the company. This is especially helpful if you own multiple LLCs as the profit and losses from each roll up to your personal taxes (a loss on one can offset a profit on another).

Liability Protection for the Real Estate Investor

As the name implies, an LLC provides limited liability to its members, meaning that any liability created by the company is limited to the company. The members’ personal assets are protected from all claims against the company. Partnerships and unincorporated businesses do NOT provide liability protection. It is critical that you protect your personal assets as a 2005 Congressional study stated: “small businesses bear 68 percent of business tort liability costs”. A properly set-up and maintained LLC can protect the owner’s interests in the assets of an LLC from the owner’s personal creditors.

Setting up an LLC for your Investment Properties

I recommend that you consult with a qualified real estate attorney when you set up your first LLC (or purchase your first investment property). Pay them to establish the LLC on paper and with the state. Have them teach you what should/must be done on an annual basis to maintain both the legal entity of the LLC and the litigation protection of the LLC. This may cost up to $1000 per LLC.  Some attorneys may offer a discounted price.

How Many Properties per LLC?

This is where a good attorney can weigh the liability protection versus the costs. Many advisors will tell you to set up one LLC per property. Practically speaking this is easy when you own 2-4 properties, but it will become increasingly cost prohibitive when you own 15 properties. Not only does it cost about $360 (in Minnesota, using BizFilings.com) to set up an LLC initially, but each year your CPA will charge you to prepare and file the tax return for each LLC (this costs me about $400 per LLC-you can imagine your tax bill if you had 15 LLCs!). Most real estate investors will put 3-5 properties in each LLC (grouping them based upon geography, age, liability risk, or equity position).

Moving your Properties into your LLC

A common misconception is that you must buy the investment property in the LLC’s name. Unfortunately, you would need to use commercial financing (with a 20% down payment) to have your LLC buy the property initially. A “Quit Claim deed” is all that is required to legally transfer the property from your personal name to your LLC. The mortgage(s) will stay in your personal name and it will remain on your credit report, but you will gain the liability protection mentioned above. This Quit Claim deed process requires a simple one page document signed and notarized by all owners of the property and it is then mailed with the appropriate filing fees (about $50-75) to the County recorder where the property is located.

Property Management Considerations

Technically, each LLC should have its own checking account, corporate credit card, and Quickbooks file. Again, as above, this may be possible with a limited number of LLCs, but it can be overwhelming to think about 15 checkbooks, 15 corporate credit cards, and 15 LLCs signing leases and performing evictions. Many real estate investors will transfer their properties into “ownership” LLCs which simply hold the properties. They will then set up a “management” LLC that signs all leases, pays all bills (including mortgages), contracts for all repairs, and retains one or two corporate credit cards. To keep the liability protection intact, you should have a management agreement signed by both the “ownership” and “management” LLC.

Using the LLC

All the work and cost of establishing the LLCs can be wasted if a judge agrees with the lawsuit plaintiff, that the LLCs are just shells. Follow your attorney’s advice, but generally, you should hold meetings (and keep written minutes of the meeting) on a bi-annual to annual basis. You should record decisions and “vote” on changes to the company. Lastly, have your attorney review your work annually to insure you are maintaining your legal protection in the event of litigation.

As you can see, an LLC has many benefits over other corporate entities (or no entity at all). Having an LLC for your real estate investment is an important step in providing protection for both your personal and corporate assets. Consider the creation and use of an LLC as important as learning how to find tenants.

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