The Ten Commandments of Real Estate Investment

Many of my clients are individual real estate investors.  Over the years, I have seen certain issues arise time and again with respect to this group of clients that sometimes cause legal headaches for them…and for me.  That is why I created a presentation some time ago called “The Ten Commandments of Real Estate Investment” which outlined some common do’s and don’ts when it comes to real estate investment.

Here they are, in true biblical verse:

#10 – “Thou Shalt Not Own Property in Thou’s Own Name”

Especially in a pro-tenant state such as Minnesota, owning investment real estate such as residential rental properties in your name individually is a dumb idea.  Instead, a single member limited liability company should be utilized to shield your personal assets from the liabilities arising from owning the property.  Absent egregious behavior on the part of the LLC owner, creditors of an LLC are limited to the assets of the LLC as to any judgment obtained against the LLC.  For those investors who own multiple properties, owning each property within a separate single member LLC has the additional benefit of compartmentalizing liabilities for each property within the particular LLC which owns that property.  What about administrative hassle such as tax reporting for these types of entities?  There isn’t any, as a single member LLC is a “disregarded entity” for Federal income tax purposes, meaning that all income from these entities are itemized on the LLC owner’s personal return.

The aforementioned reasons are why I’ve often said that use of single member LLCs to own real estate might be the biggest no-brainer there is.

#9 – “Thou Shalt Not Make Usurious Loans”

Some investors choose to be lenders, whether that be in the form of contract for deed sales or a straightforward loan transaction.  These types of investors provide a needed alternative for those who are unable to obtain traditional bank financing, and their payoff is that they charge a higher interest rate than traditional bank financing.  There are limits, however, to how much they can charge, and those limits are set forth in Minnesota’s usury statute.  Minn. Stat. § 334.01, Subd. 1 provides that “no person shall directly or indirectly take or receive in money, goods, or things in action, or in any other way, any greater sum, or any greater value, for the loan or forbearance of money, goods, or things in action, than $8 on $100 for one year.”  In other words, the maximum amount of interest that can be charged on loans of $100,000 or less in Minnesota is 8%; any higher rate is considered “usurious”, with the result that a lender who seeks to collect such interest can not only be barred from doing so, but a court can order that any interest already so paid must be paid back to the borrower with penalties.  There are exceptions to the usury law, such as for loans over $100,000.00 and loans to business entities such as corporations or LLCs, and proper consultation with a knowledgeable attorney as to the usury limits is a must.

#8 – “Thou Shalt Not Make Mortgage Loans Without Proper License”

Our Eighth Commandment also arises in the lending context, and it pertains to private parties making mortgage loans.  Not only does an investor have to be concerned about the usury statutes, but the investor also has to be aware of the fact that in Minnesota, as is the case in many other states, a mortgage loan originator must be licensed by the state.  Minn. Stat. § 58.04, Subd. 1(a) provides that “no person shall act as a residential mortgage originator, or make residential mortgage loans without first obtaining a license from the commissioner according to the licensing procedures provided in this chapter.”  Many people believe that since they’re dealing with investment property, that the property is non-residential and therefore Section 58.04 does not apply.  This is not the case, as Minn. Stat. § 58.02, Subd. 21 defines “residential real property” as “property improved or intended to be improved by a structure designed principally for the occupancy of from one to four families, whether or not the owner occupies the real property.”

#7 – “If Thou Are Not So Licensed, Thou Shalt Not Make Mortgage Loans Without Proper Exemption”

The Seventh Commandment is a corollary to the Eighth Commandment, and it relates to an exception to the general prohibition of Minn. Stat. § 58.04, Subd. 1(a).  There is an exemption to this general rule which permits not more than three loans in any twelve month period, but in order to qualify for this exemption the person making the loans must be using their own funds and they must apply for and obtain an exemption from the state.  Minn. Stat. § 58.05,  Subd. 5, however, provides that “a person must obtain a certificate of exemption from the commissioner to qualify as an exempt person under section 58.04, Subdivision 1.”  Many people misunderstand this exception and attempt to make loans without obtaining the exemption, which can expose them to the same significant fines and penalties which are imposed for violations of Section 58.04.

#6 – Thou Shalt Not Make “Sham” Mortgage Loans to Redeem Property in Foreclosure

Chapter 58 provides yet another trap for unwary investors.  Some investors look for treasure amongst the trash; that is, they look to find properties in foreclosure that could have significant equity if the junior liens on the property could just be extinguished.  Years ago when the real estate market was hot, a group of troublemakers known as “equity strippers” played a game where they would make a small loan to a homeowner who was in default of their mortgage, then redeem the property as junior creditor at the foreclosure sale and then lease the property back to the homeowner or sell it back on a contract for deed.  They would then create terms in the lease or contract, as applicable, which would guarantee a default by the previous owner and then walk away owning a property with significant equity which they could now sell after evicting the former owner. 

In light of those unfortunate transactions, Minn. Stat. § 58.13, Subd. 1(a)(13) was born.  This statute provides that “no person acting as a residential mortgage originator or servicer, including a person required to be licensed under this chapter, and no person exempt from the licensing requirements of this chapter under section 58.04… shall: make or assist in making any residential mortgage loan with the intent that the loan will not be repaid and that the residential mortgage originator will obtain title to the property through foreclosure….” 

My advice to investors trolling the foreclosure listings for a potentially valuable property is to look for those properties that have small junior mortgages, judgments or homeowners association liens that you can purchase and redeem as a junior creditor; do not attempt to place a new lien on the property during the foreclosure period as you run the risk of violating Section 58.13.

#5 – (When Applicable) Honor the FHA Seasoning Requirement

Some investors plan for a quick turnaround on properties they purchase.  Particularly when they’re purchasing foreclosed homes which have been trashed by the owner during the owner’s post-sale redemption period, these investors plan to fix up the property and recoup the costs of the improvements as soon as possible through a sale.  Standing in the way of that is the FHA’s “seasoning rule.”

On May 1, 2003, HUD imposed a 90 day title “seasoning requirement for all new FHA insured mortgage loans.  This rule can be found at 24 C.F.R. § 203.37a. “Seasoning” refers to the length of time that the seller has owned the property. Home buyers cannot obtain a conforming mortgage if they are putting less than 20% down and the seller hasn’t owned the property for at least 90 days.  The rule was originally put in place to prevent certain “flipping” transactions where a party would purchase a property and immediately sell the same property at a marked-up price.  With the majority of mortgages these days being FHA insured products, investors need to budget for a 90 day hold on their properties.

#4 – When Using Self-Directed Retirement Funds, Thou Shalt Not Engage in Prohibited Acts

One of the more popular alternative financing mechanisms for real estate acquisition is the use of the investor’s self-directed IRA.  These accounts, which can be established through a qualified third-party administrator, allow for the IRA owner to make investments which are not typically permitted by the traditional financial advisor, including real estate.  There are, however, restrictions which come with the use of self-directed funds, and some investors proceed without a full understanding of these restrictions.

A self-directed IRA is governed by the same regulations as any other IRA account.  These regulations prohibit certain “self-dealing” transactions between the IRA and its owner.  In the real estate investment context, the regulations prohibit the IRA owner from performing work on property owned through the IRA.  The regulations also prohibit the IRA owner from personally guaranteeing a loan where IRA funds are also used.  Most importantly, the regulations prohibit transactions with the IRA owner, their spouse, lineal descendants (parents and children) and entities or trusts controlled by any of these parties.  Violations of the regulations would mean that the IRA owner received a distribution from the IRA and, if the IRA owner is under age 59 ½, harsh taxes and penalties will apply.

#3 – Thou Shalt Not Convert a House in Minneapolis to Rental Property…Without Paying…Big Time

The Third Commandment is less of a rule than a warning.  The City of Minneapolis, in its infinite wisdom, has actually passed ordinances in an attempt to discourage investors from purchasing homes and converting them into rentals.  One of these ordinances is the imposition of a $1,000.00 “Rental Dwelling Conversion Fee” which must be paid in order to convert a homestead property into non-homestead property (such as a rental property).  Inexperienced real estate investors would be wise to simply avoid purchasing property in a City which views them as “the enemy”.

#2 – Thou Shalt Not Obtain a Certificate of Title for Torrens Property Without a Proceeding Subsequent to Initial Registration

When an investor approaches me about redeeming a property in foreclosure as a junior creditor, one of the first questions I ask is whether the property is abstract or Torrens.  Most investors are surprised to learn that Minnesota has two separate recording systems and that if the foreclosure is on a property registered in the Torrens system, a proceeding must be commenced through the Examiner of Titles in the county where the property is located in order to have a new certificate of title issued in the new owner’s name.  This proceeding is called a “proceeding subsequent to initial registration”, or “pro sub” for short.  I also inform the investor as to the cost of this proceeding (which does require an attorney’s assistance) which should be budgeted into an acquisition strategy.

#1 – Thou Shalt ALWAYS Hire a Good Real Estate Attorney

Like you couldn’t see this one coming?  Following the First Commandment helps you comply with the Second thru Tenth Commandments.