How Trusts Protect Your Short-Term Rental Properties
Trusts have long been seen as an effective tool for asset protection and estate planning. However, many short-term rental investors have been confused over how a trust should be incorporated into an asset protection strategy that provides protection, flexibility, and control. We will take a few minutes to unpack the concept of how a trust can provide you protection and control over your short-term rental assets.
Foreign Asset Protection Trusts
Let me start by saying, not everyone needs the protection of a foreign asset protection trust. If you are a short-term rental investor that is working a W-2 job and is considering your purchase of your first short-term rental property, a foreign asset protection trust makes no sense. Why? Because they are complicated to set up, maintain and are a significant investment designed to protect individuals with a well-developed portfolio of high-risk assets. The being said, it is important to analyze the advantages and disadvantages of establishing a foreign asset protection trust:
What are the advantages of a foreign asset protection trust? The biggest advantage of a foreign asset protection trust is that they work! There is numerous case law establishing that creditor attacks from the IRS, FTC, and SEC have failed to penetrate the protection provided in a properly established foreign asset protection trust in a favorable jurisdiction.
Although there are many jurisdictions you can consider for a foreign asset protection trust, the oldest and most established jurisdiction is the Cook Islands. The first foreign asset protection trust legislation was introduced with the Cook Islands Trust Act in 1984. This foreign legislation provided statutory non-recognition of any other jurisdictions judgments, including the United States. In other words, if a judgment is brought against you and the creditor attempts to attack a Cook Islands trust, the judgment will be worthless!
In the United States, attorneys like to start with a fishing expedition by filing a lawsuit and amending their filings against the defendant. This allows them to fish into the claim and figure out which legal argument is strongest in court. However, if you bring a judgment in the Cook Islands, you are required to start your case over from the beginning if you amend your filings. This can create a significant deterrent for creditors and attorneys attacking your trust.
The burden of proof in court for a plaintiff’s attorney suing a Cook Islands Trust is beyond a reasonable doubt. In other words, a suing attorney attacking a foreign asset protection trust must prove their case at the same level as a prosecutor proving a murder trial! Additionally, the Cook Islands do not allow attorneys to take contingency fees for lawsuits. This is critical because this will require to pay the attorney out of their own pocket on an hourly rate with little chance of success in trial.
What if you lose in trial when attacking a foreign asset trust in the Cook Islands? Loser of the lawsuit must pay the costs and fees of the winner! Another deterrent to bringing a lawsuit in the Cook Islands is that the statute of limitations to bring a lawsuit is short and most attorneys will never attack a Cook Islands Trust because it is too expensive and too risky.
What are the disadvantages of a foreign asset protection trust? They are expensive! It can easily cost $50,000 – $75,000 or more to set up a foreign asset protection trust and usually requires a minimum of $10,000 per year to maintain it. The Internal Revenue Service also requires you to file Form 3520 and 3520A each year with full disclosure of assets and the role of the trustees. If the assets are moved offshore, the Foreign Account Tax Compliance Act (FATCA) applies, and additional reporting requirements will exist for IRS compliance. Finally, the biggest drawback of a foreign asset protection trust is that you lose control of the trust assets because the foreign trustee will have legal title to the assets. This is a big negative! You want to maintain both protection and control over your short-term rental assets!
Domestic Asset Protection Trusts
Another option to consider is the use of a Domestic Asset Protection Trust to protect your short-term rental properties. The first Domestic Asset Protection Trust was established by Alaska in 1998. The statute emulated the Cook Islands Trust Act and attempted to provide similar protection. Subsequently, nineteen states have added a similar protection: Alaska, Delaware, Hawaii, Michigan, Mississippi, Missouri, Ohio, Oklahoma, Nevada, New Hampshire, Rhode Island, Connecticut, Indiana, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming.
What are the advantages of a domestic asset protection trust? The biggest advantage is that they are cost effective and state and federal compliance is much easier than a foreign asset protection trust.
What are the disadvantages of a domestic asset protection trust? They do not work! The idea of a domestic asset protection trust was good in theory but presents challenges due to the full faith and credit clause of the U.S. Constitution. States are required to give full faith and credit to the laws, judicial proceedings, and judgments of other states. An Alaska domestic asset protection trust may claim to provide protection against a California judgment against a short-term rental property, but in reality, these states must respect a California judgment based upon the Constitution.
Under Section 10 of the Uniform Voidable Transactions Act, the home state of the asset controls in court. As such, using a preferrable state’s domestic asset protection trust provides little protection if your short-term rental is located in a different state. Additionally, Section 548e of the Bankruptcy Code provides a creditor the ability to obtain assets transferred to a self-settled trust within 10 years of its origination. As such, the older a trust is, the more protection it provides.
Finally, California has ruled that merely setting up a domestic asset protection trust has been ruled as evidence of a fraudulent transfer. In other words, a California court ruled that merely attempting to protect your assets in a domestic asset protection trust must have been done solely to perpetuate a fraud against a creditor.
The ideal scenario would be to establish a trust that blends the best of both a domestic structure (cost effectiveness, control, and easy maintenance) and a foreign domestic asset protection trust (protection). This ideal scenario can be achieved through a hybrid trust.
A hybrid trust is achieved by establishing a foreign asset protection trust from the beginning that is linked to a domestic asset protection trust. This structure allows the domestic trust to be a simple grantor trust for tax purposes but stands ready to provide total protection in the event of a lawsuit as a foreign asset protection trust.
How is this achieved? The foreign asset protection trust is established and registered offshore and linked back into the United States by the IRS as a domestic grantor trust. Under I.R.C. 7701(a)(30)(e), a two-part test was established by the IRS in order for this structure to be effective. It requires: (1) A U.S. jurisdiction (court) must have the primary supervision over the trust AND (2) control of the trust by the trustee must be vested in one or more United States persons.
The hybrid trust structure allows you to have the control and flexibility of a domestic trust, coupled with the compliance and protection of a foreign trust. In practice, here is how it works:
Pre-lawsuit – a United States jurisdiction is established for the trust. If you reside in one of the nineteen states with a domestic asset protection trust statute, you can easily establish a trust in that state. If not, a Nevada domestic asset protection trust can be established and referenced in the foreign asset protection trust.
Pre-lawsuit, the trust is nothing more than a simple grantor trust and disregarded for tax purposes. This allows you to continue to take advantage of all the tax benefits as a short-term rental owner. Additionally, you can maintain control of the hybrid trust pre-lawsuit by being the trustee and remaining tax neutral. Prior to a lawsuit, you have minimal IRS compliance issues: No IRS Form 3520 or 3520A, No IRS FATCA Disclosures, No other IRS filing requirements. All trust assets remain in the United States in a local bank and no requirements exist for an active foreign trustee.
Post-Lawsuit – a creditor or personal injury brings a lawsuit against your short-term rental property. What now? The foreign asset protection trust assigns the trustee the power to declare an event of duress. The special successor trustee in the foreign jurisdiction becomes co-trustee of the trust and can now remove the local trustee (YOU) because you are in a jurisdiction where the event of duress occurred. At this point, the foreign trustee can take steps to protect the assets, including the establishment of foreign bank accounts, selling, and leveraging assets for protection.
Trust Planning With Your Short-Term Rental Asset Protection Plan
By combining LLC, LP and Trust entities to create a custom and comprehensive asset protection strategy, you maintain control over your assets, while ensuring a hybrid trust provides ultimate protection in the event of a lawsuit. Essentially, you control your Limited Partnership, and your hybrid trust owns your limited partnership.
An additional benefit of this strategy is the estate planning value it provides to you and your family. In the event you die, all your trust assets would pass through your living trust to your beneficiaries. This strategy allows you to avoid costly litigation in probate court and a smooth transition of your wealth to your designated heirs, while maintaining maximum estate tax exemptions under the law.
If you are sued or attacked by a creditor, the hybrid trust (listed as your limited partner in your Limited Partnership holding company) makes a unilateral withdrawal from the partnership, allowing a severance of the relationship and an additional layer of protection for your assets.