Real estate investment in California is not just about acquiring properties; it’s about understanding the intricate legal landscape that governs these investments. For those who have formed entities to own their real estate, when you throw in the complication of a divorce for yourself or your business partner(s), it can negatively impact the business in various ways. Therefore, it’s crucial to recognize the potential complications that can arise in the event of a divorce, and the impact a divorce may have on you or your business partners and the business entity itself. Let’s delve into this topic and explore protective measures you can take.
1. Common Entities and Problems for Real Estate Investment and Divorce in California:
Before diving into the protective measures, it’s essential to understand the common entities through which real estate investors in California hold their properties and how issues arise in the divorce process for nondivorcing business partners:
Sole Proprietorship: In an ideal world, a real estate investor that owns multiple properties will have likely shifted out of this type of real property ownership and have no properties in transition from the buyer(s) to an LLC owned by the buyer(s) (for example). But if a divorce happens during the transition from purchase to transfer of title to a business entity there are so many complicated issues that will arise namely that there will need to be a tracing as to where the purchase funds came from to acquire the real property. For example, tracing of purchase funds from community/martial sources will be less complicated compared to a property that was purchased say using a BRRR method (or a hard money lender). Moreover, entering into a divorce will tangle a property up into litigation for a few months without a court order saying otherwise. So that interest on a hard money loan will eat into your profits. Additionally, for division of interest, there is no legal distinction between the owner and the business of a sole proprietorship. So, if there is a silent partner somewhere, that person is going to have to file a joinder to protect their interest in the real property.
Partnership: Obviously, this is when two or more individuals share ownership. There are different types, such as general partnerships (where all partners share equally in both responsibility and liability) and limited partnerships (which offer limited liability to some partners). Without clear agreements between the partners as to what happens in the event of divorce, partners as well as the business of the partnership (accounting records) can be dragged into court for valuation purposes.
Limited Liability Company (LLC): An increasingly popular choice, LLCs provide liability protection to their members (owners) while offering flexibility in management and taxation. Similarly with the partnership above, the operating agreement needs to be clear as to the management and ownership interest of the members. For example, the spouses may be considered one or two members but be sure to consider their community property interest when considering their percentage of ownership because the spouse of a member in a community property state (California) owns a 50% interest of the member’s share unless the spouse states otherwise in writing.
Corporation: This is a separate legal entity distinct from its owners. Shareholders own the corporation and directors oversee its affairs, and officers manage day-to-day operations. There is a tendency for S corporations to be passthrough corporations like partnerships where are a few to 1 shareholder. Again, like a partnership, in a community property state such as California each spouse of the shareholder owns a 50% interest of the shareholder share unless the spouse states otherwise in writing.
2. Potential Impacts of Divorce on Business Partners:
When a real estate investor faces divorce, several complications can arise for their business partners:
Asset Division: Without protective measures in place, a divorcing spouse might claim a share of the investor’s interest in the real estate entity.
Management Disruptions: The divorce process can lead to distractions and potential disputes, affecting the day-to-day management and decision-making of the entity.
Potential Sale or Liquidation: In extreme cases, a court might order the sale or liquidation of assets to facilitate a divorce settlement, impacting the continuity of the real estate investment.
3. Protective Measures for Business Partners:
To shield business partners from the potential fallout of a partner’s divorce, consider the following protective strategies:
Operating Agreements or Partnership Agreements: These foundational documents should contain provisions addressing divorce scenarios. For instance, they might stipulate that in the event of a divorce, the non-divorcing partners have the right to buy out the divorcing partner’s interest at a predetermined price.
Buy-Sell Agreements: These agreements detail what happens if a partner wants or needs to sell their interest, which can include divorce scenarios. Funding mechanisms, such as life insurance or installment payments, can be established to facilitate smooth transitions.
Prenuptial or Postnuptial Agreements: These marital agreements can specify that business interests remain separate property, ensuring they aren’t subject to division in divorce proceedings.
Corporate Bylaws or Shareholder Agreements: For corporations, these documents can outline restrictions on the transfer or sale of shares, providing partners with some control over who can become a shareholder in the event of a divorce.
While real estate investment in California offers lucrative opportunities, it’s essential to proactively address potential challenges, especially concerning divorce. By implementing the right protective measures and agreements, investors can safeguard their business partnerships, ensuring the continuity and success of their real estate ventures. Always consult with legal professionals familiar with California’s family and business laws to tailor solutions that best fit your unique situation.