What Is a Bankruptcy-Remote Entity?
Bankruptcy-remote entities, or BREs, are very common in apartment investing. Find out what you need to know.
- Why Bankruptcy-Remote Entities Are Used in Multifamily
- Which Loans Require Them?
- How to Form a Bankruptcy-Remote Entity
- 1. Name Your Legal Entity
- 2. File Articles of Organization, Create a Holding Structure
- 3. Draft an Operating Agreement
- 4. Get Professional Advice
- 5. Register for Taxes
- Costs of a Bankruptcy-Remote Entity
- Related Questions
- Get Financing
Bankruptcy-remote entities, or BREs, are used to limit the financial risk of a project. They are extremely common in commercial and multifamily real estate and are required by many lenders.
This article explores the hows and whys of bankruptcy-remote entities as they relate to multifamily properties.
Why Bankruptcy-Remote Entities Are Used in Multifamily
Bankruptcy-remote entities offer a level of protection for investors and lenders in the multifamily sector.
For an investor, these entities ensure that the bankruptcy of another partner doesn’t impact your property or investment.
Let’s use an example to illustrate what I mean: James and Michelle are 50/50 partners on a multifamily investment with a market value of, say, $1 million.
James falls behind on a $650,000 personal home loan and ends up declaring bankruptcy. His assets are liquidated to pay down his debts…but does that mean he must offload his multifamily property, too?
That depends. If his ownership interest in the apartment building is through a bankruptcy-remote entity, it is generally protected. That’s a big sigh of relief for Michelle.
It’s a relief for multifamily lenders for the same reason. If the small apartment building is tied to a multifamily loan, liquidating that asset in bankruptcy proceedings could mean the lender doesn’t earn their full return on the loan — and they may even take a loss.
For this reason, BREs are used in nearly all multifamily transactions to effectively separate assets from individuals, thus keeping them safe from any personal bankruptcy issues that an investor may have.
Which Loans Require Them?
The vast majority of lenders require that their borrowers utilize bankruptcy-remote entities to qualify for a loan for the reasons above. The following is a non-exhaustive list of financing types that typically require them.
Freddie Mac loans
HUD multifamily loans of all types
USDA loans
CMBS loans
Bank and credit union loans
Life company loans
What is a bankruptcy-remote entity?
A Bankruptcy Remote Entity is a legal entity that is structured in such a way that, if the parent company declares bankruptcy, it will not likely affect the financial status of the borrowing entity itself. This protects both the borrower, lender, and HUD from any unexpected financial complications. However, there is one major downside; in most cases, if a property is losing money, the borrower cannot inject cash into the property in order to save it from foreclosure. More information can be found at HUD 223(f) Loans.
What are the benefits of setting up a bankruptcy-remote entity?
The benefits of setting up a bankruptcy-remote entity include protecting the borrower, lender, and HUD from any unexpected financial complications. This is because, if the borrowing entity’s parent company declares bankruptcy, it will not likely affect the financial status of the borrowing entity itself. Source
What are the risks associated with a bankruptcy-remote entity?
The main risk associated with a bankruptcy-remote entity is that, if the property is losing money, the borrower cannot inject cash into the property in order to save it from foreclosure. However, they may be able to get a HUD 223(d) operating loss loan in order to inject some cash into the property and give it time to stabilize. Source
How does a bankruptcy-remote entity work?
A bankruptcy remote entity is a legal structure that protects the borrower, lender, and HUD from any unexpected financial complications in the event that the borrowing entity's parent company declares bankruptcy. This structure ensures that the borrowing entity itself will not be affected by the bankruptcy. However, there is one major downside to this structure; in most cases, if a property is losing money, the borrower cannot inject cash into the property in order to save it from foreclosure. Source
What are the legal requirements for setting up a bankruptcy-remote entity?
The legal requirements for setting up a bankruptcy-remote entity vary depending on the jurisdiction in which the entity is formed. Generally, the entity must be structured in such a way that it is legally separate from its parent company, and that it is not liable for the debts of its parent company. Additionally, the entity must be structured in such a way that it is not subject to the bankruptcy laws of the jurisdiction in which it is formed. For more information, please refer to the HUD 223(f) Loans Bankruptcy Remote Entities page.
What are the tax implications of a bankruptcy-remote entity?
The tax implications of a bankruptcy-remote entity depend on the type of entity and the jurisdiction in which it is located. Generally, a bankruptcy-remote entity is treated as a separate legal entity for tax purposes, meaning that it is subject to its own tax obligations. For example, in the United States, a bankruptcy-remote entity may be subject to federal income tax, state income tax, and local income tax. Additionally, the entity may be subject to other taxes, such as payroll taxes, sales taxes, and property taxes. It is important to consult with a tax professional to understand the specific tax implications of a bankruptcy-remote entity.
Source: HUD 223(f) Loans: The Downsides of Bankruptcy Remote Entities
Most of these financing types also require the borrower to own no other assets through the entity, meaning they are generally single-asset entities.
How to Form a Bankruptcy-Remote Entity
To create a BRE for a multifamily investment, you generally need to follow the five steps below. Note that these steps are not universal, as they are handled at the state level. Most states, however, do have a similar process in place.
1. Name Your Legal Entity
Legal entities are registered at the state level, so you will need to choose a name for your LLC (or LP) that meets your state’s business requirements and is not yet taken. To check the availability of your selected name, most states offer an online business search function.
2. File Articles of Organization, Create a Holding Structure
You will need to file articles of organization with your state's business registration office, which usually requires a fee. The articles should include language indicating that the LLC is being formed as a bankruptcy-remote entity and will operate in compliance with the laws governing BREs in your state.
The BRE should also be part of a holding structure that separates the ownership of the property from the ownership of the BRE. One way to do this is through a series LLC, which allows multiple properties to be held in separate series or cells, but some lenders will not permit this.
3. Draft an Operating Agreement
Any operating agreement should include provisions that make it difficult for the owners of the BRE to file for bankruptcy or to have their bankruptcy affect the BRE's operations. This may include restrictions on the ability of owners to transfer ownership or assets, limitations on distributions and dividends, and requirements for maintaining certain levels of capital and insurance.
4. Get Professional Advice
To ensure that your entity is bankruptcy remote, you should strongly consider getting legal and financial opinions from third-party professionals. These opinions can provide assurance that your LLC has been structured in a way that will protect it from the bankruptcy risk of its owners.
5. Register for Taxes
Everyone’s favorite part: You will need to register your LLC for both state and federal taxes. This could include obtaining an Employer Identification Number, or EIN, from the Internal Revenue Service, even if you will not directly employ anyone through your entity.
Costs of a Bankruptcy-Remote Entity
The costs of creating a BRE can vary widely from state to state. That said, expect to pay an upfront fee to register your LLC, usually between $50 and $100, followed by recurring costs to keep it active — though not all states require those. You may also have to pay a small fee (typically less than $50) to reserve a name for an LLC.
Discover the one-off and recurring fees for each state.