LLCs and personal mortgages

Multi-Family and Apartment Investing
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LLCs and personal mortgages

Jared Ryan
San Jose, CA · Member since 2019 · 22 posts · 7 votes

Hello BiggerPockets!

I'm exploring the possibility of getting a 10-unit apartment building. With that in mind, I'm wondering if I should get an LLC.

Benefits of LLC:

1. If I live in the property, I, Jared, can rent from my LLC, and that provides come interesting tax advantages. Though I got lost in the weeds here, I couldn't quite figure out how advantageous that would be.

Could someone please provide more insight on this?

2. Liability protection. Well, sort of. Everywhere I read says just go for good insurance, at least for newer investors. Maybe when the portfolio gets larger, or if I were branch into other areas of real estate, it would make sense (wholesaling, agent, flip, etc.).
3. If I want to go buy more real estate, the commercial loan and LLC don't show up on my personal credit.

That's pretty nice if I want to go buy future 1-4 unit properties. However, I've read that the commercial loan / LLC is still something I need to disclose as I try to get funding for my next property. So, does the LLC actually benefit me at all, when it comes to seeking future loans? If the lending institution knows about the commercial loan / LLC after all, it seems like I would probably qualify for the same mortgage amount that they would lend to me without an LLC, but just perhaps I would get a better rate with having the commercial loan in the LLC because I would have better credit.

The reason I ask is because I have not yet utilized the oh-so-beautiful FHA loan, so after I use my full borrowing capacity on the commercial property, I'd probably try to buy up the most expensive 4 unit or smaller that the bank will let me purchase, and knowing how LLCs impact my personal borrowing ability will help me gauge how much I should be able to borrow for the FHA loan. And if I should get the LLC at all.

Cons of LLC:

- It costs time and money to set up and maintain, and it costs different in each state. So...to know if I should get one, I should just make sure the benefits outweigh the cons.

Are there any other pros/cons I'm missing here?

Thanks in advance!
Jared Ryan

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David M.
Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
5y

@Jared Ryan

You might want to read this first:   https://www.biggerpockets.com/...

Some more info is here:   https://www.biggerpockets.com/...

Next, in general consult a professional...  Also, consult a professional about #1.  That should be a self rental situation.  In that case, your rent is considered active income, subject to all taxes at your ordinary rate including self employment tax I believe.  Meanwhile, your expenses are passive.  That is a really bad situation.

The LLC doesn't provide any tax benefits, only liability protection. But, that being said, there is much talked about how lawyers are able to pierce the corporate veil. I think its because most people don't operate their LLC correctly. Many brag about all the deductions they are doing and that their cpa/accountant is doing for them and its right. However, the corporate veil is a legal issue, not an accounting issue. So, "pure" accountants don't know or care about the corporate veil issue.

Protecting the corporate veil basically brings in lots of additional costs/overheads. The big one is needing to use commercial financing since a legal entity, such as a LLC, is not eligible for conforming residential loans.

Realize that 1-4 family homes are considered residential.  5 or more family homes/properties are considered commercial properties.  So, if you are doing larger properties you are going to be handling it as a commercial transaction anyway.

FHA loans require owner-occupation.

I'm not so sure you understand what you are trying to convey with the following: "...so after I use my full borrowing capacity on the commercial property..."  I don't.

Be wary of those that want you to have the loan in your personal name and the Title in the LLC. I elaborate more in this discussion:

https://www.biggerpockets.com/...

Also, I don't think you fully understanding how real estate lending works...

For your reference, here is a post on the insurance idea side:  https://www.biggerpockets.com/... .  The general idea is when you are starting, you really don't have that much liability that the insurance can't handle is the short of it.

I'd  be happy to chat if you'd like.  Its save me from having to type out a "one-way lecture."  Good luck.

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  • David C.
    Accountant · NC · Member since 2017 · 64 posts · 26 votes
    5y

    @David M.

    Correct. The issue is most underwriters are not properly trained and the procedures and systems that they use do not properly account for cash flow. It's takes an underwriter who is willing and wants to challenge themselves to grasp self-employed tax returns.

    0Reply
  • Joe SplitrockPro Member
    Moderator
    Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes
    5y

    @Tim Delaney he purchased in December 2020, but placed tenants in April. That means it wasn't in service in 2020. Even if he advertised it in 2020, with no income on a first property it should not be claimed on taxes. 

    Given that he didn't even know what a schedule E was before this discussion thread, I highly suggest getting a consultation with a tax professional. House hacking is harder than a standard rental property to claim on your taxes, because you need to split expenses between personal and rental. That means setting up basis for depreciation is not as simple as subtracting land value from purchase price and every common area expense is split. 

    @Jared Ryan there is nothing wrong with getting an LLC, but odds are good that you will not be able to take out a loan for a ten unit building with that LLC. Your new LLC will have no credit history, so to get that loan approved, you will need to be a cosigner on that loan or even secure the loan personally.

    As others said, the 10 unit property will be on your taxes and could even show up on your credit report as a cosigning. The property will be disclosed to the bank, so the income and/or expense will be part of your financial record. 

    As far as tax advantages of renting from your own LLC, I would drop that idea quickly because the IRS prohibits it. You are creating phantom losses for tax gain that serve no business value. (Reference the economic substance doctrine of Section 7701(o) of the Internal Revenue Code.)

    2Reply
  • Jared Ryan
    OP
    San Jose, CA · Member since 2019 · 22 posts · 7 votes
    5y

    Thanks all, it seems pretty clear that the DTI being separate is only applicable if the LLC has its own track record and I'm not personally guaranteeing the loans in it. Which, I would have to do with my future LLC being brand new, and being the sole owner. Maybe setting up an LLC and using it years down the road, then possibly, maybe it could qualify for loans based on its own merit, and then I could qualify for personal loans where they focus more on my own merit (even though they would be aware of the LLC, too).

    But until then, there is the Global Debt from the LLC perspective taking my personal finances into account for getting loans for the LLC, and as the person signing the LLC's loans, the LLC is very much visible on my personal finances. There's no real way that these can be separated when you're starting out, which makes sense because the finances are very much dependent on each other in the beginning.

    And yeah, the link David M. had provided also made it pretty clear...don't rent to yourself. Thanks for also confirming that, Joe Splitrock.

    And yes, that's right, I only started renting it in April 2021, so I'll need to get educated on that for when I file taxes for 2021 next year. But that's a completely different discussion.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Joe Splitrock

    You might want to double check.  Just because there aren't tenants in there doesn't mean that it was NOT placed into service.  If he advertised it for rent in Dec, then most likely it was considered placed into service albeit for probably a week or two.  Technically, it should be part of his tax return... 

    But, I do agree that with a househack it will be more complicated.  We've had discussion threads on BP where apparently just about every does it wrong, trying to 90% of the expenses when its more like 25%.

    0Reply
  • Grant W. Wilson
    Lender · Boerne, TX · Member since 2018 · 29 posts · 28 votes
    5y

    Another Pro you might value is the privacy of an LLC. Anyone can look you up on public records and see that Jared Ryan owns that property. I personally don't like this, as it means if anyone were to sue you, or if you ever had to declare bankruptcy, or if anyone simply wanted to simply find your home address - it would all be listed on the Appraisal District's property profile.

    One additional Pro - you can take all the cash flows coming into the LLC and set up a bi-monthly or monthly "salary" that you pay yourself/your spouse in order to establish the type of income (W2) needed to qualify for mortgages in your personal name. If you are attempting to use the rental income towards a loan application without employing this method, lenders will refuse to count the investment income until you have received it for 2 years. This applies on a property by property basis. So as you add additional properties, they will have to be cash flowing consistently for 2 whole years before you can count them in underwriting.

    1Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Jared Ryan

    Be mindful that achieving anonymity via LLC's is a bit more complicated. You'll have to nest LLC's and start from an anonymity state. In other discussions, one well regarded author (who is a lawyer and cpa) writes that in the end you will probably be disclosing if you ever get to court. Oh, since you are from California it just gets more expensive. CA charges $800 (or was it $700) annually per LLC even if its formed out of the state. That's is brought up all the time. That will eat into your profit pretty quickly. Many in CA haev to think really hard about using a LLC.

    Converting rental income into salary is a pretty advanced technique.  Usually, its not advisable since you are converting your income from one of the most tax advantageous categories, passive income, to the least, active income.  You will be taxed at your ordinary rate and be subject to "all" taxes including self-employment (and don't forget state and local taxes such as unemployment, disability, etc).  As we mentioned before, the rental income is already being added towards your income for your dti.

    1Reply
  • Joe SplitrockPro Member
    Moderator
    Rental Property Investor · Sioux Falls, SD · Member since 2015 · 9k+ posts · 18k+ votes
    5y
    Originally posted by @David M.:

    @Joe Splitrock

    You might want to double check.  Just because there aren't tenants in there doesn't mean that it was NOT placed into service.  If he advertised it for rent in Dec, then most likely it was considered placed into service albeit for probably a week or two.  Technically, it should be part of his tax return... 

    But, I do agree that with a househack it will be more complicated.  We've had discussion threads on BP where apparently just about every does it wrong, trying to 90% of the expenses when its more like 25%.

     Normally if it is advertised and rent ready (someone can move in), then yes you can claim the property. The house hack aspect means it is a personal residence. If you use a property for personal use and do not rent more than 15 days, the primary use is not considered as a rental and it cannot be claimed on schedule E. This is to prevent people from claiming their primary or vacation home as a rental to create tax loss. 

    House hack should normally be split by either square feet rented versus not rented or number of rooms. The IRS gives some latitude saying "reasonable method" should be used. You are right that 90% is not reasonable. The trouble is most house hackers are newbies who took zero time to educate themselves on tax law and they are too cheap or broke to hire a tax professional, even though they need one badly. As the saying goes, "you don't know what you don't know" and that is so true in the case of rental properties.

    1Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Joe Splitrock Thanks for clarifying/reminding.  I forgot about the 15d for a house hack.  :)

    0Reply
  • Jared Ryan
    OP
    San Jose, CA · Member since 2019 · 22 posts · 7 votes
    5y

    I didn't advertise until March, I took my sweet time moving in. So nothing reported on tax returns. But good to know that you can roll back those benefits to when you start advertising for all future properties.

    It was interesting looking into tax benefits for househacking. It seems like I can deduct 75% since I'm 1 of 4 people on depreciation, repairs, insurance, etc. If my "reasonable" estimation goes by square feet, it doesn't look as good for me...so maybe more around 40-50% for some items. But still, on everything that can't get deducted, the taxes hurt so much. The problems of living in an expensive market...you make more, but you also get taxed more.

    And with that in mind, I would probably not pay myself a salary out of my LLC since I'll probably keep my W-2 for another 1-3 years to really kickoff the portfolio, and that would lead to high taxes on that rental income. It's good to know that is an option in the future, though; when I quit my W-2, it'll depends more on if I want to make more from tax deductions, or if I want to qualify for loans. I'd need to revisit this, at that point.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Jared Ryan

    Buddy, you need some serious studying...

    "...roll back those benefits.."   Roll back what benefits? I'm pretty sure that Dec to March is all on you...  That's what Splitrock was saying...

    Yup, your 75% ideal is exactly what I was saying --- ain't goin' to happen.  Its not rocket science.  Say you have 150sqft bedrooms.  Thats 450sqft. Lets say you have a 2000sqft house.  Since only the 450sqft is specifically rented out to your tenants and the rest is yours/common, then its 450/2000 or 22.5% --- just for this example.

    I don't do this sort of investment, but as I vaguely recall, I'm not sure if you can deduct utilities since its not separately metered.  The prior BP discussions basically pointed to this form of house hacking (where you rent out by the bedroom) really has little tax benefit.  You just get live-in tenants / roommates and collect some rent that you have to pay tax.

    Don't make up or assume how you think you can make money...

    0Reply
  • Jared Ryan
    OP
    San Jose, CA · Member since 2019 · 22 posts · 7 votes
    5y

    @David M.

    First. That's why I'm here, David. Trying to learn all I can. No need to patronize me, it's a little insulting.

    Second. For clarification, that's why I said on future properties. If I advertise in the future and things don't get filled right away, now I know I can still deduct back to that date that I put it into service. Not going to try to claim tax benefits back to December on my current property.

    Third. Not making things up, David. Again, a little insulting. Here's a reference: https://www.nolo.com/legal-enc...

    You can use any reasonable method for dividing these expenses. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. However, the two most common methods for dividing an expense are either based on the number of rooms in your home or based on the square footage of your home.

    So, for things like utilities, 75% is reasonable as 1 / 4 people in the home. For pretty much all other deductions, though...it's square foot of their 3 bedrooms and 1 full bathroom divided by the total square footage of the house. Probably more around 35% for my home.

    I appreciate all your advice, but not always loving the way you share it.

    0Reply
  • David M.
    Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes
    5y

    @Jared Ryan

    Sorry....

    Guess a little punchy tonight...  Guess I should stay off the boards tonight.

    I'll quit here, but find some better material.  Splitrock and I have been touching on most stuff and adding some depth.  I guess it depends on what you do in the future.  If its a househack it doesn't work that way.  there is a difference between prior to service, after, and sometimes it can be in service --- then go out of service --- then back in...

    Good luck.

    0Reply
  • Jared Ryan
    OP
    San Jose, CA · Member since 2019 · 22 posts · 7 votes
    5y

    Haha the sass just comes out more on some days than others, I get that and embodied it just a few minutes ago, @David M. Thanks for saying that, and again, for all your help. And noted about the househack not being straightforward. I definitely plan on working with a professional on my taxes next year, especially if an LLC and commercial loans come into the picture.

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