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Refinance through LLC

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MIKEPIN

Junior Member
Florida

My wife and I own a rental property. We need to refinance. We have a really good offer from a bank, but they require us to move to the property into a Delaware SPE.
We would make it an LLC.

We have paid down the house a bit and we have had it for many years and depreciated it.

Would we run into tax issues like capital gains if we transfer to an LLC?

Any other ideas?
 


Taxing Matters

Overtaxed Member
I'm a bit wary of the bank requiring you to transfer the property to a separate entity. It really should make no difference to the bank. it's risks are exactly the same whether you put it in a LLC or not. And the requirement specifically for a Delaware entity? That is bizarre. It should not matter to the bank in what state the LLC is set up. In general there is no benefit to you for doing that, and it results in extra costs and administrative work. Did the bank give you an explanation for the reason it wants you to do this? You are getting a really good offer, is it a lot better than everyone else is offering? If so, again that triggers warning bells for me.

The only time I've ever seen a lender have a need for a borrower to move property to a separate entity is to get around state usury laws. Some states exempt loans to business entities from their usury laws. Usury laws are laws that set the maximum allowed rate of interest that a lender may charge. In Florida, the maximum rate of interest that may legally be charged is 18% unless the loan is for more than $500,000, in which case there is no limit except for the really high limits of the state's loan sharking statute. And in Florida that 18% applies to all loans, whether to individuals or to business entities. In today's low interest environment, no lender in a real estate loan will have a legitimate need to charge high interest (certainly not enough to trigger the usury laws) unless your credit really sucks. If I were you, I'd have the proposed documents closely reviewed by your own real estate lawyer to ensure the lender isn't setting up to screw you on this. There is probably something going on here that the lender is not telling you.

As for your tax question, moving the property to a LLC won't change how the rental property activity is taxed. If you own the property jointly now then you have a partnership already, and moving it to a LLC that you each own wouldn't change that. If just one of you owns the property now and just one of you owns the LLC after then the rental is just a sole proprietorship. You may elect to have the LLC taxed as a S corporation or C corporation, but there is likely no benefit to you in doing either of those. Indeed, the C corporation might result in more tax paid. But by default, the LLC is treated as either a sole proprietorship if it has one owner and a partnership if it has more than one owner.
 

MIKEPIN

Junior Member
Thanks for your answer.

I have two banks suggesting a DE SPE, a mortgage broker (not mine) tells me that is not uncommon.

  • DE SPE is more favorable to lenders because the laws in that state are more advanced relative to other states. Some features like the bankruptcy of an owner or member don't cause the SPE to dissolve is an advantage. Rating agencies view DE SPEs more positively than other states.
  • Ultimately a SPE in Delaware will provide you with the best rate, otherwise Leverage will be decreased by 5% and the rate will be 25bp higher.
I like the idea of moving the property into a DE SPE (as an LLC), but my concern is that I do not want any tax disadvantage. Property right now owned by my wife and me and we would have the LLC together.

Somebody told me that this could tricker capital gains.
 
Last edited:

FlyingRon

Senior Member
I don't know why it should have any effect on capital gains. What's going to be different is your tax filings. An LLC for a married couple (not in a community property state) is going to require a partnership filing. You just can't pass it through as sole proprietorship on your joint return (as you could without the LLC or you might if you were in a community property state).

Are you sure that snippet you posted isn't talking about using a Delaware LLC vs. some other state's LLC, rather than an LLC vs. personally owning the asset?
 

Taxing Matters

Overtaxed Member
I like the idea of moving the property into a DE SPE (as an LLC), but my concern is that I do not want any tax disadvantage. Property right now owned by my wife and me and we would have the LLC together.
I think having a LLC may indeed be useful. I advise my clients that want to do rental properties that a LLC or LLP is a good idea. It can provide some limited liability protection (though less than many clients assume) and they are not all that expensive or difficult to set up and maintain. But generally there is no good reason to set the LLC up in state other than the state in which you are conducting the activity. If the property is in Florida, then unless you have some very unusual circumstance you are better off just forming the LLC in Florida. If you form it in Delaware, you are not getting any extra benefit from that, but you do get extra cost and administrative work. Why? Because if you form a Delaware LLC, you still have to then register the DE LLC in FL as a foreign LLC in order to get the LLC protection in FL. That means you pay the same fees, etc, to FL that you would have if you just formed in there in the first place, and now you have to do reports, etc, in two states instead of one. And all that for what? Unless you can articulate a clear advantage to forming it in Delaware over Florida then it is a waste to form the LLC out of state.

Now I have clients who will say to me "but lots of big name companies form their corporations in DE so there must be some great reason for choosing to incorporate there." And they are right. For large publicly traded corporations there is a distinct advantage to forming their corporations there. But those reasons are unique to large publicly traded companies and aren't things that help a small closely held business. You see, Delaware has laws that favor corporation management over shareholders and Delaware also has specialized courts that expedite resolving cases between shareholders and management. That's a powerful combination that draws corporate management to want to have the business incorporated in that state. But you and your wife are both the owners and managers of the business. Nor is your business publicly traded. So you won't have need of those special laws and courts that DE has.

Somebody told me that this could [trigger] capital gains.
I assume this person was not a tax lawyer. If you and your wife own the property now 50% each and you transfer it to a LLC that you each own 50% each then there will be no tax event here and no capital gain recognized. And the taxation of the income from the LLC will continue as before, as a partnership between you and your wife. (If you've not been treating it as a partnership up until now, you may need to fix that.) You may want to see a tax lawyer to review your set up to make sure you're doing the taxes correctly. But if you set up the LLC properly you should not have any tax consequence moving the property to the LLC.

I would still encourage you to see a real estate lawyer about that bank loan. The bank's requirement to transfer the property into a DE LLC is odd, and the loan documents should be carefully looked at to be sure you won't get screwed by the bank later on.
 

MIKEPIN

Junior Member
My main concern was to not trigger any captial gains taxes moving the properties into an LLC.

Are you sure that snippet you posted isn't talking about using a Delaware LLC vs. some other state's LLC, rather than an LLC vs. personally owning the asset?
Yes, 100%. They do not requite an LLC. They requite a Delaware SPE. Most SPEs are LLCs.

I found more:

We are able to obtain more competitive interest rates though Commercial Mortgage Backed Securities (“CMBS”) loans instead of traditional bank financing. CMBS loans meet special requirements allowing them to be bundled and sold in blocks on capital markets. Usually income properties with tenants are the most common types of projects eligible for CMBS loans.

The CMBS lenders have a checklist of requirements that the borrower must satisfy to be eligible for this type of financing. The special purpose entity (“SPE”) which is almost always an LLC is one of them.

An SPE LLC Operating Agreement will prohibit any activity or ownership of assets outside the scope of the particular activity and real estate being financed. For the investors in these CMBS loans to reduce their risk associated with various freedoms inherent in an LLC, the borrower LLC must put on “handcuffs” and give up many freedoms with the LLC to be eligible for the reduced rates that come with CMBS financing. The LLC Operating Agreement must contain certain unusual provisions, such as no amendments to the Operating Agreement without lender’s consent.

Accordingly, the Certificate of Formation and Operating Agreement for this type of LLC will generally have a long list of restrictions on the company that are copied from loan documents. Significantly, CMBS lenders do not rely on having these provisions in the loan documents but require them in the company’s organizational documents, perhaps to emphasize that the prohibited acts exceed the company’s authority in addition to constituting a loan default.

The list of restrictions are intended to assure that the company remains a single purpose entity which is “bankruptcy remote”. This means that should the company’s principals, parent company or affiliates become insolvent, the SPE LLC will not be brought into the bankruptcy or insolvency proceeding affecting related persons. “Bankruptcy remote” does not mean “bankruptcy proof”. Bankruptcy can still occur if the business of the SPE LLC fails, although, as discussed below, lenders seek protections even in this instance.

The biggest risk being reduced by the SPE structure is the risk of interruption in payments from tenants should the member of the LLC declare bankruptcy. For example, in the event a loan is to finance a building used for student housing, multi-family housing, shopping center or commercial office buildings with tenants, then a bankruptcy of the member in a non-SPE LLC may cause the rents to be paid to the bankruptcy trustee or debtor in possession. This is a risk to the bank or investor “holding the paper.” Thus to reduce that risk the LLC may have a “special member” who only becomes a member with a vote in the event the single equity member experiencing a trigger event, such a bankruptcy.

Depending on the lender, often the lender’s checklist requires the SPE LLC to be a Delaware LLC.
 

Taxing Matters

Overtaxed Member
My main concern was to not trigger any captial gains taxes moving the properties into an LLC.

You already have your answer on that.

If you want to subject yourself to the restrictions this lender seems to want to impose to get a bit better rate on the loan, that is of course up to you.

 

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