mortgage interest question

[Kram BergGold]

My client wants to buy a piece of real estate that will be placed in a partnership LLC (the two partners will be him and his wife). I believe this is ok to do. He does not want to make this a disregarded entity. The way he wants to finance this is to take out a home equity loan for $300,000 against his primary residence. If this were not in an LLC I would just atttach a form to his 1040 saying we are tracing the debt and not treating it as home mortgage interest and then he would have not problems with mortgage debt limits or AMT. Can this be done where the LLC will be the owner or does the LLC have to be the borrower?

[Koss]

Reframing the Question

My client wants to buy a piece of real estate that will be placed in a partnership LLC (the two partners will be him and his wife). I believe this is ok to do. He does not want to make this a disregarded entity. The way he wants to finance this is to take out a home equity loan for $300,000 against his primary residence. If this were not in an LLC I would just atttach a form to his 1040 saying we are tracing the debt and not treating it as home mortgage interest and then he would have not problems with mortgage debt limits or AMT. Can this be done where the LLC will be the owner or does the LLC have to be the borrower?

For federal tax purposes, the LLC does not exist. The LLC is recognized as an entity only under state law. However, this does not mean that it is a disregarded entity. For federal tax purposes, an LLC can be anything it wants to be; it simply has to make the right election. It can be an sole prop, a partnership, a C corp or an S corp. You have indicated that it will be a partnership.

With that being said...

The entity can certainly hold title to the real estate.

This is a multiple choice quiz.

Where is the entity going to get the money to buy the real estate?

(a) The entity is going to borrow the money from a bank.

(b) The entity is going to borrow the money from one or more individuals who are also members of the LLC.

(c) The entity is going to buy the real estate with money that was given to it in the form of a capital contribution from one or more individuals who are also members of the LLC.

- - - - -

Maybe your client should borrow the money as an individual by taking out a mortgage loan against his principal residence, and then lend the money to the LLC. If he does that, then the loan to the LLC can also be a mortgage, in which your client, in his capacity as an individual, is the lender...

But would that make it a related-party transaction? If so, what are the consequences?

In case you haven't figured this out yet, I don't have all the answers to this one. I'm just trying to pick your brain and get more information about exactly what your client is trying to accomplish.

Burton M. Koss
koss@usakoss.net

[Koss]

Mortgage Debt Limits

Okay, so you want to avoid exceeding the mortgage debt limits, acquisition debt vs. equity debt, etc., etc. I think I get that part...

If your client borrows money by taking a loan against his home, and uses the money to make a capital contribution to the LLC, then the LLC could purchase the real estate without a mortgage.

Could you then trace the interest on the home loan, on your client's 1040, be declaring it to be investment interest? In other words, he borrowed the money for the specific purpose of making an investment in an LLC.

Or...

Suppose your client borrows the money by taking a mortgage against his home, and then lends the money to the LLC. The LLC purchases the real estate, and the loan from your client to the LLC is structured as a mortgage on the real estate owned by the LLC.

So now your client, in his individual capacity, has mortgage interest income, because he is the lender in the mortgage taken out by the LLC, and he has mortgage interest expense because he took out a mortgage on his personal residence. Now, what about the mortgage debt limits?

Here again, perhaps you could trace the interest on the loan on his personal residence to his investment activity in the LLC. In this scenario, he didn't use the loan proceeds to make a capital contribution to the LLC, but he still used the loan proceeds to make an investment. Lending money to an LLC so that it can buy a building, and structuring the loan as a mortgage on the building, sure sounds like an investment to me. So maybe you could still treat it as investment interest.

So... let's see here... his 1040 would have three types of interest on it:

1. Investment interest income, because he is the lender in a mortgage taken out by the LLC to buy the property


2. Mortgage interest expense from the equity loan on his home, which you are classifying as investment interest

3. Mortgage interest expense paid by the LLC, which will flow through to your client's K-1

Forget about #3 for the moment. Investment interest is limited to investment income. So if the interest rate of the mortgage taken out by the LLC is a half point higher than the interest rate of the mortgage taken out by your client as an individual, then it won't quite be a wash; he'll have net interest income from the transaction.

But he would still have the full benefit of the mortgage interest expense paid by the LLC, in the sense that it would certainly reduce the net income of the LLC that flows through to his K-1.

Unless this is an LLC that is not expected to have any net income for the first few years. Then I suppose that would open a whole Pandora's box of questions about whether the net losses are active or passive...

BMK