Q: My husband and I have rental properties with mortgages under our name.
We set up a limited liability company to separate our personal and business real estate properties. I’m the manager of the company and my husband is the managing member.
Our mortgages have prepayment penalties and having the mortgages has affected our debt-to-income ratios. We were recently turned down for a mortgage for another real estate acquisition.
How can we transfer the debts from our name to the limited liability company? If we refinance our loans under the limited liability company’s name, will refinancing satisfy the “soft” prepayment clause in the mortgage? Can we avoid the prepayment penalty?
A: You may have entered a black hole of real estate ownership. While you probably have good cash flow from the homes or buildings you own, your income is probably reduced by the depreciation you take in owning these properties.
This depreciation — the tax benefits you get from owning a property that allow you to reduce you tax liabilities each year — causes your income to go down. The more real estate you own, the bigger the effect on your tax return. Thus if you own a couple of single family homes, you will see some impact on your income taxes, but if you own large commercial properties or dozens of residential properties, the impact can be quite large. You can even live quite well but show a loss on your income taxes.
If a large part of your income is from your real estate business or you have enough buildings to affect your income, many residential lenders will have difficulty giving you financing. You should try to find a commercial lender or a residential lender that has extensive experience with people that own many rental properties to help you out in your future deals.
As far as transferring title of the properties from your name to the name of a limited liability company, your efforts will be in vain if the lenders still require you to personally sign the loans.
If the limited liability company were able to secure financing without your personal guarantees, that would assist you in your ability to obtain loans for other properties you may wish to own and live in. But, if the company’s structure is such that the losses and gains flow directly to you and your income tax return, you may end up in the same place. Your tax return will show you with little income to justify new loans.
While you may find a residential lender willing to lend you money, it is more likely that residential mortgage lenders that keep the loans in-house — that is, they do not sell the loan in the secondary market — or a commercial lender will be a greater source of financing for you in the future.
Whether you’ll be able to avoid the repayment of the prepayment penalty will depend on the terms of the prepayment penalty. If the terms of the prepayment penalty state that you do not have to pay the penalty if you sell the home, your transfer of title may not satisfy this requirement. The lender would be looking for a true sale of the property and not a transfer of title from your name to an entity you control. You need to review the terms of the prepayment penalty and have a discussion with your lender to determine if the prepayment penalty can be waived under your circumstances.
Overall, you need to figure out how to structure your real estate transactions going forward. You should sit down with a good accountant that has a fair amount of experience with real estate investments to strategize what you should do.
Once you figure out the game plan, you should look for a lender that can be a partner in financing your real estate transactions going forward.
Published: Mar 7, 2006