lenders and LLCs–rental property stuff
It is usually a good idea to own rental property through an LLC. As the name suggests, an LLC is designed to limit liability.
Think of a limited liability company as a legal liability firewall vehicle. In other words, if some sort of legal claim arose from the operating of your rental property (say a “slip and fall” accident or something), then any such legal liability should remain contained within the LLC and should not spill over into your personal finances or other business ventures. That assumes that you have just one rental property within that LLC and that you have done a reasonably good job of treating your rental property LLC as a normal business, including a separate bank account, proper accounting, etc. So again, the LLC structure to own and operate a rental property is the way to go in most instances.
Sounds simple, right? I have recently encountered a handful of situations where individuals have purchased a rental property in their personal name, with the eventual intention of transferring the property into an LLC after the closing of the purchase/loan. In every instance, the real estate agent and the loan broker have told the prospective buyer that there is no problem following this approach of closing the loan/purchase in the name of a person and then transferring into an LLC after the fact. However, there is usually one VERY big problem—it is almost a certainty that such a transfer of the real estate (i.e. the “collateral” for the loan) after the closing of the loan will be a default under the loan agreement. Why then would a real estate agent and a loan broker be so casual about advising the borrower to proceed in this manner?
Each case is different, but let me offer a few ideas as to how and why this happens on such a regular basis. These are rather blunt/harsh observations (so be warned), but such bluntness does not make them inaccurate.
First, real estate agents and loan brokers get paid a commission to close deals. When the deal closes, the agent and broker get a check and then move on to the next potential client/deal. There are some instances when the real estate agent and loan broker simply don’t care about what happens next and there are also some instances when such professionals are simply ignorant of the legal realities (ignorance can sometimes be bliss).
Second, continuing with the lack of knowledge theme, you can be quite confident that whomever at your bank is working with you to get the loan will NOT be the person who is tasked with oversight and compliance of your loan after it closes. This is important for a few reasons, including the fact that even if you get a series of verbal assurances/promises from your loan agent about how you can transfer your loan into the LLC after the fact, the promise-maker (in that instance) will not be the person who will be in charge of determining whether your loan is in default later. And again, because there are different persons at the lender doing different things, this leads to the idea that the right hand does not necessarily know or care what the left hand is doing.
What happens if you get the loan in your name and the property continues to be owned in your name? Well, among other things, your LLC (if you have one) is useless. An LLC will only provide benefit if it owns the business asset and is used as the main vehicle through which you operate your business.
Ok, then what happens when the individual goes ahead and closes on the loan in their own name and takes the suggestion of the real estate agent after the fact to transfer the property into the LLC? There is a very, very high likelihood that even the “attempt” to make such a transfer is a default on the applicable loan agreement. In other words, going down that path could result in the lender having the ability to declare your loan in default and demand immediate payment from you (or foreclosure).
I have heard it suggested recently by a real estate agents involved in a transaction such as this, and while giving similar “advice” to a client, that it is unlikely that the bank would ever learn about the transfer. This is again misinformed and inaccurate in most instances. Further, why would it be a “wise” course of action to do something that you know is not correct, but on the hope and belief nobody will find out? And yet, this is the line of reason often suggested by certain real estate agents and loan brokers. By the way, I fully acknowledge that this does NOT apply to all real estate agents or loan brokers. As with all professions, there are good and not-so-good real estate agents and loan brokers. Further, I believe that most often these professions are acting mostly in ignorance.
In order to have the protection of the LLC to the highest degree possible, you will want to deed the property to the LLC and then record the deed with the applicable county recorder. This then puts the world on notice that the LLC (rather than you) owns the real estate. There is an extra measure of legal liability protection obtained by this process. Even so, by putting the world on notice that you have made this transfer (for legal liability protection purposes), you have also put the lender on notice. Most mortgage companies do periodic audits of real estate records involving their collateral. This is how a lender would most likely obtain notice that you have transferred the real estate to an LLC.
What is the solution to these potential issues? Form the LLC upfront and obtain the loan in the name of the LLC. Alternatively, if the loan has already closed, talk to the lender and get written approval to transfer the loan to your LLC after the fact. Please note here that when it comes to avoiding the claim of your default under the loan agreement for transferring the collateral without permission, you will want to have WRITTEN approval from the lender. Do not rely on a verbal conversations, for a variety of reasons, including the fact that the loan agreement itself will most likely provide that waivers can only be done via written communications.
What do you do if your loan is closed and the lender will not consent in writing to letting you transfer? In that case, it might be worth looking to refinance with a new lender. As we all know, there are lots and lots of banks out there…:) Also, you might be surprised to learn just how willing the people at your current bank are to work with you once they realize you are willing to consider other banking options.