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The Jan & Feb ’07 issues of Mr. Landlord contained a two-part article on protecting your real estate assets from legal claims through the use of liability insurance, trusts, and limited liability corporations (LLC’s) with emphasis upon equity stripping. This one page paper will briefly summarize the two-part article. Our paper is designed solely to provide readers information and not to provide guidance, as The Stott Team is not licensed to provide either tax or legal advice. I searched Google for Equity Stripping Using LLC’s and came up with 652,000 entries. The two articles in Mr. Landlord are useful in providing an overview; however, they do not provide actual guidance in setting up the LLC’s nor is their information as detailed or extensive as that provided on the Internet by companies that specialize in this area.
Liability insurance protects you against personal injury such as a slip and fall. However, liability insurance does not protect you against environmental hazards; fair housing violations, or disputes that might lead to lawsuits, such as tenant disputes, contractor disputes, and neighbor disputes. There are varying types of trusts that provide varying degrees of protection against legal claims. However, trusts do not provide you the limited liability of an LLC. Done properly, an LLC protects all of your assets outside of the LLC entity such as your home, savings, and valuables. However, an LLC does not protect the property equities within the LLC entity itself. If you own several rental properties, the equities of all your rental properties may be at risk.
Assume you own four rental properties each worth $250,000 with each having a mortgage of $150,000, for a total value of $1 million with $600,000 in mortgages and $400,000 in equity. What is at risk in a lawsuit is the $400,000 of equity, as the bank’s mortgage of $600,000 (your debt) has no value to the claimant. Equity stripping is a technique that makes the $400,000 in equity also become a debt through the use of two completely separate LLC’s. One LLC will become your Real Estate LLC and the other, your Lender LLC.
To enable equity stripping, your Lender LLC makes a mortgage loan to your Real Estate LLC for the existing equity that is in the rental properties or $400,000, thereby stripping out all the equity in the four properties. The loan from the Lender LLC to the Real Estate LLC has to be a real loan with a promissory note, transfer to funds, etc; i.e. an arm’s length transaction between the two LLC’s. Therefore, funds need to be provided to the Lender LLC to enable the actual transfer of the $400,000. Once the Real Estate LLC receives the funds, they can then disburse the money back to you to enable you to be able to repay any borrowed funds.
The mortgage loan provided by the Lender LLC is written without any monthly payments; however, interest will accrue and be added to the loan balance thereby offsetting any future equity growth in the properties via appreciation, upgrading, amortization, etc. The Real Estate LLC has no value as the market value of $1 million for the four rental properties has been offset by the $1 million of mortgage debt…$600.00 via the four mortgages held by the original lenders and $400,000 by the mortgage held by the Lender LLC. Therefore, the Real Estate LLC is not a target for claimants. Similarly, the Lender LLC also is not a target, as it only owns a paper mortgage. Both LLC’s need to file their own federal and state income tax returns as a “partnership flow-through tax entity,” thereby making the transactions tax free under the IRS partnership provisions. The Lender LLC reports imputed interest as ordinary income while the Real Estate LLC deducts the interest. Only two LLC’s are needed for all your properties. You can subordinate the equity stripping loan to a junior position for refinancing purposes, and you can equity strip your other assets such as your home, savings accounts, etc.
Mr. Landlord published by Home Rental Publishing/Mr. Landlord Inc., Box 64442, Virginia Beach, VA 23467 www.mrlandlord.com 1-800-950-2250
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Equity Stripping
Click here to view the entire newsletter.
The Jan & Feb ’07 issues of Mr. Landlord contained a two-part article on protecting your real estate assets from legal claims through the use of liability insurance, trusts, and limited liability corporations (LLC’s) with emphasis upon equity stripping. This one page paper will briefly summarize the two-part article. Our paper is designed solely to provide readers information and not to provide guidance, as The Stott Team is not licensed to provide either tax or legal advice. I searched Google for Equity Stripping Using LLC’s and came up with 652,000 entries. The two articles in Mr. Landlord are useful in providing an overview; however, they do not provide actual guidance in setting up the LLC’s nor is their information as detailed or extensive as that provided on the Internet by companies that specialize in this area.
Liability insurance protects you against personal injury such as a slip and fall. However, liability insurance does not protect you against environmental hazards; fair housing violations, or disputes that might lead to lawsuits, such as tenant disputes, contractor disputes, and neighbor disputes. There are varying types of trusts that provide varying degrees of protection against legal claims. However, trusts do not provide you the limited liability of an LLC. Done properly, an LLC protects all of your assets outside of the LLC entity such as your home, savings, and valuables. However, an LLC does not protect the property equities within the LLC entity itself. If you own several rental properties, the equities of all your rental properties may be at risk.
Assume you own four rental properties each worth $250,000 with each having a mortgage of $150,000, for a total value of $1 million with $600,000 in mortgages and $400,000 in equity. What is at risk in a lawsuit is the $400,000 of equity, as the bank’s mortgage of $600,000 (your debt) has no value to the claimant. Equity stripping is a technique that makes the $400,000 in equity also become a debt through the use of two completely separate LLC’s. One LLC will become your Real Estate LLC and the other, your Lender LLC.
To enable equity stripping, your Lender LLC makes a mortgage loan to your Real Estate LLC for the existing equity that is in the rental properties or $400,000, thereby stripping out all the equity in the four properties. The loan from the Lender LLC to the Real Estate LLC has to be a real loan with a promissory note, transfer to funds, etc; i.e. an arm’s length transaction between the two LLC’s. Therefore, funds need to be provided to the Lender LLC to enable the actual transfer of the $400,000. Once the Real Estate LLC receives the funds, they can then disburse the money back to you to enable you to be able to repay any borrowed funds.
The mortgage loan provided by the Lender LLC is written without any monthly payments; however, interest will accrue and be added to the loan balance thereby offsetting any future equity growth in the properties via appreciation, upgrading, amortization, etc. The Real Estate LLC has no value as the market value of $1 million for the four rental properties has been offset by the $1 million of mortgage debt…$600.00 via the four mortgages held by the original lenders and $400,000 by the mortgage held by the Lender LLC. Therefore, the Real Estate LLC is not a target for claimants. Similarly, the Lender LLC also is not a target, as it only owns a paper mortgage. Both LLC’s need to file their own federal and state income tax returns as a “partnership flow-through tax entity,” thereby making the transactions tax free under the IRS partnership provisions. The Lender LLC reports imputed interest as ordinary income while the Real Estate LLC deducts the interest. Only two LLC’s are needed for all your properties. You can subordinate the equity stripping loan to a junior position for refinancing purposes, and you can equity strip your other assets such as your home, savings accounts, etc.
Mr. Landlord published by Home Rental Publishing/Mr. Landlord Inc., Box 64442, Virginia Beach, VA 23467 www.mrlandlord.com 1-800-950-2250
Back to Useful Newsletter Articles