Latest posts by Matt Holmes (see all)
- CoBuy Greater Seattle Housing Market Update – Sep 2018 - August 28, 2018
- CoBuy Greater Seattle Housing Market Update – July 2018 - July 20, 2018
- Co-owning a home: How to split ownership between co-buyers - June 14, 2018
Should you form an LLC to co-buy a home?At CoBuy, the company we founded nearly two and a half years ago, we come into contact with a lot of people looking to jointly purchase property. It’s truly fascinating to meet and interact with so many different people. From unmarried couples who have decided they want to start building equity to groups of friends teaming up to buy an investment property, we’ve seen a lot of different combinations of folks interested in co-ownership.
One question that keeps popping up is “should I use an LLC to co-buy a home?” It takes both hands to count the number of times I’ve heard this question asked over the past week. It’s interesting that for at least some of the people who have asked this question, the default assumption seems to be that using an LLC to co-buy a home is the way to go.
Personally, I would not choose the LLC path when co-buying a home. Years of research and experience dealing with numerous co-buyers of all stripes have informed this view. But that’s just me. A quick Google search reveals that there are plenty of articles out there with different points of view. Separating fact from fiction can be challenging when many articles are written to further a business agenda or generate referrals. At CoBuy, we’re strong proponents of the “information is power” mantra because we believe that consumers make better decisions when they are better informed.
Why do people think forming an LLC to buy homes makes sense?
I don’t know. And often they don’t seem to know, either. No joke. And I don’t mean that in a bad way. Curious as we are, we have started to ask people why they think forming an LLC to purchase a home makes sense. The most common answer is “I don’t know” or “somebody told us we should.” In other cases, folks point to anonymity or cite a desire to limit liability associated with the property and ring-fence personal finances in the event of a claim or loss against the property.
Wikipedia defines a Limited Liability Corporation (LLC) as “the United States-specific form of a private limited company. It is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is not a corporation in and of itself; it is a legal form of a company that provides limited liability to its owners in many jurisdictions. LLCs are well-known for the flexibility that they provide to business owners; depending on the situation, an LLC may elect to use corporate tax rules instead of being treated as a partnership, and, under certain circumstances, LLCs may be organized as not-for-profit.”
But is using an LLC to co-buy property a good idea? And is it even viable? To answer these questions, we consulted some of the top professionals in the CoBuy ecosystem across lending, legal, and tax. What we learned is that it really depends on the circumstances. Every situation is different. It is important to think about who will be involved, what each party brings to the table, and the shared goals for co-ownership are all pre-requisites.
Financing in a nutshell
The major hurdle to buying a home for most of us is securing financing. Assuming you and your co-buyer(s) will be taking out a loan to finance the purchase of a home, then understanding how lenders operate is a logical place to start.
In the purest sense, the business model of any lending institution (including banks and mortgage lenders) is based on borrowing and lending: they borrow at a rate lower than the rate at which they lend and take the spread. To stay in business, lenders must be able to accurately price the risk for the loans that they originate. When it comes to residential mortgages, a well-defined and heavily regulated lending framework gives traditional lending institutions recourse to the underlying asset (the home) in the event of default by the borrower(s). Furthermore, the borrower(s) are treated as joint and severally liable: they personally guarantee the debt to the lender in its entirety.
Most lenders won’t finance an LLC
A Limited Liability Corporation, by definition, excludes any sort of personal guarantee. In the absence of any personal guarantees, financing the purchase of a home entails greater risk to the lender. So it’s hardly surprising that many lenders do not lend to newly-formed LLCs created solely for the purpose of buying and owning residential property. To confirm this, we spoke to six loan officers from regional and national mortgage lenders.
The result? None of the loan officers surveyed said that a newly-formed LLC would be eligible for traditional financing.
That’s not to say that it isn’t possible, but in cases where it is possible the terms would be less favorable (e.g. a commercial loan) and the lender may require a personal guarantee from the co-buyers (negating the key benefit of using an LLC). According to one loan officer we spoke to, “There are very limited options for mortgage financing if the LLC will be the borrower.” A second loan officer agreed, “You can find financing for LLC’s for residential purchases but not typically through standard financing channels. You often need a commercial lender or specialty lender. Using an LLC limits the potential financing options and typically results in a less desirable loan package in my experience.”
Multiple loan officers also cautioned against co-buyers trying to transfer Title to an LLC after closing on the purchase, citing that this could have severe financial consequences. Upon hearing this, we decided to check with one of our favorite Seattle-based real estate attorneys, Shane Yelish. Shane explained, “most lenders will not lend to an LLC on the run-of-the-mill residential purchase transaction. In an effort to get around this, some borrowers decide to purchase the property in their individual names and then convey the property to an LLC after closing. This can create other significant issues, like triggering the due on sale clause in the promissory note.”
The bottom line: “creative” tactics could result in the lender knocking on the door and asking for all their money back.
Legal, accounting, and tax…oh my!
Forming an LLC involves time and costs – after all, you’re setting up a business. According to Yelish, “there is the cost of forming the LLC with the Secretary of State and the annual fee to maintain the LLC.” Then, of course, you’ll need an LLC operating agreement and you and your co-buyers will have additional reporting and accounting responsibilities. Creating an LLC “generally makes it a partnership for federal income tax purposes,” according to Luke Frye, CPA and Founder of Timber Tax. “That means you’d have to file a Form 1065, due March 15th. [The LLC] is a ‘flow through’ entity for federal income tax purposes, which means it doesn’t pay federal income tax, but you do on your personal return. This would then be reported on a K-1 and carried to schedule E on your personal return due in April. You may have other state and local tax obligations as well.”
For a primary residence, using an LLC could jeopardize tax benefits such as mortgage interest tax deductions and capital gains exclusion. Under current guidelines, homeowners who reside at their primary residence for over two years are not taxed on gains upon sale (up to $250,000 for a single person or $500,000 for a married couple). For co-owners who purchased a primary residence five years ago in Seattle now looking to sell (at roughly 50% over their purchase price), this could easily amount to tens of thousands of dollars each. For qualifying investment properties, the use of an LLC could complicate 1031 exchange eligibility upon sale. This, too, could be the difference of tens of thousands of dollars.
It’s true that an LLC can insulate the co-owners from personal liability and provide anonymity. These benefits depend, however, on the entity being operated properly on the tax, accounting, legal, and administrative fronts. Administrative errors or violation of LLC restrictions could have consequences for the parties to the partnership both individually and collectively.
When using an LLC to co-buy property makes sense
There are two cases that may justify the use of an LLC to jointly buy and hold property:
- Co-buyers who are making an all-cash purchase and do not require financing
- Professional real estate investors with larger property portfolios.
In both cases, there are material differences when it comes to clearing the financing hurdle. If you don’t require a loan to purchase a property, this is a moot point. Investors who can prove cash flows from existing property holdings are often classified differently. These folks are also likely to benefit from well-established banking relationships.
Co-buyers who require financing and aren’t yet part of the landed gentry may want to consider a Tenants in Common structure. Tenants in Common “...is the best alternative in most circumstances,” says Yelish. While TICs may not benefit from the liability protection afforded to LLCs, other cost-effective options like insurance policies are available. Such tools can be a cost-effective method of safeguarding co-owners, particularly for co-owners of investment property.
As with any important purchase, it pays to do your homework. Anyone considering co-buying and co-owning a home or a multi-family property should ask themselves:
Who will be party to the transaction?
What is each party bringing to the table? Is financing required?
What are the goals for co-ownership?
If you are considering co-buying property, CoBuy can help. We make it easy to co-buy, minimize the time and cost, and help you protect yourself and your investment. We can also connect you with CoBuy-certified™ professionals from our network of lenders, agents, attorneys, and CPAs at the right time.