Why Investment Property Loans Close in an LLC

Investor loans close in an LLC because they’re business-purpose loans, and on the programs we offer the lender requires it: DSCR, rental portfolio and fix and flip loans are made to a business entity, usually an LLC or corporation, and they’re full recourse, so you sign a personal guarantee. The LLC holds title. You still stand behind the debt.

That’s different from a conventional mortgage, which is made to you personally. Fannie Mae, for instance, buys loans made to borrowers who are natural persons, with a few exceptions for certain trusts, and an LLC isn’t one of them. So the entity question usually comes up the first time an investor moves from a conventional loan to a DSCR or flip loan.

Why the lender wants an entity

Credit extended primarily for a business purpose is exempt from Regulation Z, the federal Truth in Lending rule behind most consumer mortgage disclosures. That’s the main reason the product can exist in the form it does: underwritten on the property’s rent, with no income documents and no debt-to-income test. The entity is how the file shows, on paper, that this is an investment, not a residence.

It also gives the lender a clean borrower to lend to and a clean title to lend against.

The guarantee is the catch

Many investors form an LLC expecting it to shield them from the loan. For this debt, it doesn’t. Full recourse means that if the property is sold at a loss after a default, the lender can come after you personally for the shortfall.

What the LLC may still do is separate the property’s other liabilities (a tenant’s injury claim, say) from your personal assets. How well it does that depends on your state’s law and how you run the company. That’s a question for an attorney, not a lender.

Single-member or multi-member

For the loan, both work. The difference is mostly tax and paperwork.

• Single-member LLC: by default the IRS treats it as a disregarded entity, so the rental shows up on your personal return much as it would if you owned it directly. It can elect to be taxed as a corporation instead.
• Multi-member LLC: by default the IRS treats an LLC with two or more members as a partnership, which means a separate partnership return each year. It can also elect corporate treatment.

Expect the lender to ask for the operating agreement and to see who owns what, and ask early which members will need to sign the guarantee.

Deeding a property into an LLC before a refinance

The common case: you bought a rental in your own name, it’s worth more now, and you want a cash-out DSCR refinance. The new loan has to close in an entity, so title has to move to the LLC at or before closing.

Here’s how the math might look. You own a house worth $300,000 with a $150,000 mortgage, and you’ve had it longer than 90 days, so the appraised value is used. A cash-out refinance at 75% LTV is up to $225,000. Paying off the old $150,000 leaves up to $75,000 before closing costs, assuming the rent passes the 1.05x test.

Three things to settle before you record a deed.

Due-on-sale. Most mortgages let the lender call the loan if title is transferred. Federal law, the Garn-St Germain Act, bars lenders from enforcing that clause on certain transfers of 1-4 unit residential property, such as a transfer into an inter vivos trust in which the borrower remains a beneficiary. A transfer to an LLC is not on that list. If the refinance pays off the old loan at the same closing, the question usually goes away. If you deed the property weeks before the refinance, the old loan is still in place while title sits in the LLC, so check with your current servicer and your attorney first.

Transfer taxes. Some states and localities charge a tax when a deed is recorded, and the rules on transfers to an entity you own differ from place to place. Some exempt them; some don’t. Your attorney or title company can tell you what applies where the property sits.

Title insurance. Your existing owner’s title policy was issued to you. Whether it continues to protect you after the property moves to an LLC depends on the policy’s terms. Ask the title company handling the refinance whether you need an endorsement or a new policy.

What to have ready

• Articles of organization (or the certificate of formation) and any amendments
• The operating agreement, signed
• The EIN letter from the IRS
• A certificate of good standing from the state, if the title company asks
• The deed or vesting history if you’re transferring a property in

None of this is legal advice, and we don’t give it. The point is to know the questions before closing week. For how the entity fits into qualifying, see DSCR loan requirements and the DSCR loans page.