Let’s say that you have a rental with significant equity.You hold it in an LLC for asset protection. That’s a good first step.
The problem is that if a tenant or guest of a tenant has a legitimate claim arising from the property, he or she can proceed against the property held in your LLC. They may not be able to sue you personally (assuming you properly maintain and operate your LLC), but they can go after all your hard-earned equity in your property.
For example, say you have a rental worth $200,000 but the mortgage is only $80,000, meaning you have $120,000 in equity in your property. If a liability occurs on the property which either isn’t covered by insurance or is in excess of policy limits, you could lose the property and all $120,000 of your equity.
Perhaps the easiest way to reduce your exposed equity is to get a second mortgage on your property. The obvious downside is that you now have another loan to service and another drag on your cash flow.
A better option is to get a secured line of credit (LOC) on the property. For example, if a lender gives you an $80,000 line of credit, it shows an $80,000 lien on the property, regardless of the outstanding balance on the loan. If you never draw on the LOC (a difficult temptation to resist), you never pay any interest and your cash flow remains intact.
The problem with this is that if you wait until after a liability occurs on the property to draw on your LOC to reduce your equity, a creditor could go after those funds.
Is there any other way to protect your equity? Yes, but it requires some effort on your part. Essentially, you can set up a separate, independent LLC to act as your own private, personal lender. This technique is sometimes known as “equity stripping”.
In order to pull this off you need to have sufficient liquid funds to create your own note and second deed of trust. That’s the catch – you need to have access to funds on a short-term basis.
Here’s how it works:
- You create a new LLC to act as your own private lender (a “finance LLC”).
- You fund this with a significant amount of cash – in this example, $100,000. If you have a line of credit or access to funds on a relatively short-term basis, this makes it easy.
- Your finance LLC (which holds the $100,000 cash) lends your rental LLC (which owns your rental) $100,000, evidenced by a promissory note and secured by a second deed of trust.
- You actually transfer $100,000 from the finance LLC to the rental LLC. If no funds are transferred, a creditor could set aside the lien as bogus.
- You make payments each month on the note from your rental LLC to your finance LLC. It is a legitimate financial arrangement with bona fide substance, even though in essence, you are taking money out of your left pocket and putting it into your right pocket.
- Over a matter of time, your property LLC distributes $100,000 back to you. There are no tax consequences to you because your LLC is a “disregarded entity” for tax purposes.
- You can then contribute the funds back into your finance LLC as a capital contribution. This is also tax-free.
- The funds, in essence, go from your finance LLC to your rental LLC and then back into your finance LLC.
At the end of the day, you are back where you started, except that you now have a legitimate $100,000 second deed of trust on your rental, and your equity has been reduced from $120,000 to $20,000.
The advantage of being your own lender as opposed to taking out a second loan on your property with a third party is that you pay interest to yourself rather than losing the interest paid to a third party.
For income taxes, it’s a wash. Your rental LLC pays $100 in interest and your finance LLC receives $100 in interest, giving you a net zero tax effect.
For those with significant equity in a property and sufficient cash to be your own lender, this can be a slick way to transfer equity from an LLC with potential liability to an LLC with no liability, thereby securing any equity in a rental for yourself and removing it out of the reach of a creditor.