Disclaimer: Information presented here is what we learned, not advice on what you should do. It is presented only for self-education. This is not expert advice. This is not legal advice. I am not a lawyer. I am not an accountant. I am a licensed real estate agent in California, but I am not your agent. Consult a professional that works for you.
What We Learned From Moving Our Properties Into an LLC
Highlights
Here’s what happened when we (finally) decided to deed our properties, which we owned in our own names, into respective LLCs:
- If you have a property you own “free-and-clear”, you can deed it to your LLC whenever you so choose.
- If there is a conventional residential loan on the property underwritten by the Federal National Mortgage Agency (FNMA or colloquially “Fannie Mae”), you can deed it to your LLC provided that the interest in the property is not diluted. The exact criteria are given here in FNMA’s Servicing Guide.
- If there is a commercial loan on the property, based on our experience, you want to work with your lender to check under what conditions the property can be transferred into an LLC.
- You can also DIY it, but then be prepared maybe to go through what you will read about below.
To understand why this last recommendation, you want to read this story in its entirety. If you find real estate interesting, you may find the details moderately amusing too.
Beginning
In the beginning, just as most small-time real estate investors, we decided that we would buy property and hold title in our own names. My (life) partner and I became business partners and we bought several multi-family properties as joint tenants. Holding title as joint tenants implies equal ownership, and automatic right of survivorship. If one of us dies before the other, the other gets one’s share automatically.
As the number of units we had grew, so grew the unusual situations we got into with our tenants. After some 8 units or so, we started getting tangled into all sorts of life situations with our tenants. To give you a sample of some unusual situations: We had a tenant die in the unit (of natural causes). We had a tenant who witnessed a crime and was afraid would face retribution because of deciding to witness against the perpetrator; and who asked us to break the lease and leave. We had a tenant who ran a money forgery operation out of their unit. (What?!) We had your run-off-the-mill domestic disputes, divorces, co-renting friends who decided to stop being friends, and all sorts of other life situations. Not to leave an impression that it was all bad, we have seen a tenant rebound from a bad patch in their life, turn things around, and start a family. We helped them buy a nice home.
All this time, we were lucky that in no situations there was a question of our own liability. But, the message we got from all of that was clear: the frequency of events requiring special attention was rising, perhaps more than linearly with the number of units we own. It was a matter of time before something would happen where our liability could be called into question, irrespective of the amount of care we put into operating our units to the standards of the trade.
One way to handle the liability is to buy an umbrella insurance. However, that approach has its limitations. We were agonizing over ways to remove the uncertainty around the amount of our liability, which kind of naturally led us to LLCs, as a vehicle for holding title to real property. I was studying the advantages of an LLC setup in real estate at about the time that my partner discovered Anderson Business Advisors, and visited their seminars. Now, the seminar was very much pitchy, playing into people’s fears and risk aversion. It did contain enough nuggets of wisdom anyways, helping us realize that we wanted the additional anonymity and asset protection offered by careful LLC setups. I suppose we got sold on the story then and there. So, you know, you may want to take a step back and check whether our excess paranoia around liability is something you support yourself or not. I am not one to persuade you either way, and this story is about our way of thinking only.
Once we realized this, what remained was to plan the transfer and execute it. At least for the time being I will, however, not go into exhaustive detail of the transfer. The basics are quite simple really: create your LLC, file the correct paperwork, pay the correct fees, and it is done. This you can more or less dig up on the Internet yourself.
The unclear bit, and the one which is hard to inform yourself about on the Internet for whatever reason, is what you need to do if the property you want to transfer into an LLC is not owned “free-and-clear”. This is because pretty much any real estate loans have a “due on sale” clause. This clause, under some conditions, allows the lender to demand that you “accelerate” the payback of the loan. The term of trade is “calling the loan due”, or just “calling the loan” for short. The due on sale clause gives the lender a way out if something unforeseen happens with the property. One unforeseen “something” would be a drastic decrease in the property’s value. This happened to quite a few homeowners during the 2008 credit crunch. Another unforeseen “something” is the sale of the property. If a property that you hold a mortgage to is sold, and you decide to stop paying the mortgage, ostensibly the interest in the property by the new owner would be in conflict with the interest in the property that the bank has, and the bank could find itself unable to collect that sweet interest which caused it to lend you the money in the first place. Another setup in which it may become lucrative for the bank to pore over the books looking for LLC transfers would be a drastic jump in interest rates. It would then become attractive to banks to threaten with calling the loans due in an attempt to coerce the borrowers to refinance into more expensive loans.
The only way the bank can know that a property might have been sold is the recording of a deed naming a new owner of the subject property. But, a change of ownership is exactly what happens if you transfer your property into an LLC that you own. By default, the bank has no way to know that the LLC is, ultimately, controlled by you so that effectively no ownership change really took place. Well, actually, they could figure it out in some cases if they wanted to dig deep enough. But, banks are in the financial business and do not want to spend resources tracking corporate ownerships and transfers. So they leave an option to react to any such event, hence the “due on sale” clause. This is the theory.
The practice, however, is different. I have read on many occasions (no citation, sorry), that the banks are more than happy to not raise a stink around ownership transfer, so long as the mortgage payments checks arrive at a regular pace and the loan is being repaid as agreed. We asked our business advisor about the odds of having a loan called in the case of a transfer to an LLC. The answer was, paraphrased, “In the 35 years I have been helping my clients make these transfers, this has happened to me only once.” We took that to mean that such situations are very unlikely.
Our Plan
We were still not all that convinced, since the message we got was that, while this is not strictly allowed, it is so common that it is being tolerated by the banks. So, odds are that something would happen there. We were especially worried about the residential loans we held, because at the time we were not aware of the loan servicing guidelines that would make the transfer seem OK. In retrospect, our business advisor should have pointed us at those guidelines at least for some of our properties. But they didn’t, so I imagine they were not aware of them either. So much for the value of the business advice.
They did tell us something useful though. In the case that our loan gets called, the banks are usually willing to work with the borrower to fix the issue with the title. The advisor said that we want to ask for forgiveness, not permission, and should the bank object to the ownership transfer, we should “simply” transfer the property back into our own names, and stay put. At least until we pay the loan back.
While this eased our anxieties, it still seemed like a lot of work to just stay in place, potentially. So we were looking for a way to test these waters safely. We figured that we could try things out by transferring first a property we had a commercial loan on. Our thinking was that the commercial lender would not care about who exactly owns the property as the loan they gave us was a commercial loan with underwriting rules created by the bank, not by the FNMA.
So, we would go and transfer this property first, and see what happens. In case you are curious, we set things up so that each property has its own separate LLC, but the partitioning of properties over LLCs is an exercise that is left to the personal sensibilities and risk tolerance of the reader.
With that, we went on and filed the appropriate paperwork, and had the modified deed in hand within a few months. Yes, it takes that long to finish everything off. We also did not want to bother with figuring out the exact paperwork, more so because our properties are spread out across multiple states and getting everything just right is not a very rewarding exercise. So we paid Anderson Business Advisors to work out the process for us, leaving it to us to sign at the dotted lines, notarize a few docs, make a few photocopies and lick a few stamps.
The Letter
We were several months after the time we completed the transfer of our property into an LLC. We had an LLC in good standing, we signed new contracts in the name of the LLC with our property manager, transferred all utilities, had a working set of bank accounts and everything seemed to be just fine. A side benefit of this setup was that we no longer needed two signatures on documents that deal with the fate of the LLC: just one authorized signature was enough, which did wonders for our time planning, as my partner was able to run the property with full autonomy, and only occasional consultations with me. This allowed me to fully focus on my day job, which I still need to treat as first priority for at least a couple more years.
And then, one day, a letter came in the mail. It was from the contact person in our lender’s bank, informing us that we have formally fulfilled the conditions for the loan to be considered in default. While this was not what we had hoped we’d read, it was not entirely a surprise. It was always a possibility, no matter how remote. The letter said that there was a “sale or transfer of collateral without prior written consent”, which we were expecting to see should this letter ever arrive. The letter did have two surprising assertions: (1) it alleged “failure to pay property taxes prior to delinquency”, and (2) an entire paragraph which essentially says that the bank is willing to work with us to cure the problem that arose.
My thoughts: (1) was a complete surprise to me, as I was absolutely certain that I had paid all the taxes in full, and by the due date since we first acquired the property, to the day of the notice. And while we were informally aware that (2) was true, based on the information we dug up independently as well as the info provided by our business advisor, I never really expected to see it in writing.
The letter had cut out two work items for me. One was to figure out where the purported tax delinquency came from. The other was to take it up with the bank and see how we remedy the situation. Suffice it to say I was not very keen on reversing everything we had done up until that moment, and was curious to see if a solution could be found.
Delinquent Taxes
I didn’t figure this out on my own. After checking with the county tax collector and verifying that our parcel had zero dollars of outstanding taxes, I wrote an indignant letter to our lender contact, claiming that I do not understand where the alleged delinquency came from (true), and in general, what is going on (truer).
The contact person replied fairly quickly with the parcel number (“APN”) that I did not recognize. I was stumped. I went to the parcel registry at the tax collector’s website, entered the APN in question. And surely enough, there was the parcel which mind you, I did not think we owned at all, with our LLC listed as the owner. And surely enough, it did have delinquent taxes, and what is worse, it had more than a decade’s worth of delinquent taxes on it.
My heart sank then and there, as I realized how this whole course of events likely started: this parcel, with delinquent taxes on it, got transferred into the name of our LLC. It’s worth noting at this moment, that the listed prior owner of the mystery parcel was the seller who sold us the subject property in the first place. But, somehow the lender got wind that this parcel, which they somehow knew was ours, had delinquent taxes on it. I am guessing that this triggered some alarm somewhere, they took notice of something funky going on, and did a complete audit, thus becoming fully aware of our little ruse. Banks are sensitive to tax issues, because tax liens are settled before any other debt, including first mortgage liens. Which means, it could eat into the bank’s proceeds should the property go into foreclosure. And then they sent us a letter.
But then, I saw something else unusual. The assessed value of the mystery parcel was set at $2. You read that right, the amount was two dollars even. And the decade-and-a-half of unpaid taxes, along with any penalties, amounted to $83. So, delinquent taxes indeed, and for many years at that, but something that is extremely easy to cure. So my next stop was the assessor’s payment portal, where I settled the debt.
The next thing was to understand where the mystery parcel came from. It turned out that the mystery parcel was a piece of land, measuring not even a full 100 square feet, abutting the other, larger parcel where our buildings mostly stood. It incidentally contained just a corner of one of our buildings on the larger parcel. I suppose this was a vestige of the lively history of property ownership in that little midwestern town. Still confused, I went back to read our title, and surely enough the mystery parcel was mentioned there, at the very end. It was so far back in the document that the county assessor failed to notice that, when we bought the property, we also bought these 90 or so square feet of land. Just as we didn’t notice either during due diligence, and also into the entirety of our ownership of the property.
So there’s a lesson for y’all: read your titles to the end. All sorts of unexpected things may lurk there and may surprise you.
Making Good with the Bank
Next up, I was going to call our contact point up and let them know that the delinquent $83 have been paid, and to ask what else we’d need to do to make good with the bank and clear up the default.
What I realized, to my dismay and considerable annoyance of my (life) partner, was that our contact point was not someone with a real understanding of the situation. They were a middle-man, proxying between us as the bank’s borrowers and the faceless, nameless financial machine that runs in the bank’s basement. So they didn’t really have any insight into what would need to happen. We’d need to take it a step at a time.
At that time, however, I was almost convinced that I understood what was going on. The bank worried that the property may have been sold, jeopardizing their ability to foreclose on the property in case of a default. A previously unforeseen party may have laid claim on the property. They wanted assurance that nothing had really changed.
And indeed, this was confirmed in the first request. We were asked to provide the LLC’s operating agreement and our tax returns. I surmised that this could be used to confirm that the ultimate ownership structure did not change. You could see this by noting that #1: the LLC has us noted as owners, and #2: that our tax returns show forms K-1 from the owning LLC.
And then, the requests came at a pace of about one per week, for a number of items. First it was out W2s. Then it was our detailed income declarations. Then the rent rolls from the property. Then a request for a personal financial statement (“PFS”).
Then came a new loan application form. At this point it became clear to me what was going on. The lender seemed willing to modify the loan such that the LLC is now the borrower, but they would retain a personal guarantee from us. But, to do this, they would need to qualify us for the loan again, and qualify the property again based on how well it performs at this new time.
In the end, the following happened:
- The bank removed the old loan which was in our name.
- They had us sign and notarize a new note that had the LLC as the borrower, and us as personal guarantors.
- No other loan terms were changed, the loan “simply” moved into the LLC, following the property. We also had to re-certify which account we wanted the loan repayments to be auto-drawn from. Having completed that final task, it seemed like the matter had been laid to rest, at long last.
This is the current situation as well. We expect no further unusual dealings with the bank, so long as we keep paying the loan off as we promised. Luckily, the property performs well enough for that not to be a big concern.
That said, had the property not been performing, or had our personal guarantees and financial positions been insufficient for the bank to approve the modification of the note, we could have been forced to pony up the remainder of the loan and pay the bank off in cash. I think this is worth knowing.
Conclusion
So this concludes the story about our big and unexpected adventure with transferring a property into an LLC. Hope you liked it and found it educational. It’s one of the paths less trodden in the realm of real estate financing, and by all other accounts something that almost never happens. We have since transferred all our properties into LLCs or land trusts, and no holders of conventional notes objected. In the last days of 2021, we finally achieved the corporate structure we wanted, a journey we started somewhere in 2019. This structure will simplify our personal books by a lot and give us more latitude in our future dealings. I still hope never to need the protections that the LLCs afford, but at least now we can say we did what we could to plug any holes.
