how to structure a private loan

Question

Hello,

I have some family members that are willing to lend me money for flipping and buy/hold deals. What is the best way to structure this? Just do a note/personal guarantee for each property seperately and pay them back after each deal? Or should I form an LLC with them and put the terms of their profit in  the operating agreement? Thanks!

Aaron Pfeffer · Answer

Tax implications not withstanding and assuming you do not put them in the LLC (unless they are an operator with you and want to absolutely share in your liability, which is JV partnership and not a Private Lending scenario)...

1. Record the DOT that secures the Promissory Note with the county

2. Get them 125% Title Insurance with appropriate Endorsements to further secure their loan. Get CPL prior to closing

3. Further make sure that exceptions you (they) allow to remain on the Preliminary Title report do not interfere with their lien, especially any defaulted taxes that may come with the purchase of the property

4. List them as Loss Payee on Hazard Insurance, and get correct insurance specific to a flip (for at least 12 months)

5. Use a reputable third party servicing company to make your payments to, so that they can generate necessary end of year tax documents for both yourself and your Private Lender

Michael Cavicchi · Answer

I was actually about to make a separate post about this. I'm not sure I have an answer but I do know I have questions along similar lines.  I know that there can be tax implications for both the lender and receiver.  What is the best way to avoid problems with the IRS? To just have the promissory note written, signed and notarized so that it can be handed over to a CPA at the end of each year? Should the check be made out to someone personally or would it be better to be written out to an LLC?

Really looking to avoid putting anyone including me in a bind by borrowing money from them.

Michael Cavicchi · Answer

@Tom S. Thanks for the details! Yes that's what I was talking about just wanted to make sure doing it right and not screwing someone over on their taxes.

And @Basit Siddiqi thanks! I guess I just wanted to make sure the loan didn't get mistaken as a gift and then someone audited over it in taxes but I guess good record keeping is the answer for that.

Basit Siddiqi · Answer

@Mikki McIntyreYou definitely want a loan agreement set up.The loan agreement should have important information such as1) lender and loanee2) Loan amount3) interest rate4) When you will pay back interest and principalBoth parties would then sign the document. Another thing to add is if you will be buying properties outright in cash and if the lenders want a security interest in the property in the chance that you default(doubt it if they are friends/family) but others may want that security.

Basit Siddiqi · Answer

@Michael CavicchiA loan and a gift are two separate thingsIf the lender gives you 50,000 as a loan where you have to repay it back in 5 years at 10% interested. If you pay back the loan and the interest - this is considered a loan.If the lender decides to say keep the $14,000 and only give me $36,000 and interest. This is a loan forgiveness which is considered a gift. This may require the filing of a gift tax return.

Tom S. · Answer

@Michael Cavicchi  As an example, for me at least, I have a loan from someone for $120k.  The interest I pay is about $8k per year.  The $8k is on my Sch E, along with other interest from another investor plus the bank, so about $16k entered on one line.

That's all we do on our end for the tax return.  We of course have detailed records such as the loan documents and bank statements that support the numbers, in case it's ever questioned.

I'm not familiar with the gift tax threshold so as mentioned, definitely contact a tax professional.  An attorney should be drawing up your loan docs as well.

Hope that helps.

Michael Cavicchi · Answer

@Tom S. yes that definitely makes sense.  But I mean lets say it's a more substantial amount like 50k.  At that point you're over the gift tax threshold so is the IRS going to want proof that it's a loan and not a gift?

Tom S. · Answer

@Michael Cavicchi  Generally only the interest has to be reported.  So if the family member lends you $10k and you pay $1k in interest for the year, the family member should report the $1k as interest income.  If it's a buy and hold rental property, you would deduct it on Sch E.  If you paid back the $10k principal (or any principal) within the tax year, generally there's no tax impact for that.

That's a simple real life example for me; certainly speak to a tax professional as well.

Matt B. · Answer

I have never done one but my parents have. They simply went to a lawyer, signed an agreement with the lender (family), and made their monthly payments as agreed.

I would imagine you can form an LLC together but then they are sharing the risk associated with the loan as well as the LLC. I would imagine they wouldn't want to take the additional risk unless they were really looking to enter a partnership.

how to structure a private loan

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