How to invest with family?

Question

BP,

We are buying a rental property in Seattle, Washington and our family would like to invest with us. They will be giving us $50k towards a $600k property. It is not a "gift", they want their share of the income and appreciation when we decide to sell. We can't put the property in an LLC because we don't want to risk the due on sale clause with the mortgage. We also would like to avoid them being named as an owner to prevent them from any liability (though an umbrella policy may be the solution to that). And, I think it would be easier from an accounting prospective if everything ran through our return and we could just give them a distribution of net income.

- Is there a way to structure this investment as a loan that has a variable rate based on net income and then some sort of balloon payment when sold?

- I presume it would be fraud for them to use their annual exclusion gifts to give us the cash, and then for us to use our annual exclusion gifts to "gift" back an amount equal to net income and then to "gift" back an amount equal to their share when the property is sold in the future ?

I would really appreciate you sharing any thoughts or recommendations you may have.

Thanks,

David

Brandon Hall · Answer

@David Pendergraft There are a couple of issues with the "loan" scenario. When families loan money to each other, they often don't do it correctly (maybe they don't put everything they need to in writing, or they charge too little interest, or they don't collateralize it) which can lead to the entire amount being classified as a gift. Additionally, if you take the loan, you need to understand that it will be classified as a liability on your personal balance sheet and will increase your debt-to-income ratio. You will need to disclose this loan to all lenders in the future until it is paid off. Can you attach the loan to the net income the property generates? Potentially, but why make it more complicated than it needs to be? Set a fixed interest rate and stick to it.

For the gift question - when a family member gives a gift, they cannot expect anything in return for that gift. If you started paying them back their gift, using your annual exclusion, the family members would not report it as income, yet they would be earning money on their "gift" so it will be seen as tax evasion (fraud). If I were an IRS agent or lawyer, I would see that you are returning the gift your family members gave you, plus some, and disqualify the entire thing as a gift and reclassify it as a loan, because that's what it is.

My suggestion would be to look into the loan option, or flat out sell them an interest in your property.

Jesse T. · Answer

I would lean towards structuring it as a loan.  If they are looking for an income stream - interest-only may work well for both parties.

Do you need this money to make the investment?  If you need the money how much is it compared to your investment?  If it is a small percentage of your investment - it may not be worth the complication of an equity partnership.  Partition lawsuits can be a big risk in a partnership - so have a buy-out clause if you do go the equity route.

Just because they have limited upside on this deal, doesn't mean it has to be that way on future deals.  It probably would be cleaner to have you manage their property or a deal where the equity is 50/50.  However I think a smaller loan is a much better way to start than jumping into a more involved relationship with potentially more money at risk.

Ben Leybovich · Answer

Nope - it's either equity or debt. Equity puts them into this as a lien, behind the first, if you have a first. They can get escalated %, but it has to be stated and there is no exposure to capital gains. You will need to let your bank know, if you are getting a mortgage at the time of purchase, and the payments to your family will need to be part of DSCR.

If they want equity appreciation exposure, they will have to be a partner, and to protect them you'll need to set up an entity. However, you are not getting a salable note at the bank for an entity owner...

Hope this helps.

Michele Fischer · Answer

If your family is open to a loan rather than sharing in the benefits, the simplest way to handle this is to do paperwork for a loan, charging a market interest rate, amortized over whatever period you agree to.  Going forward this is mortgage/interest expense to you and interest income to them.

Jedd Braunwarth · Answer

@David Pendergraft what type of financing have you looked into? If you set up an LLC with your family for this property and purchased the property via the LLC with a commercial loan this should work. My conventional lenders will not let me own property under my LLC but I recently switched to commercial lenders and they have no problem with me purchasing property under my LLC.

I will be expanding and bringing on outside investors with this strategy. The commercial lender will/may still need tax returns, financial info, etc. from all members of the LLC. They lender can go to each individual discretely so all financial info is not shared with all members.

How to invest with family?

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