LLC for business & interest deduction + residence?

[John Oliver]

I have some questions regarding the purchase of a personal residence, potentially via an LLC (state of CA). The following describes the scenario and goals (which are somewhat unique). The names and amounts are fictional, to protect privacy.

My friends Tim & Jennifer sold their San Francisco home for $3.1M (adjusted basis of $800K), for a profit of $2.3M. They can take the capital gains exclusion of $500K (married filing joint), resulting in a taxable gain of $1.8M.

They decided to structure the deal as an installment sale (deferring the tax), with a deposit of $1.3M from the buyer, and seller financing (a note) for $1.8M over 20 years @ 5% interest, with interest only payments until maturity (note #1).

Tim & Jennifer know a private investor willing to loan them $1.6M over 20 years @ 5.6% interest (note #2), with interest only payments until maturity, using note #1 as collateral.

• The private investor is not purchasing Tim & Jennifer's note, only using it as collateral.

Tim & Jennifer will receive annual interest income of $90K from note #1, resulting from the loan to the buyer of their home.

Tim & Jennifer will pay approximately $90K in annual interest on the loan from the private investor (note #2). They want to be able to deduct the annual interest paid on note #2, so that the interest deduction offsets the interest income from note #1. In order for the note #2 interest to be deductible, the proceeds must be used for investment or business purposes.

However, Tim & Jennifer want to use the deposit they received from the buyer, plus the proceeds from the investor loan (note #2), for a deposit on the purchase of another home selling for $4M, and get a mortgage for the balance ($2.9M down, with a $1.1M mortgage, ignoring fees). This presents a challenge.

I'm researching the options available for Tim & Jennifer to achieve their goals legally, without running afoul of tax regulations that would result in disallowed deductions, plus penalties & interest.

Technique #1 (appears ill advised)
One technique that a mutual friend mentioned is that they could create an LLC (Tim & Jennifer as sole members), using the investor loan proceeds to fund the LLC (as a "business"), then have the LLC purchase the new residence (the LLC would be on the title, instead of Tim & Jennifer). However, that technique raises several red flags in my mind:

• If the LLC exists solely to hold the primary residence, and has no real business purpose, I'm concerned that the IRS would rule that it's a "sham", and any tax deductions would be disallowed.
  • Most likely due to violating the Economic Substance and Substance Over Form doctrines.
• If the LLC has some additional (real) business purpose (e.g. additional rental properties, or a commercial venture...such as selling office supplies), then the personal residence is in jeopardy in the case of a lawsuit brought against the LLC resulting from any investment or business property held within the LLC (e.g. slip and fall at a rental property).
  • Even in that case, I'm assuming the residence would still be classified as personal property (even if held within the "business" LLC), so that any expenses paid (maintenance, repairs, etc) would not be deductible.
  • Not to mention that mixing personal and business assets within the LLC creates additional risk for "piercing the veil" (alter ego) for any potential judgments.

If they decided to proceed and ignore the above issues associated with using an LLC, there are additional issues:

• It's more difficult to get financing for personal property held in an LLC, and any financing would be at a higher interest rate.
• It's more difficult to get hazard insurance.
• They would need to pay the LLC (themselves) fair market rent, as tenants of the residence.
• They (as LLC members) would need to pay income & FICA taxes on the income (rent) received from themselves as tenants (resulting in double taxation of that money).
• They might lose their capital gains exclusion:
• If they keep it as a Single Member LLC (since they're husband & wife in a community property state), they could probably keep the capital gains exclusion, since the IRS typically considers that a "disregarded entity" (as long as the LLC has not elected to be treated as a corporation for tax purposes). However, if they ever added another person to the LLC (one of their children or another relative), they would lose the exclusion, since it would then be taxed as a partnership. By the way, if this were taking place in a non community property state, I believe they would lose the capital gains exclusion altogether (since they would be taxed as a partnership).
• Loss of the Homestead Exemption

Technique #2
A second technique proposed, assuming that Tim & Jennifer already have a significant investment portfolio, is to liquidate some existing investments to fund the down payment on the new home, and use the investor loan proceeds for new investments, with a goal of producing 6% (or better) average annual returns over the next 20 years (resulting in approximately $5M, or more, over 20 years).

Technique #3
A third technique (if they don't have a significant portfolio), is to deposit the loan proceeds in a new investment account (targeting 6% average annual returns over 20 years), then borrow against the investment account (margin loan), using the margin loan proceeds for the down payment on the new home. The problem is that they probably won't be able to take out a loan large enough for the down payment they want, due to margin loan leverage limits.

Technique #4 (appears ill advised)
A fourth technique advised by others is to simply deposit the investor loan proceeds into an interest bearing account for 30+ days, with the notion that doing so completely fulfills the "investment purpose" requirement, after which they can withdraw the funds and use it for the down payment (while still taking the interest deduction each year). However, this seems to fly in the face of the tax code interest allocation (tracing) rules, as specified in Treasury Regulation 1.163-8T, and discussed in IRS pubs 535 & 550.

Can someone (preferably with tax expertise) confirm all of the above, particularly the problems with techniques #1 and #4? If there's anything I missed, please feel free to elaborate.

Are there any other options available for Tim & Jennifer to legally achieve their goals?

Thanks in advance for any help.

John

[Dave Foster]

@John Oliver, it may be water under the bridge for your clients if they have actually consumated the sale.  However, if they have not and if they're willing to exercise a little patience then they have an excellent opportunity using a combination of sec 121 primary residence exclusion, 1031 tax deferred exchange, and installment sale rules to accomplish the following:

1. Take 500K in cash tax free immediately upon sale.  And secure their 121 homestead exemption on a new property.

2. Defer tax on then entire remaining portion of the sale while creating cash flow investment assets.

3. Create income from the mortgage offered to their buyer that is tax free except for the portion allocated to interest.

From what you describe I think they could get exactly where they're trying to go without having to pay any tax and without having to create an unwieldy structure.

[Jenifer Levini]

Look, the fictional Tim & Jennifer have enough money to hire a great accountant or lawyer. if they are going to be so cheap as to get advice here on BP instead of hiring professionals, then they will get a big audit! There are a few errors or misunderstandings of tax law in the scenarios that you describe. The best advice you can give them is to work with professionals!!

Jen

PS. I'm not a tax lawyer or an accountant.