Additional capital contribution or loan to my LLC?

Question

Hi, my husband and I are 2 members of an LLC (treated as a partnership).  We decided that it's easier to buy a rental property using cash instead of trying to find a mortgage under the LLC name.  We have some cash savings, but don't have enough. We are planning to take out a HELOC against our primary residence, and put that money into LLC.  The question is:  is it better to treat the infusion of HELOC money as additional capital contribution or as a loan?

To make it easier to understand, here are some numbers (not exact numbers in real world):

Husband and wife, each contributed $100k to LLC as capital contribution -- $200k in LLC to start.  Needed $500k to buy a house, so we were $300k short.  Took out a HELOC against primary residence to get $300k.  To properly record the infusion, we can treat it as (1) Additional $150k capital contribution by each member, so the LLC capital is $500k;  or (2) A loan of $300k by the members to the LLC.

Is there a difference in either approach, as it relates to tax or legal protection?  The loan repayment is irrelevant to the Profit/Loss calculation of the LLC, right?  So the only thing that impacts the P&L is the loan interest payment.  However, since the LLC as a partnership is a pass-through, whatever interest payment made by the LLC (as an expense) is an income to the members, so it all washes out at the end, when everything is aggregated on the 1040, which will be married filing jointly.

I know every person who responds to this post will say "talk to a CPA".  I understand the value of a CPA, but part of the fun of being on BP forum is to educate myself and learn things, so that I don't have to rely on my CPA all the time, not to mention that he does charge me by the hour.

Lisa Marie · Answer

@Ashish Acharya @Eamonn McElroy, thank you both for the reply.  I have a related question: we are taking out a HELOC against our primary residence to finance the purchase of the rental property.  Based on my research, the interest payment on the HELOC is not tax deductible because the funds are not used for improvement of the primary residence.  Is there any way we can get a deduction on the HELOC interest on our 1040?  If it's truly not tax deductible, we may start looking for a HELOC for the rental property.  When we use the proceeds from the new HELOC to pay off the first HELOC, how does that impact the tax? Let's use the same numbers:

Each member has $250k capital.  Take a HELOC on the rental property and got $300k.  Do a capital distribution of $150k each to the members. Is this a non-event regarding tax?  That way the member's capital contribution is back down to $100k each, and the LLC is now paying for the HELOC interest, which is deductible against the rental income.  (However, the HELOC interest on the rental may be higher than the HELOC interest on our house. So we will have to do the math.)   Am I on the right track?  Any other idea that may be more tax advantageous?

Eamonn McElroy · Answer

Agree with Ashish.  Treat it as a capital contribution.  Treating it as debt is more administrative work and there's no advantage.

Then if you really want to educate yourself, google "partnership debt financed acquisitions" to learn about what's going to happen regarding the HELOC interest on your 1040.

Ashish Acharya · Answer

Your understanding is correct. I would do capital contribution as it give you basis to deduct losses, if you are not limited otherwise.

If debt agreement is not drafted correctly (these kinds of debt rarely do), it will not give you basis to deduct your losses.

These might be reclassed as equity rather than debt if all the obligations of debt payments are not followed. Too much admin work to track the debt obligation, get out 1099s for interest payments, if needed, and pay someone to draft it correctly to get the basis.

Eamonn McElroy · Answer

Any other idea that may be more tax advantageous?

This is where your CPA comes in.  We don't know your facts, circumstances, and goals.  Furthermore, we don't even have a great handle on what it is that you're trying to accomplish.

Don't let the tax tail wag the dog.  You can complicate things pretty quickly.  You're getting into debt financed distribution territory in your latest post, which generally increases the amount of work your CPA needs to do and therefore your fee.

If you can't speak to your CPA without him or her charging you hundreds of dollars, or if your CPA can't convey concepts and holistically advantageous paths forward to you, you should probably look for a new CPA.

You shouldn't have to learn tax law and strategy just to talk to your CPA.  As an external member of your team, that's their job.

Ashish Acharya · Answer

You can deduct the interest as unreimbursed partnership expenses in Sch E page 2.

You usually don’t get LOC for rental. You need to have good relationship with portfolio lender to get LOC on your rental.

On your example, interest on debt financed distribution has to be treated differently as well. All of these questions are complicated. Glad you are thinking about it. Make sure you bring that up with on your CPA.

Additional capital contribution or loan to my LLC?

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