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The Southern California Expensive House Strategy

By Arnold Williams

Mortgage and Lending with Arnold Fitger Williams

June 22, 2007 06:13 AM

Southern California has more than its share of very wealthy people: and these people buy houses to suit them, with mortgages in the same category.

But there's a tax planning problem with these houses: the mortgage deduction covers only the first million dollars, and they require gardeners, maids, poolmen, and other higher-end maintenance. They are, in other words, not a good investment.

How do we change them into a good investment?

By shifting their ownership. By having them owned by an S Corporation, which leases them back to the owner at market rates plus costs sufficient to maintain them.

In the S corporation, maintenance is a tax deduction which flows through onto the owner's tax return. The mortgage interest is fully deductable to the S corp, and hence to the owner. When the owner wants to downsize, a 1031 exchange into a smaller house and a series of TIC investments allows for a change in cashflow, as tax deferred and tax sheltered money replaces the straight expense of the prior mansion. The presence of the corporation affords some liability protection from property-related lawsuits.

Will their mortgage loan be called? Possibly: but probably not. Yes, interest rates are rising, but those who make these loans may prefer simply to keep getting paid rather than force an early repayment. For those lenders in the other category, a bridge loan is not that hard to secure for the people in that category: and new financing will be in the name of the S corporation, guaranteed by the owner.

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Monique Rice

Global Realty - Beverly Hills, CA

1) Are you saying you turn this into an S corporation after you purchase it, because I can only guess that you would have a problem getting a loan with a reasonable interests rate?

2) What if you wanted to purchase a second home?

3) How would it work if you started purchasing several homes as investment properties? Do you recommend a different kind of corporation?

This is very interesting to me.

Thank you.

Jun 22, 2007 06:24 AM

Arnold Williams

Arnold Fitger Williams - Los Angeles, CA

Monique:

1)I'm usually talking to people who have already bought their house. I don't do residential mortgages.

2)Talk to your lawyer.

3)Talk to your lawyer.

Really, you need an accountant and a lawyer, both of whom INVEST IN REAL ESTATE THEMSELVES to answer these questions for you. (If they don't invest in real estate, they are unqualified to advise, no matter how smart they appear).

Jun 22, 2007 09:11 AM

Anonymous

Blogger To Be Named Later

Arnold, I'm curious. Do the majority of these purchases start out intended as investments? Or are you describing a Plan B option that's available to the sellers if they're situation changes? Well-written post. Thanks.

Jun 22, 2007 09:52 AM

Andrew: No. They start out intended as a showpiece house. Then the owner decides that the house has more expenses than he thought, and asks for ways to make this work for him. That's when the S Corporation move happens.

Jun 22, 2007 03:31 PM

Bill Roberts

Brooks and Dunphy Real Estate - Oceanside, CA

"Baby Boomer" Retirement Planner

Hi Arnold, I like your thinking on this but I might suggest an LLC instead of the "S" corp. An "S" corp is really just an alter ego and doesn't provide real security against liability lawsuits, but an LLC with at least one other member could provide absolute security, both for the homeowner and the house.

If the lender doesn't accellerate for the "S" corp they probably won't for the LLC either.

Aug 03, 2007 06:30 AM

I've tended to take Brogan, Duffy's memo when I suggest clients talk to their lawyer and CPA. I have learned to be skeptical over the years when anyone claims that something "provides absolute security" -- my experience suggests that even the best, most carefully elaborated structure provides a better settlement price for the lawsuit, but payments are almost always made at some point. Brogan Duffy is <a href="http://www.broganduffy.com/Publications/Form%20of%20Entity%20Paper.pdf">here</a>.

Again, this is what I hand someone who is going to talk to his lawyer and CPA about formation: I suggest that I have seen this done with an S Corporation, but the form that they use should be the one their advisors recommend.

Aug 03, 2007 10:59 AM

Arnold, I downloaded and read the Duffy pdf. It primarily discusses taxation and does not get into the issues of "piercing the corporate veil" and protection against judgments. These are two very significant issues for people with assets.

As usual I appreciate your willingness to share your knowledge and information.

Aug 03, 2007 11:58 AM

http://www.bulletproofveil.com/case_studies/llcveilpiercing.pdf (an older, but short, summary of the problems with LLCs, and why corporations and LLCs have the SAME issues of piercing the corporate veil.)

http://home.law.uiuc.edu/~ribstein/Abolishing%20LLC%20Veil%20Piercing.pdf (see Part 1 of this article on the state of the current law.)

Again, a restatement: if you want protection against judgements of any kind, you won't get it. If you want a good bargaining position in case you lose in court, you can get it, and settle for cents on the dollar, and there are lawyers who specialize in the formation of the entities that permit this. One of the best even has a fairly informative website, http://www.assetprotectionbook.com/ , though if you like humorous perspectives, his http://www.quatloos.com/ most famous site has it in spades. Since I don't represent my clients as an attorney, but solely as a commercial mortgage broker, I don't make the mistake of giving them legal conclusions: I just hand over some general considerations and suggest that they talk to their CPA and attorney about these issues. Even when their CPA or attorney isn't an expert, and calls me for more information, I let THEM tell their client what they discover, not me.

Now, a further note: I'd suggest, gently, that if you have a really complicated asset protection plan in place, most lenders won't even talk to you. Keep in mind that they need their money, with only a short, legally mandated delay, when the loan goes south, and most of them recognize asset protection as a fence against them. I can get loans here, too: but they're more expensive to set up, and require different guarantees.

Aug 04, 2007 11:45 PM

Arnold, Once again you have gone "above and beyond" in your response. Thank you very much. I appreciate your position of not wanting to become their attorney by your actions. I agree that somebody else should carry this burden.

If the property is in a "single entity" LLC it should not bother the bank "who" owns the LLC. Their interest is secured.

P.S. I read the pdf on "piercing the LLC veil. I agree that the "rules" should be the same for LLCs and corporations in matters of fraud, however, the presumption of "alter ego" applies to an "s" corp just by its very nature.

Aug 05, 2007 03:05 AM

The Southern California Expensive House Strategy

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