If you and one or more other co-owners want to jointly purchase real estate to be used as rental property, you could set up a limited liability company (LLC). This may protect your personal assets from obligations that arise from the rental property activity, but you could encounter some difficulties in obtaining mortgage financing as an LLC.
As explained by The Money Coach, most mortgage lenders won’t make a distinction between the LLC and the individual co-owners. The credit score, income, and assets of each co-owner will be taken into account in granting and underwriting the mortgage loan, just as if the individuals were co-signing the loan. If the lender agrees to grant a loan in the name of the LLC, the co-owners may be required to act as personal guarantors of the loan, thereby eliminating the protection of personal assets from obligations of the LLC.
Matthew Graham points out in Mortgage News Daily that lenders consider a non-owner occupied loan to be more risky and therefore require a larger down-payment and generally a higher interest rate. Generally you would need at least a 20% down payment for a conventional loan.
You could potentially qualify for an FHA loan for a 2, 3 or 4-unit building, but you would have to reside in at least one of the units. As indicated by Bonnie Wilt-Hild for the National Association of Mortgage Processors the requirements for 3-4 unit buildings are different. In order for the mortgage to be FHA-insurable, in addition to closing costs, you must demonstrate that you have 3 months of PITI (principal, interest, taxes and insurance) in reserve after closing. Also, you would have to show that the property is self-sufficient — the monthly rental income covers the monthly PITI payment.
Another possibility would be to purchase the property in your individual names as co-owners. This may allow you to obtain a mortgage loan at a lower rate of interest and possibly with a lower down payment, depending on your credit, income and assets. As suggested by Ilyce R. Glink and Samuel J. Tamkin on the Law Problems website, you could keep the property in your own names and take out enough insurance to cover the potential liabilities you had intended to protect your personal assets against by buying the property through an LLC.
Or you could take out the mortgage loan in your own names and then transfer title to an LLC after closing, for example through a quitclaim deed. In that case you should also have the deed recorded with the title company and have a new title insurance policy issued in the name of the LLC. However, Glink and Tamkin point out that transferring title to the LLC could trigger a clause in the mortgage agreement that allows the lender to call the loan. This due on sale clause gives the lender the right to demand full repayment of the loan if the property is sold or title is transferred.
The due on sale clause to call a loan if title is transferred is a right that the lender has, but is not an obligation. Whether the lender decides to call a loan may depend on the market and economic conditions. In any event, you may want to consult with a real estate attorney before deciding to purchase a property through an LLC.
Sources:
Bonnie Wilt-Hild, FHA News: 3-4 Unit Properties, National Association of Mortgage Processors
Ilyce R. Glink and Samuel J. Tamkin, Creating LLC to Buy Rental Property, LawProblems.com
Matthew Graham, Questions & Answers, Mortgage News Daily
Will Forming an LLC For Real Estate Investing Help Me Get a Mortgage Loan? The Money Coach
