We have some rental properties in a family LLC. It has some loans from banks. We have some securities similar or greater in amount to the rental properties. Margin loans against those securities could be an easier (banks really rake you over the coals providing documentation for real estate loans) and cheaper (rate tends to be lower) way to finance properties.
What if, the securities are put in a separate, second LLC? Then that LLC would borrow using margin loans and lend the money to the existing related party (both would have the same owners) LLC to buy properties.
I'm trying to figure out the basic tax situation in doing this, to decide if it's at all worth pursuing. If an individual takes out a margin loan, the interest is 'investment interest expense' deductible on Schedule A only if you itemize, among other limitations. But that would be a key limitation in this case because most of the LLC members don't itemize.
But, could the new 'lending' LLC instead consider the interest if got on loans to the other LLC to be 'business interest income' or 'passive interest income' and likewise treat the interest expense on the margin loan as 'business interest expense' or 'passive interest expense'? Bottomline question does this idea (or is there any other simple idea) allow the margin borrowing, which is ultimately for the 'passive' purpose of buying rental properties, to be deductible to the members who do not itemize on Schedule A?
the IRS has tracing rules, REG 1.163-8T, which basically say to look to what the borrowings were used for to determine if and where they are deductible. since your margin loans would be used to buy more real estate the deduction would be related to the real estate and not be schedule A investment interest
what you must be careful of is what is referred to as debt-fianced distributions.
A debt-financed distribution occurs when a passthrough entity, such as your LLC, secures debt and then distributes a portion of the debt proceeds to its owners. then the deductibility of the interest to the partner depends on what distribution proceeds are used for. Under Temporary Regulations Sec. 1.163-8T and IRS Notice 89-35, there are two ways by which the debt proceeds and related interest expense may be allocated by the passthrough entity. The first is the general allocation rule, which allows for the allocation of the interest expense to be in accordance with each owner’s use of the debt proceeds. The second and more practical method, known as the optional allocation rule, permits the allocation of the distributed debt proceeds and the associated interest expense to one or more expenditures made during the same taxable year as the distribution.
The owner’s share of the passthrough entity’s interest expense on debt proceeds allocated to distributions to owners should be included on the “other deductions” line on the IRS Form 1065, Schedule K-1 and identified as “interest expense allocated to debt-financed distributions.”
If the received debt proceeds were used for income-producing activities or investments, the related interest expense to the owner is deductible. But, if the debt proceeds were used for items of personal in nature (i.e. buying a boat), then the related interest expense would not be deductible to the owner.
Thanks very much for that detailed answer. But just to clarify on the first point, there are two LLC's, say LLC1 and LLC2, both owned by the same people in the same proportions. Mechanically speaking if LLC1 held both the properties and the securities*, and took out margin loans on the securities to finance properties, I would feel confident to enter the interest on the margin loans on Line 9 'Interest' under 'Rental Real Estate Expenses' on Form 8825 Worksheet for the properties financed, because as you say that's the purpose of the margin loans. In the actual case LLC2 would own the securities, no rental properties, and take out the margin loan, the proceeds of which, along with its excess cash (from securities distributions), it would lend to LLC1 to finance properties. In principle this should come out the same, and LLC1 would again record the interest expense on its loans from LLC2 on line 9 Form 8825, I assume. But how would LLC2 record the interest paid to it by LLC1 and the interest it (LLC2) pays on the margin loan, on Lines 7 and 15 of Form 1065 'business interest income' and 'business interest expense'?
*it wouldn't for protection of the securities from lawsuits arising out of real estate activities.
there could be a problem with LLC2. I can't say how the IRS would look at the transfer of securities. technically a distribution of securities (property) would require LLC1 to recognize gain for the difference between the FMV on the date of distribution and their cost. Losses would be deferred. there could be other issues unique to each partner depending on their participation in activities of the partnerships.
Consulting a professional who could research the tax consequences of these actions in more detail would be advisable.
Let's say there's no transfer of any securities from one LLC to the other. LLC1 doesn't have any securities, and LLC2 is formed with the capital contribution being securities owned by the members nothing to do with LLC1. LLC1 borrows from LLC2 to buy properties: seems straightforward for LLC1 to record the interest expense of that loan under 'interest' in Rental Real Estate Expenses Form 8825. My basic question, in the steady state case, also setting aside for the moment any distributions either LLC makes to members, how LLC2 would record the interest income on the loan to LLC1 and its interest expense on the margin loan that funds the loan to LLC1. As business interest income and expense on lines 7 and 15 of Form 1065? It the answer is pretty likely yes, it would be worth moving ahead to sort out other details. Thanks again.