This Article is designed to be of general interest. The specific techniques and information discussed may not apply to you. Before acting on any matter contained herein, you should consult with your personal legal adviser.

This week my client Dick closed his loan. Dick has owned a small apartment building for several years. His mortgage was at 8.875% interest, and the value of the building has increased since he bought it.

Dick wanted 3 things:

1. Put some cash in his pocket by doing a cash out refinance;
2. reduce the mortgage interest rate; and
3. keep the loan non-recourse (no personal liability if the property suffers a downturn and Dick is unable to pay the mortgage).

Unfortunately, the mortgage broker took until September before the loan was ready to close. Dick and I signed over 15 documents (in quadruplicate). FedEx to the bank's lawyers was $62. It would close tomorrow.

Wrong! The financial markets then went haywire. The Japanese bank which had been ready to lend $2.6 million had major problems and changed its mind - they halted all real estate loans. Legally, the bank was in breach of contract (its written loan commitment), and Dick is entitled to sue them, but practically, lawsuits are no fun (especially against a foreign bank), so the mortgage broker found a new lender.

Unfortunately, the chaos in the financial markets made all lenders more cautious. Qualifications for loans were raised; a new lender was found, but needed lots of additional documents before closing the loan. Finally, this week it is done.

Back in June, the original loan simply called for Dick to be the borrower; the new lender required that Dick form a "bankruptcy-remote, single-use entity" as the owner of the property.

"Single-use entity" means a separate entity which will not have problems if another investment or property owned by Dick suffers a liability.

"Bankruptcy-remote" means that the new entity is so separate that if Dick suffered a personal financial catastrophe, the property would not be affected.

Under the original deal, Dick would have had an extra $60,000 cash out. The new loan was less favorable than the original loan in several aspects. It was only $2,550,000. Then there were the increased costs.

The new loan required a survey to prove that the building did not encroach onto an adjacent property. This cost $3,000. [The original deal did not require a survey.]

Unlike the original loan, the new loan required formation of an LLC. First Dick paid the costs of forming the LLC. Then every year the California LLC minimum income tax is $800. Annual LLC income tax return preparation will cost about $425. This is a cost Dick will pay every year, not needed under the original loan.

The new loan required impounds. Impounds are not all bad. They are a budgeting tool, whereby the lender requires payment in monthly installments toward the major repetitive ownership costs: taxes and insurance.


Previously, the property manager wrote a big check twice a year to pay the taxes.

With an impound, it is broken down into 12 small pieces. An impound is not wasted money. Since it is collected in advance (so it is there when the big check needs to be written), it's just money paid before its time.

The limited circumstances in which Dick can be sued are:

• he lied in his mortgage application;
• he fails to pay the mortgage but collects the rent and does not pay it all to the lender;
• the building suffers an insured loss and Dick keeps the insurance payoff; or
• environmental problems arise.

We were another of the expenses in the loan. Banks lend money all over the world. They usually hire lawyers near their home office. (The borrower pays their fees as part of the costs of the loan.)

But the banks' lawyers do not know local law and they need assurances about the legality of the borrower. They make the borrower hire a lawyer to give a legal opinion that:

1. Under California law, the borrower is legitimately formed, in good standing, and legally capable of executing the loan documents.
2. The borrower has executed the documents properly. (The person actually signing the documents is authorized to sign, making the documents effective.)
3. The lender will have all rights of a secured lender under California law if the borrower defaults.

Most commercial loans are "conduit loans." They are combined into huge packages with other loans to be resold to pension plans, insurance companies, or mutual funds. Since they are resold, they must be in standardized forms meeting uniform guidelines.

Since summer, 1998, we have represented 5 borrowers on loans of this type. 4 of the loans required a bankruptcy-remote single-use entity. Only 1 loan let the borrower personally own the property and borrow the mortgage.

One benefit of having an entity as the owner of the property is asset protection for the individuals in the event that a catastrophic occurrence happens at the property. If an accident occurs, an LLC or other entity may insulate the individual owners from personal liability.

Since our law practice emphasis is estate planning (as well as taxation and real estate), each of the required entities has another feature not normally found in these entities. We built in (and negotiated approval from the lenders) the right to make gifts (to the clients' children and grandchildren) of shares in the entity, as an estate planning tool.

Most people know that they may give away $10,000 per year tax free. Few clients have the desire or the liquidity to give away money, but many own shares of apartments or other buildings. They may give away non-voting shares, yet the clients retain total control.

If you would like more information on this technique, please see Family Partnerships.