You wired seventy one thousand dollars from your personal savings account into the LLC’s checking account on Tuesday. On Thursday the LLC wired it to the title company as the down payment. Both wires cleared. The deal closed. And then your accountant asked a question you had not thought about: was that a capital contribution or a member loan?
Most investors treat this as a bookkeeping detail to sort out in April. It is not. How that money is booked changes what the lender sees during underwriting, changes your basis in the entity, changes whether the LLC owes you anything, and in a multi member deal it changes who gets paid first when the property sells. Lenders ask about it directly on entity deals, and the wrong answer, or a confused one, stalls files.
The two ways money enters an LLC
There are only two. Everything else is a variation.
A capital contribution is equity. You put money in and you get ownership, or you increase the ownership you already have. The LLC does not owe you the money back. There is no note, no interest rate, no maturity date. The contribution increases your capital account and your tax basis in the entity. You get the money back only when the LLC distributes profit, refinances, or sells and liquidates.
A member loan is debt. You lend money to the LLC, the LLC signs a note payable to you, and the LLC owes you principal plus whatever interest the note says. It sits on the balance sheet as a liability. You can be repaid ahead of any distribution to members, because a creditor gets paid before an owner does, even when the creditor and the owner are the same person.
The single member owner reads that and thinks it makes no practical difference, because it is all my money either way. That is true for the cash. It is not true for anything else.
Why the lender asks
On a rental loan closing in an entity, the underwriter is running three separate checks on that money, and the contribution versus loan question touches all three.
Check one: source of funds. The lender has to see where the cash to close came from and be satisfied it is yours and that it is not borrowed from an undisclosed party. This is the same analysis behind gift funds and source of down payment on a rental loan, and it is why a deposit that appeared in the LLC account six days before closing gets a letter of explanation request and a deposit that has been sitting there for four months does not.
Check two: is there a hidden second lien. This is the one investors trip over. If you book the money as a member loan, you have created a debt owed by the borrowing entity. The lender wants to know whether that debt is secured by the subject property. An unsecured member loan is usually fine. A member loan secured by a mortgage or deed of trust recorded against the same property is a second lien, and almost no rental loan program allows undisclosed subordinate financing. If your attorney recorded something to protect your loan to your own entity, disclose it before the title commitment does it for you. That is exactly the kind of item that shows up in Schedule B of the title commitment and turns a clear to close into a three day scramble.
Check three: does the operating agreement allow it. A member loan from a member to the entity is a related party transaction. Many operating agreements require member consent for the entity to borrow, and some require unanimous consent. The underwriter reads the operating agreement anyway, so if the document says the LLC cannot incur debt without a majority vote and the file contains a member note with no resolution attached, that is a condition. This is one more reason the operating agreement your lender actually reads deserves more attention than the template you downloaded in twenty minutes.
What it does to your numbers
Here is the part that matters most and gets discussed least. A member loan does not change the debt service coverage ratio. It absolutely changes your cash flow.
Take a single family rental at a purchase price of two hundred eighty five thousand dollars. You put twenty five percent down, which is seventy one thousand two hundred fifty dollars, and finance two hundred thirteen thousand seven hundred fifty. Say the rate is 7.25 percent on a thirty year amortizing term. Principal and interest works out to about one thousand four hundred fifty eight dollars per month. Taxes run three hundred twenty a month, insurance one hundred forty five, no association dues. Total PITIA is one thousand nine hundred twenty three dollars.
Market rent is two thousand four hundred.
DSCR is 2,400 divided by 1,923, which is 1.25. That clears every standard program and prices well. Run your own version of this in the DSCR deal calculator before you assume your deal looks the same.
Now suppose you booked the seventy one thousand two hundred fifty as a member loan to the LLC at eight percent interest only, because your accountant said it was cleaner for getting your money back out later. That note costs the LLC five thousand seven hundred dollars a year, or four hundred seventy five a month.
The lender’s DSCR is still 1.25. The subject lien did not change, and the ratio only counts the subject lien’s PITIA. But the actual bank account looks like this: two thousand four hundred in, one thousand nine hundred twenty three out to the mortgage, four hundred seventy five out to you. The property nets about two dollars a month.
That is not a problem if you understand it, because the four hundred seventy five is going into your pocket rather than a stranger’s. It is a serious problem if you do not, because you underwrote a property you believed threw off four hundred seventy seven dollars a month of free cash and it actually throws off nothing until the member note is retired. Investors who do this across four properties and then hit a vacancy discover the reserve math does not work, and the path from there to a missed payment and a default is shorter than it looks.
The rule of thumb: the ratio measures the lender’s risk. It does not measure yours.
The multi member version, where this gets expensive
Two partners agree to a fifty fifty deal. Partner A has cash and partner B has the deal and will manage it. Partner A puts in the full seventy one thousand two hundred fifty. Nobody writes down what that money is.
Eighteen months later the property sells for a fifty thousand dollar gain. Partner A believes the seventy one thousand comes back off the top and then they split. Partner B believes they are fifty fifty on everything including the sale proceeds, which after paying off the loan means A gets roughly sixty thousand and B gets sixty thousand, and A is short eleven thousand on the money he actually put in.
Both readings are defensible if the paperwork is silent. If the money was a documented member loan, A is a creditor and gets repaid before any split, and the answer is not ambiguous. If it was a documented capital contribution, then whether A gets it back before the split depends entirely on the distribution waterfall in the operating agreement, and most downloaded templates do not have a waterfall at all. They say distributions are made in proportion to membership interest, which means A gets half of his own money back.
This is the same class of problem that shows up when partners try to change the cap table mid loan. See adding or removing an LLC member while the rental loan is outstanding for how the lender reacts when the ownership picture moves after closing, and selling the LLC instead of the house for what happens when the exit is a sale of the entity rather than the real estate.
What actually gets requested in the file
On an entity rental loan closing in an LLC, expect the underwriter to want some combination of the following. Not every file draws every item, but every item on this list gets asked somewhere.
- Two months of statements on the LLC operating account showing the funds present and seasoned, or a clean paper trail from your personal account into the entity account
- A source of funds letter for any large deposit that is not payroll, rent, or an obvious transfer between your own accounts
- If the cash came from another property, evidence of the closing or the draw. Money pulled from a line against an existing rental is common and generally acceptable, and is covered in using a HELOC or cash out on another property for the down payment
- The operating agreement, read for borrowing authority, signing authority, and any consent requirement
- A member resolution or consent authorizing the loan and naming the signer
- If a member note exists, a copy of the note and a written confirmation that it is unsecured and subordinate
- A completed entity organizational package, which for a newly formed LLC is a heavier lift. See what lenders check when the entity has no history
Notice what is not on that list. No lender is going to tell you which structure to pick. They are checking that whatever you picked is documented, consistent, and does not put a lien in front of theirs.
How to choose
Nobody should make this call from a blog post, and the tax consequences vary enough by state and by situation that you want a CPA and a licensed attorney in the property’s jurisdiction actually looking at your facts before you paper anything. That said, here is the plain shape of it.
A capital contribution tends to fit when you are a single member owner who is not planning to pull the cash back out in the near term, when you want the cleanest possible balance sheet for future financing, and when you care about maximizing basis for loss deduction purposes. It is also simply the default: if you put money in and paper nothing, most accountants will book it as a contribution.
A member loan tends to fit when you genuinely expect to be repaid on a schedule, when there are multiple members contributing unequal amounts and you want the priority to be unambiguous, or when the money came from somewhere you need to service, for instance you drew on a personal line of credit and the LLC needs to cover that payment. In that last case a member loan is not a tax strategy, it is just an accurate description of what is happening.
Whichever you pick, paper it the day the money moves. A one page member note or a one page contribution memo signed and dated at the time costs nothing. Reconstructing the intent two years later during a partnership argument or an audit costs real money, and the reconstruction is never as favorable as the contemporaneous document would have been.
One more practical point that comes up constantly: keep the entity account separate and run everything through it. Do not pay the roofer from your personal card and reimburse yourself later with a memo line that says stuff. That habit is what piercing the veil arguments are built from, and it also makes the source of funds review far more painful than it needs to be. The protection you built the LLC for, including the charging order protection that limits what a creditor of you personally can reach inside the entity, depends on the entity looking like a real entity.
The short version
Equity in, no repayment obligation, higher basis, gets paid last. That is a contribution. Debt in, repayment obligation, note and rate, gets paid before members. That is a member loan. The lender does not care which one you chose. The lender cares that it is documented, that the operating agreement permits it, and that nothing you did put a recorded lien ahead of theirs.
And whichever you chose, remember that a member note is real money leaving the property every month even though the coverage ratio pretends it is not. Underwrite the bank account, not just the ratio.
If you are structuring an entity purchase and want the financing side looked at before you paper the money, get in touch or call 412-990-2941. FMC Capital is a Pittsburgh-based mortgage brokerage financing investment property for real estate investors in Pennsylvania and additional states.
FMC Capital, NMLS #1840537. This article is general information for real estate investors and is not tax, legal, or investment advice. Entity structure, capital account treatment, and the tax consequences of member loans vary by state and by situation, and interest rates, program terms, and underwriting guidelines vary by lender and are subject to change. Consult a CPA and a licensed attorney in the property’s jurisdiction before structuring contributions or loans to your entity. NMLS #1840537.