Tax Code’s Officially Designed “Rent-to-Own Your Home” Program for Investors and Renters
You can realize big benefits with the tax code officially designed “rent-to-own your home” program.
This program. known in the tax law as a ”Shared Equity Financing Agreement,” avoids many of the problems with the lease option, yet provides similar income-producing possibilities and the same. or better. potential for far less rental hassle.
You may have heard the expression, “Let’s get together!” That’s what happens in the shared-equity deal. Both the landlord and the tenant have ownership interests in the home that the tenant is occupying.
For the landlord, the shared-equity arrangement produces great results. Imagine a rental property where you have
- no vacancies,
- no hassles,
- no management fees, and
- a known and positive cash flow.
This is what shared equity can do for you as a landlord.
It also produces great results for the tenant, giving the tenant a down payment on a home, as well as equity in the property. The landlord-investor and the tenant-homeowner share the property in this tax-law initiated and approved arrangement.
Example.
Say you are the landlord.
- You own 65 percent of the house and the tenant owns 35 percent.
- The tenant pays rent to you for use of your 65 percent.
- This 65 percent is your rental property, treated the same as any rental property, even eligible for a section 1031 tax-deferred exchange.
- The special tax-law-defined shared equity applies to tenant use of the property as a principal residence only.1
This article gives you the details you need to get started in the shared-equity rental business, a no-hassle (well, mostly) way to own rentals.
Advantage 1-No Vacancy
Landlords hate vacancies.
When the old tenant leaves, you have to spend time and money both finding the new tenant and getting the rental ready for the new tenant. Besides the outflow of money to get this done, you have no inflow of rental money during this vacancy period.
The vacancy problem can turn a profitable rental property into a big loser (imagine a few months with zero rent and big fix-up expenses). Vacancy attacks your wallet in three ways:
1. The cost to find a new tenant
2. The cost to fix up the property so that it is ready for the new tenant to move in
3. The absence of rental income
Shared equity eliminates the vacancy problem because your co-owner tenant uses the property as his or her home. Very few people just walk away from their home and give up their equity. No, your tenant is very likely to stay in this home until he or she exercises either
- the purchase option clause, or
- the “let’s sell the property now” clause.
With shared equity, the landlord-owner does not fix the clogged toilet in the middle of the night. This is the tenant-homeowner’s responsibility. Nice!
Because the tenant not only inhabits the home, but either buys the property by exercising his or her buy-out option or shares in the profits when the property is sold to a third party, the tenant has a vested interest in keeping the property in good shape.
You can expect your tenant-owner to
- water and maintain the lawn and garden;
- be careful of the walls and other interior surfaces; and
- generally improve the place.
You can pretty well bet that the tenant-owner will not trash or neglect the place.
Further, you can structure the shared-equity agreement to encourage good care of the property. After all, you and the tenant are in the same wagon with the same goal-.to make the property more valuable.
Eliminating the hassle of repair is a huge factor favoring shared equity.
You know that rental property repairs wait until that golden moment when it is least convenient for you to take care of them. Now, you can shift that burden to the tenant-owner and minimize or even eliminate the inconvenience to you.
To avoid hassle, some landlords hire management companies at fees ranging from 5 percent to 10 percent of rents, depending duties. Management companies provide wide-ranging services, including
- advertising for and screening prospective tenants,
- Inspecting the properties, and
- arranging for or even doing the repairs.
Shared equity gives you a built-in property manager who has a far greater incentive than a management company to keep the property in great condition.
With shared equity, you rent to a tenant who wants to own the entire property, or at least his or her share of the equity, in three, five, or ten years.
From the beginning of this relationship, you know
- the rent, including annual adjustments for inflation and possibly other factors like adjustments for property tax Increases;
- the term of rental, including renewal options, if any; and
- the option arrangements for the buyout, including perhaps the methodology for defining fair market value should the tenant want to buy the property at that time.
With the shared-equity contract, you pretty much know how this property is going to perform. Sure, potential problems, like roof leaks, could put a fly in the ointment, but for the most part, you know far more than most landlords when they enter into a rental arrangement with a tenant.
Although shared equity has been codified for more than 30 years, no public rulings and only one private ruling exist. The courts have not had to decide much in this area.
This is probably because, unlike lease options, the rules are straightforward and clear.
Private letter ruling 8410038 gives a big picture of how shared equity works.2
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Here we have the landlord making a 20 percent down payment and taking half the mortgage.
- The tenant takes the other half of the mortgage. The equity-share agreement in this ruling says that at the end of five years, the tenant can buy out the landlord by reimbursing the landlord for the down payment, and
- paying the landlord 50 percent of the increase in equity since Inception of the agreement.
- During the five-year rental period that this ruling discusses, the tenant paid the landlord a rental for the landlord’s ownership interest and also paid 50 percent of the mortgage.
You have almost no choices when it comes to dividing expenses in a tax-law-approved shared-equity arrangement.
In a shared-equity deal, the regulations clearly state that both the landlord and the tenant-homeowner must split the tax benefits in accordance with ownership interests.3
This is unlike regular partnership rules that allow various allocations of expenses and depreciation.
The general partnership rules do not apply to the official shared-equity financing agreement.
If the shared-equity relationship is as tenants-in-common (most equity-share deals involve tenants-in-common), tax law follows state law, which generally requires that you allocate repairs, interest, taxes, and other expenses according to ownership interests.
For example, in Boyd, the court ruled that the taxpayer, who paid 100 percent of the repair expenses, could deduct only 50 percent, the percentage equal to his ownership percentage.4
The court noted that this taxpayer, under New Jersey state law, had the right to seek reimbursement for the other 50 percent; thus, his deduction was limited to 50 percent.
In James, the court ruled that Joseph James, who paid 100 percent of the mortgage interest and property taxes on two rental properties, could deduct 50 percent, the percentage equal to his ownership percentage.5
Thus, a landlord who owns 40 percent of the property gets 40 percent of the deductions for mortgage interest, property taxes, and repairs.
The IRS example above had a 50-50 ownership when the investor made a 20 percent down payment and was on the hook for half of the mortgage.
Apparently the reason for the 50-50 setup is that the homeowner-tenant agreed to make the landlord whole by first returning the 20 percent down payment before splitting the profits. Had the down payment not been returnable and profits split 60-40, this arrangement would have been a 60-40 deal.
You can see that there are different ways for you to structure your shared-equity arrangements.
- To get this right, make sure to work with a lawyer familiar with shared-equity agreements.
- Keep in mind that the shared-equity agreement is a creature of tax law that requires allocation of expenses in proportion to ownership.
The law says that the landlord and tenant must agree on a “fair market rent” at the “time they enter into the agreement” to share equity.6
The landlord has a fixed rent, known in advance, and possibly adjusted for inflation.
You have to love it! You know the rent in advance, and you know the vacancy rate in advance. Yes, ifs good to be the landlord in a shared-equity deal.
But don’t get too comfy just yet.
Remember, this is a tax-law deal. It requires proof.
You need proof you are charging your tenant-owner a fair rent.
Gather fair-rent evidence and put it in your tax files.
You might, for example, gather
- newspaper ads showing comparable rents in the neighborhood;
- Internet ads (print them out);
- written opinions from consultants or management companies; and
- the names of and rents paid by tenants In neighboring properties.
Always keep in mind that you carry the burden of proof and that the IRS never gets around to asking for your proof until well after the fact. This gives the IRS hindsight, something you won’t have.
In fact, quite often, the evidence you relied on to make your decision, if not obtained in writing and retained in your shoebox or more formal files, has disappeared by the time the IRS arrives for the audit.
Don’t take this chance. Protect yourself!
Think evidence at the inception of the shared-equity arrangement, and gather it.
The tenant-partner realizes three significant benefits in the shared-equity arrangement:
1. Detailed advance knowledge about a property that the tenant might want to purchase as a home at a later date.
2. Equity build-up during the process of learning about the property.
3. Monthly cash outlays that are not much more than the non-deductible, non-equity-building rent paid before entering this arrangement.
Say a tenant was paying $1 ,500 rent before getting involved in the shared-equity arrangement.
After entering into the shared equity agreement, the tenant might pay $750 in rent and $1,000 for home ownership, for a monthly outlay of $1,750. But with this outlay, the tenant is building equity and inspecting a potential home in great detail.
Shared equity can be a very good investment for the tenant.
Perhaps the biggest benefit to the tenant-owner is home ownership at a time when he or she lacks the up-front cash for a down payment on a home.
Horne ownership and equity build-up can start much earlier with shared equity.
If you want to be the landlord partner, where do you search for tenant partners?
The recent upsurge in home prices means more and more people have trouble entering the home ownership market, and that facilitates your search.
You might start the search your backyard by looking at your
- brothers and sisters,
- sons and daughters,
- sons and daughters of friends,
- friends of friends, and
- employees.
Placing ads in newspapers can produce the right tenants.
Some matchmakers exist on the Internet, and some put together meetings where the landlord and tenant partners can get together to size each other up.
Ways to find the landlord-tenant match are limited only by your imagination. But the match is important, as the right chemistry greatly facilitates the desired outcome.
Rule 1- written agreement.
Tax law requires that you put the shared-equity arrangement in a written document that stipulates:7
¦ ownership of the dwelling by two or more persons ( e.g., landlord partner and tenant-homeowner partner);
¦ occupancy of the dwelling as the principal home of one of the parties (e.g., tenant-homeowner partner); and
¦ rent payments by the tenant-homeowner to the landlord-investor for the rental part of the shared-equity residence.
Rule 2- joint ownership.
Although the law uses some funny language in this area, it requires that the parties to a shared-equity agreement own the property together. Technically, the wording reads that the landlord-partner and the tenant-homeowner partner must each have a “qualified ownership interest” for at least 50 years.8 For all practical purposes, this means they own the property together.
The rental term does not have to follow the ownership period. Thus you can have ownership forever and rental for 1, 2, 10, or 30 years. The purpose of the “50 years” rule is to ensure true ownership by both parties, usually as tenants in common.
Rule 3-tax benefits based only on ownership.
The shared-equity agreement must allocate tax benefits under one formula: according to ownership. If the landlord owns 55 percent of the dwelling, the landlord gets 55 percent of the depreciation, mortgage deductions, and so forth. Remember, tax law fixes shared-equity income and expenses in direct proportion to ownership.
Here are some basic things to consider when putting together your shared-equity agreement:
- How am I going to prove fair rent?
- What percentage of the home do I own?
- Can I buy out the other party?
- Will the option to buy out the other party stand up as an option under the tax law?
- Have I made sure that the expense allocations in the agreement match the tax law ownership requirements for deduction?
- Is there a date certain when we sell the property or otherwise end the sharing agreement?
- What happens if I die?
- What happens if my shared-equity partner dies?
- What happens if one party defaults on the agreement?
You want a real estate lawyer familiar with tax law’s definition of shared equity to help structure these provisions. The lawyer helps make sure that you are in compliance with the tax law so that you realize the tax benefits you expect from the shared-equity transaction.
Shared equity is tax law’s officially designed rent-to-own your home program.
For this to work, it takes two parties:
1. a landlord-investor and
2. a tenant-investor.
The landlord-investor benefits because he has no vacancies, few hassles, no management fees, and a known cash flow.
The tenant-investor benefits because he gets into this home with little or no down payment, builds equity while paying rent, and gets detailed knowledge about the property while living there.
At some agreed-upon future point in time, the landlord-investor sells his or her interest in the property to the tenant-investor or the two of them sell the property to a third party.
If you invest in real estate, you have to look at shared equity as a possible addition to your rental holdings.
- The low-hassle result that shared equity can produce makes this style of investing very attractive.
- Further, the known rents with no vacancy can ensure positive cash flow during ownership and almost guaranteed profits on the overall transaction.
If you are a tenant who wants to own a home but lacks the necessary down payment, shared equity can provide the solution.
- In fact, in some ways shared equity can work better than if you had to invest alone.
- After all, as a tenant, you now get an experienced investor (your partner) who wants the value of this property to increase as much as you do.
- The landlord-partner can bring some mentorship abilities to your table.
