Buying Out A Partner - With Complications
First of all I love the information on the site. I've done some research into buying a home and have talked to several people who have bought homes and I can never believe the stories I've heard. My response is always "why didn't you just walk out . . it's only a $2000 deposit . . . you're paying that in the first year with the difference in interest you are getting now" but after reading your site it seems to me you would have to get lucky to find a good mortgage broker and get a good loan where what you are told is what you get. The rule seems to be if you want a house "getting screwed" is just a part of the process. In this market (DELETED) you would need to be especially lucky to find someone who is willing to be honest . . . it's a risk and, again, it seems to me being honest is will just lead all clients to the fibbers who, frankly, tell people what they want to hear.
Anyway, back in May 2003 I was looking for a house and a friend of mine was looking to invest $70,000 (that he got from another land sale) so he wouldn't have to pay taxes on it. We ended up buying a $150,000 home where I live now. By "we", I mean "he" because my name couldn't be on the loan for tax purposes (at least that's what they told us . . . it's hard to get good information). And, I know, I know, I have no rights and he can do whatever he wants and I understand that. If anything I've had a place to live where the rent was relatively low (but it sucks that I didn't get a house when they were affordable). I've been living in this house and paying the mortgage for more than 3 years now. I'm in a much better financial situation now and I'd like to buy the house from him. He also has another $70,000 from another land sale (I'm not sure of the details but suffice to say he is thinking about paying off the mortgage). Anyway, once all this happens I want to buy the house from him at a price way below market (similar houses are now around $300,000 but there is no way I'm paying $300,000 when I could have gotten it for $150,000 when I moved in). My question is: can a seller also be a lender? Where do I start? I've talked to a few people and they won't touch it . . . in fact, they have no advice whatsoever beside for me to move out and get my own house (which they would be happy to help me with). What are the tax implications of all this?
If it was inevitable that you would get screwed as part of doing a real estate transaction, most of the information on this website would be useless and pointless. Furthermore, if it was inevitable, I'm not certain it would be appropriate to call it "getting screwed," if it happened on every transaction. What I'm trying to do here is give folks the tools to get correct relevant information, make rational informed choices, find honest competent service providers (it is not as difficult as I may make it seem sometimes, but neither is it easy!), and in general have a better outcome, which is the target you really want to hit. How much effort you want to spend is up to the individual reader. If you want to do only the easiest and most basic items, it should still make a significant difference. If you want to go whole hog, you should see much larger benefits.
Now, as to your specific situation, here are the issues I see:
First off, I have never heard of a situation where you cannot be on the title "for tax purposes." The only tax purposes that would serve is allowing the other person to get the entire deduction, which he would anyway from being the only person on the loan. As soon as the loan is recorded, there is no reason why there could not have been a quitclaim from him to him and you (in whatever manner you desired to hold it, most likely tenants in common in this case). This would have started the clock on having you on title, and since you cannot refinance for cash out within six months of having your name put on title via quitclaim, this constrains your options as well as putting you at your friend's mercy. You may have been paying the mortgage, but even if you can prove it this is unlikely to give you any legal rights if your friend decides not to play it straight.
The next issue, relatively minor, is that you have no verifiable history of paying either rent or mortgage payments at this point. Those checks you have been writing to pay the mortgage in your friend's name? Well, that mortgage is being reported as paid, but your name is not on it. Rent? Not there either.
However, assuming this really is a friend who intends to play it straight with you, this situation is very workable. If it was someone who wanted to work you over, you would be well and truly hosed. Now, you bought for $150,000, of which your friend furnished $70k. The loan for the remainder that you have been paying for sure looks like your contribution to me! By my reading, this makes him approximately 7/15ths owner, and you 8/15ths, but if your friend has been playing it straight, he's done you a pretty big favor not just by tying up his money in the down payment, but by allowing his credit to be used for your loan. This has effects on his debt to income ratio if he wants another loan, among other things. I wouldn't mind ceding him a larger share of ownership in your case.
Whatever the amounts of ownership you agree upon, however, you are also going to need to agree on a method for valuation. I'd probably agree to something like the average of a Comparative Market Analysis of sold properties in your area, and an appraisal. Appraisals are not what you could get on the market in the current conditions, and don't try to think that they are, but both measurements can be manipulated. Pay for each of them in equal shares. As compared to each of your investments, it's small potatoes, and a worthwhile guard.
You have an agreed valuation, and an agreed upon share of ownership. Out of that, you currently have a loan on your share, but that should probably be your issue, not the partnership's. So from that, you can figure what your friend's current share of ownership is, and therefore what he is due upon buy out. You should still have a pretty good ownership equity, roughly $80,000 by the rough amounts and ownership shares in the previous paragraph. So you need to come up with about $80,000 to pay off the current loan, plus about $140,000 (again, by the computations as to ownership share above, subject to revision per your agreement) to pay off your friend. Total owed: $220,000.
Now, your friend actually want to go from owner to lender, and I don't know of anything wrong with that, although in all truth I've never encountered it before in this context (seller carrybacks happen all the time in this market). Furthermore, he wants to invest an additional $70,000 in being the lender. Whereas this will not qualify for 1031 tax deferred treatment as far as I can see (consult a tax professional), this means you are going to have two loans on the property, one from a regular lender, and one from your friend. The specifics of this are difficult to see without more information, and shopping your situation around (I'm not licensed in your state, so I can't put my wholesalers through that for no potential pay off!). It could well be that your friend's loan ends up in second position, but it strikes me as more likely appropriate for a first, as the guidelines for Home Equity Loans and Home Equity Lines of Credit are more likely to have this whole situation be acceptable to your lender for the balance.
Now, as to the structure of the transaction, it's going to look like a sale, but don't expect real estate agents to want to work through that without a commission, which you are probably not going to want to pay, because all of the hard work to the transaction is kind of irrelevant in your case. On the other hand, good loan officers do these all the time. However, the commission structure for Home Equity Loans and Lines of Credit leaves them not making a whole lot of money unless you agree to pay them a flat fee for going through all of this, and for all the times I tell people that transactions aren't as difficult as some loan providers would have you believe, this is a very difficult transaction. I normally work on less than one point of total compensation for loans but I'd probably want to see about $6000 in order to put this transaction through, and that's if everything else is perfect. I don't know about your state's predatory lending law (most states have one, limiting total loan costs to a certain percentage of the loan), which may well prevent them from getting paid enough to make the transaction worthwhile for them. By comparison, on a loan of about $80,000 plus transaction costs, which is what the computations above suggest, California's predatory lending law limits total cost of the loan (and also total lender compensation via another law) to $4800. In most cases, direct lenders can basically ignore this by jacking the rate up so that they can sell the loan for more on the secondary market, but brokers cannot. And whereas that's way more than plenty in most situations, in this case it is not.
The reason why I'd want that much money is that, on top of everything else, this is a related party transaction. You are effectively selling from a partnership to one of the partners. That is going to mandate shopping lenders not only for price, but for willingness to do the transaction based upon the situation. We're going to need a very flexible lender, probably sub-prime. A paper Fannie Mae/Freddie Mac is right out. We are going to have to document an awful lot of stuff, and there are a number of points on which the loan can fall apart. You're also probably going to want this to be a short term loan without a pre-payment penalty, so that you can refinance after you've been on title six months or so, because you'll be able to get a better rate then (unless rates have skyrocketed). All this stuff adds to the complexity, and whether the loan will get funded or not is not something I can control by paying attention to underwriting guidelines like I can in other cases. This requires a lender who's willing to issue some waivers and exceptions, and I might have to submit this loan several times to different lenders over a period of months before it actually funds. That's probably the reason nobody wants it: They can't get paid enough to make it worthwhile. The predatory lending law may have good intentions, but in this particular case it's making life difficult for the consumer because brokers can't get paid enough to make it worth their while, and any given direct lender (especially the ones that consumers see, which tend strongly toward the high quality cookie cutter loan) is unlikely to have sufficiently flexible guidelines. You could go to a hard money lender, of course, but those rates are about fourteen percent or so, which causes most consumers to say, "Never mind!"
There is one other alternative. He could use that cash to buy you out, at which point he is left with basically his current loan, and I think this might even qualify for 1031 deferral (but consult a qualified tax professional before doing anything). If he can't rent it out for enough to have a positive cash flow under those circumstances, something is very badly wrong. He verifies that you've been paying rent/mortgage/whatever, and away you go with $70,000 or so in your pocket and all the leverage a qualified buyer has in a very strong buyer's market, and yours becomes a very easy transaction. I think you could do very well for yourself, given what little I know of your particular market at this point in time.
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