HOW SHOULD WE HOLD TITLE?
DO WE NEED A WRITTEN AGREEMENT?
WHAT IS EQUITY SHARING?
Suppose you are buying property with a friend, fiancé, relative or spouse. Did you know there are different types of joint ownership? Your choice has serious consequences; both on your estate, if you die, and on your rights while you live. There are three common types of joint ownership known as tenancies – all created in the deed giving you title. They are tenants in common, joint tenants and tenants by the entirety. These tenancies date their beginnings to medieval England and are best understood by examining the differences between them. The discussion that follows is based on Virginia Law. Consult with a local attorney.
Tenants in Common
The law presumes tenants in common unless the deed you receive specifies otherwise. If one owner dies the property passes to his heirs, not necessarily the survivor. If there is a Will, it controls. Lacking a Will, the Virginia Code provides rules for intestate succession. Persons who are not married or related usually use tenants in common.
A tenant in common may sell his interest without approval of the other owner. Unless specified otherwise, the law assumes you meant to have equal ownership.
Tenants by the Entirety
Tenancy by the entirety is only possible when the joint owners are husband and wife. Tenants by the entirety provides for a common law right of survivorship. The property goes automatically to the surviving spouse. No Will, probate or other legal action is necessary. One spouse can not use a Will to leave an interest to someone else.
This tenancy also follows the ancient legal theory that a married couple is one entity. Therefore, one owner may not convey an interest without the other. A creditor with a judgment against one of the owners can not collect it from entirety property. If there is a judgment against one spouse, the settlement attorney will ask for a continuous marriage affidavit from the seller. In it, the sellers will certify they have been married for the entire time they owned the property. Then, the judgment does not attach to the property or the proceeds of sale, as long as they are also maintained in a tenancy by the entirety bank account.
Upon divorce, tenancy by the entirety automatically converts to tenants in common.
Joint Tenancy
Joint tenancy is similar to tenants by the entirety but the co-owners are not married. Joint tenancy includes the common law right of survivorship, provided it is set out in the deed. Upon death of a joint tenant, title remains in the surviving joint tenant without further action. You can’t leave joint tenancy property to someone else in your will.
There are some important differences. Joint tenants are not married so they are not treated as one legal entity. One owner may petition the court to divide the property or order its sale. A judgment creditor may also petition the court to divide the property and collect the judgment from one of the owner’s shares.
Joint Ownership Agreements
The law presumes equal ownership unless there is a written agreement specifying otherwise. All joint tenants and tenants in common, even if they are equal, should have a written joint ownership agreement. That agreement will define their interests in the property and the division of profits, tax benefits, expenses and responsibilities. It will establish the duration for the co-ownership. The agreement will also limit the right of one to sell or lease his share without the other’s permission.
Consult with a real estate attorney for assistance. Joint ownership agreements are not expensive but can save substantial heartache later.
WHAT IS EQUITY SHARING?
Attention Tenants! Would you like to own a home of your own? Are you tired of paying rent for someone elses mortgage? Dont have enough saved for a down payment? Having trouble qualifying for a new loan?
Attention Investors! Worried that tenants might abuse your property? Do maintenance, management and move – out headaches scare you? Are you reluctant to take on negative cash flows because rent will not cover the monthly cost of the mortgage?
Attention Parents! Would you like to help the kids buy a house without committing to make a gift of the down payment?
Consider joint ownership. The occupant benefits by receiving part ownership of the property and all the tax advantages that go with it. The investor knows the occupant, as a part owner, will take care of the property and is unlikely to default. There is no negative cash flow on the investment. In most cases the purchase can qualify for favorable owner-occupied financing. Both the occupant and investor receive financial advantages over a traditional landlord tenant relationship.
THE HISTORY
Before 1981, tax laws considered property as a personal residence if any one of the owners lived in it. The non-resident could not treat his portion of the property as an investment and deduct costs such as depreciation, insurance or condominium fees. Only normal personal residence deductions such as interest and taxes were permitted. Depreciation was a major incentive to real estate investors as it allowed them to shelter other income from tax. It made no sense to participate in a joint ownership with a resident because the investor could not take depreciation. Simply put, the returns were much higher if you were a 100% investor owner.
Tax law changes in 1981 allowed a part – owner, investor, to take depreciation on property occupied by another part – owner. The new law required a written shared equity financing agreement often abbreviated to SEFA. Hence the name Equity Sharing evolved.
HOW EQUITY SHARING WORKED
Usually, the investor made the down payment for the purchase and the occupant paid the entire monthly mortgage payment. Since the occupant didnt own all the property, a portion of the occupant’s monthly payment was rent for his use of the investor’s portion of the property. The amount was determined by figuring the fair market rent for the home. If the occupant owned half of the home, then a portion of the mortgage payment equal to half of the fair market rent was rent. As rent it was not deductible to the occupant and considered income to the investor.
The occupant received a partial write-off of his share of the interest and taxes. The investor got the write-off for half the depreciation. Income from the rent was close to equal his obligation on the interest, taxes and condo fees so the investor usually had no income to tax. When the property sold, the parties would split the profit.
A fairly standard formula determined the division of ownership. A 20% down payment would entitle the investor to 50% ownership. The basis for this division was the observation that a 40% down payment would buy an investment property with no negative cash flow; the rent would equal the mortgage payment, taxes and insurance. If you have no negative, because the occupant is making all the payment, you should only own half the property for half the normally required down payment. (If 40% down equals 100% ownership, then 20% down equals 50% ownership)
Equity Sharing benefited the investor because there was no negative cash flow. The investment carried little risk because it had none of the headaches and uncertainties facing a landlord: maintenance, management and move-outs. Assuming modest appreciation rates of 5% per year, annual returns for the investor of 14% were common.
The occupant usually gained $200 to $300 per month over his position as a tenant. Even though the occupants monthly payment was more than he would have paid in rent, his share of the appreciation in value more than paid that back.
TAX LAW CHANGES
Changes to the tax laws beginning in 1986 severely limited the depreciation deduction by lengthening the useful life for residential property to over 30 years. In addition, there are limits on the use of passive losses to offset other income. Losses from activities such as real estate investment are passive losses. High income taxpayers may find themselves unable to deduct depreciation at all.
THE NEW EQUITY SHARING
A new form of equity sharing has emerged looking more like a traditional partnership. It is a voluntary return to the pre-1981 tax treatment. The investor still makes the down payment and the occupant pays the mortgage and closing costs. However, the investor foregoes the depreciation deduction and allows the occupant to take the entire write-off for interest and taxes. None of the occupant’s payment is rent. When the property sells, the investor is repaid and the profit is split.
This is not equity sharing in the traditional sense of the word. In fact, it may be dangerous from a tax standpoint to refer to the arrangement as equity sharing!
If the IRS treats the arrangement as equity sharing under the SEFA regulations, the occupant loses the full deduction for interest and taxes. The IRS will treat a part of the monthly payment as rent. The investor must then recognize the rental income. He paid none of the mortgage payment, so he would have no deduction for interest and real estate taxes to offset the income. The investor would owe tax with no cash in his pocket. Avoid use of the term “equity sharing.” Call the agreement a “joint ownership agreement.”
THE DIVISION OF OWNERSHIP
The new joint ownership brought about a new formula for division of ownership. The investor’s 20% down payment is no longer equal to a 50% ownership interest. Now, the investor receives his 50% interest for only a 10% down payment. The occupant pays closing costs and all the monthly payment. The occupant now has a full write-off for the entire mortgage payment. Often the investor does not co-sign on the loan so his only risk is the down payment. This is a very attractive arrangement for the investor. Annual returns of 20% or more are possible.
THE OCCUPANT’S POSITION
Where does the occupant stand? Under certain circumstances, the new equity sharing is not good for the occupant unless real estate appreciates at very high rates. Heres what to watch out for.
Look for property that is bargain priced. You are counting on future appreciation to repay the investor and realize a profit. Serious real estate investors will tell you, You make money when you buy property, not when you sell it.
In all cases, the occupant will pay more on a monthly basis than the cost to rent the property. That is because the payment of principal, interest, taxes and insurance on a 90% loan will be more than rent. Income tax deductions for interest and real estate taxes will soften the blow. In addition to a higher mortgage payment, the occupant pays for most maintenance that normally is a landlord’s responsibility. Repainting, landscaping, and appliance repairs are expensive but often ignored in projections. Many equity share agreements provide the investor will participate in major repairs.
The occupant hopes that his share of the appreciation will be enough to repay this deficiency together with his closing costs and the costs of sale. Obviously, the longer the agreement runs, the better the occupant’s chances of making a profit.
The method of defining and dividing profit is even more important than the length of the agreement. The new joint ownership agreements fall into two broad groups dividing either the equity or the profit.
DIVIDING EQUITY
Some agreements divide the equity in the property. These do not repay the occupant his closing costs or the principal amortization. The investor receives a return of the down payment, then the loan is paid off, then the equity in the property is split.
Such agreements do not generally favor the occupant. The occupant will not receive enough to reimburse the original closing costs, rent deficiency and costs of sale unless, they run for longer than five years and real estate appreciates at high rates.
The property must appreciate by twice the amount of these costs because the occupant only gets half the appreciation. Otherwise, he would be better off renting. That would take sustained appreciation of 6% per year for a five year agreement. With a three year agreement, the required appreciation rate would be 10% per year. Real estate must appreciate at rates above this, year after year, without fail, for the occupant to be ahead of the tenant with a savings account.
DIVIDING PROFIT
Other joint ownership agreements reimburse the occupant for the mortgage amortization, then the investor for his down payment, then the occupant for the closing costs. The remaining profit is split. These agreements are much more favorable to the occupant without diminishing the investor’s return to unacceptable levels.
OTHER JOINT OWNERSHIP AGREEMENTS
Joint ownership agreements are not limited to equity sharing type arrangements between an investor and an occupant. Any time two unmarried individuals acquire an interest in property they should have a written joint ownership agreement. The agreement should address the division of ownership, down payment and monthly payment. It will also define responsibility for repairs, how to treat improvements, default, and sale. The agreement will set out the terms of a future sale or lease of the property.
Not all agreements are alike. Consult with your attorney and tax advisor before entering into any joint ownership agreement.