Shared Equity: Helping Family Members Buy Their House
Your son and daughter-in-law want to purchase their first house, but their income will not carry the mortgage. Shared equity is one of a number of ways you can help them out.
Shared equity is an arrangement where you — as investors — own a portion of the property with your children. Under a shared equity arrangement, there generally are two separate entities. You (and your spouse, if applicable) would be considered the owner-investors, and your son and daughter-in-law would be considered the owner-occupants. The four of you would take title to the property. You could own fifty percent, for example, with your children owning the remaining fifty percent. Your children, as owner-occupants, would pay half of the monthly principal, interest, taxes and insurance, as well as half of the estimated fair market rental of the property. You, as owner-investors, would pay half of the monthly costs, would receive the rental income, but would also be able to get some tax benefits if the transaction is properly structured.
In today’s market conditions, where prices are clearly higher than many young couples can afford, shared equity may be the only way to permit our younger generation to get into the home ownership arena.
Here is a general outline of how shared equity works. Although there is no magic formula by which one takes title, often — especially when dealing with family — title is taken on a 50-50 split.
The owner-occupant and the owner-investor each pay 50% of the monthly mortgage costs and taxes. Both parties are entitled to deduct from their income taxes their share of the mortgage interest and the real estate taxes. The owner-occupant pays rent to the owner-investor.
In our example, because your children — as owner-occupants — will only own half of the house, they will have to pay 50 percent of the fair market rental to you as owner-investors. This rental is considered income to an owner-investor, and must be included in your tax return. The main advantage for the owner-investor is that you can depreciate 50% of the property. However, this depreciation is subject to the passive tax rules which Congress enacted with its sweeping tax reform legislation in 1986.
There are a number of legal requirements for qualifying for the shared equity program.
1. The owner-occupant must pay a fair market rental for the portion that he or she does not own.
Perhaps the best way to determine this fair market value is to ask a real estate agent to give you a statement in writing as to what they believe is the fair market rental of the property. With such a document in your files, you should be able to justify the rental if and when the IRS comes knocking at your door to challenge the shared equity concept. A Tax Court opinion has ruled that owner-occupants could pay a somewhat lower rent than fair market rental because the investor will not have any vacancy losses, and because the owner-investor will save the additional costs of hiring a property manager.
A safe harbor would be to deduct 15% from the fair market value, and then your children, as owner-occupants would pay half of that amount to you.
2. There must be an equity sharing agreement. This document, which must be in writing and signed prior to the purchase of the property, should spell out the terms and conditions between the owner-occupant and the owner-investor.
For example, when will this agreement terminate? Who has the right to buy out the other, and under what terms and conditions?
These very serious questions must be resolved, and it is strongly recommended that you do so now while you are still talking with your children. As harsh as it may sound, parents and children often get into major fights, and you do not want to wait until you start having problems in an effort to resolve these important questions.
3. One of the owners must actually occupy the property as his or her principal residence.
4. This is a requirement — and one that is often misunderstood — that the ownership interest in the property must be for more than 50 years. This does not mean that the shared equity contract has to run for more than 50 years. Indeed, most shared equity agreements run between three to seven years.
As long as you own the property outright (in “fee simple”), this satisfies the fourth legal requirement.
It is impossible in the space of this column to analyze all of the shared equity arrangements. However, it does have tremendous potential for such people as:
- Parents in a high tax bracket who want to help their children with down-payment and closing costs.
- Children in a high bracket who want to help retired parents purchase a home.
- A friend who wants to lend money to a buyer to assist in a home purchase.
- An investor interested in residential real estate investment who is looking for a solid, limited risk purchase.
- Potential buyers with limited savings — but good income — who need a bigger house than they can currently afford.
In my opinion, the possibilities of shared equity are unlimited. But, as in every real estate transaction, it requires careful planning, a well-drafted written agreement, and a full understanding of the tax and financial considerations involved in such a transaction.
Anyone considering a shared equity agreement should evaluate the numbers carefully, based on the current tax laws in effect relating to real estate.
Tax and financial planning are, of course, important considerations in these transactions, but should not be the only factors. After all, these are your children, and you want to help them out as best you can.
Written by Benny L. Kass for www.RealtyTimes.com Copyright © 2016 Realty Times All Rights Reserved.