Downside Of Selling On L/O
OK, I'm sure this info is burried here somewhere, but I'm trying to get the full-picture of the hidden differences between selling on L/O vs. CFD.
There seem to be a great number of factors. Among those I've uncovered so far are:
1 L/O may avoid "dealer status"
2 L/O may allow eviction vs foreclosure
3 CFD may have people more likely to execute, and make improvements
4 L/O may qualify for 1031 exchange
5 CFD may give seller more protection if repairs become necessary
The part I find most difficult is that for every one of the items I just mentioned, I have found contradictory opinions. It seems to me that there are a great number of benefits to be had by selling on L/O IF it is worded correctly, and IF you are in a state that is L/O "friendly" so to speak.
To choose a method, though, I would think that it would be best to know all of the downsides as well, and to be familiar with the legal, business, and tax implication in either case.
This is the general question I have, and it covers multiple forums, so I will try to be specific in this one: What are the downsides of selling on L/O vs. CFD?
I think that some buyers will want CFD, some will be more comfortable with L/O. I don't think I'm ready to exclude either method. Both are beneficial to know and understand. Both are Legitimate methods of selling. I prefer CFD. There is only one contract, only one check to collect every month, not Lease, then the non-refundable deposit check etc.
I'm not sure about the 1031 exchange. I believe you may have to have lived in the property for a period of time for it to qualify.
If you are not buying property to live in, or hold long term, then "you are a dealer". Set yourself up with a business entity to deal with the tax implications of being a "dealer", and if you have personal real estate to live in, and "Investment" properties that you intend to hold longer than a couple of years, keep them out of the dealer entity. If you're a dealer, . . . " you're a dealer". Live with it, and structure your business to deal with it appropriately.
Back to L/O vs. CFD, I don't think you have to choose one or the other.. Have a "preferred" method, and a "Fall back" method.
Jeff
[ Edited by jeff12002 on Date 05/19/2004 ]
We will name a few issues:
Note: L/O where you have the deed to the property
*If future sales price was set, seller may sell property below market value
*Buyer may have a signed agreement with a realtor/agent and may be asked to pay a commission.
*Seller may have an emergency which requires liquidation and must sell the property ASAP and the contracted buyer can not close ASAP.
*Seller can not set a profitable price
*Seller refuses to perform on agreement (sold the property to someone else) creating a legal battle.
[addsig]
1031 has nothing to do with the property being a personal residence. It is used to transfer the tax basis from one investment property to another (yes, multiple properties work; sell one buy more than 1)
You have to agree to a 1031 exchange up front so the L/O option does not commit you to a 1031 until it is time to make the deal. I would put the 1031 interest into the L/O so the option holder knows they are agreeing to participate if they exercise the option.
John
Quote:
On 2004-05-19 21:31, jeff12002 wrote:
I'm not sure about the 1031 exchange. I believe you may have to have lived in the property for a period of time for it to qualify.
Jeff
<font size=-1>[ Edited by jeff12002 on Date 05/19/2004 ]</font>
[addsig]
While I can't make heads or tails of the tax disposition (1031, etc) with L/O's, I will assume at the least that I am able to defer taxes on the option consideration (a nice benefit in itself)
It seems to me that most of the downsides I've heard about L/O's apply to CFD as well, so please allow me to rephrase the question:
What are the BENEFITS of selling on CFD as opposed to L/O? I'm coming up with a very short list, and assume this is due to my ignorance.
One benefit is the ability to sell your buyer on the tax advantages that they will have with a CFD. The Mortgage Interest deduction is one of the remaining few that Congress hasn't taken away. Since they are paying interest, they qualify for the write-off. When they Lease option, they are leasing the property from you, and you are making the interest payments. They don't qualify for the tax benefits. This will help to justify the higher monthly payments better than in a L/O versus renting.
hmm... yeah. I had thought about that, but here is my (untested) take:
If you're selling to someone on CFD or L/O with a no-reassignment clause (not to an investor) they are not likely to be too RE savvy. Generally speaking, I would think that such a person would be more concerned about the down and the monthly than anything else (including price and certainly taxes). Now, when selling on L/O (If I understand correctly) I get the mortgage interest deduction.
Yes, it is a benefit to them to get the deduction, but this is a level of abstraction. Given two situations... one where they get the deduction, but pay a higher monthly, and one where they lose the deduction, but pay a lower monthly, I would think that close to 100% would choose the lower monthly... even if it meant they ended up paying a little more overall.
Therefore, in terms of pitching benefit to the buyer, I'd rather keep the deduction (I'm likely at a higher rate anyway) and give them what they really want anyway... a lower monthly figure. Any thoughts?
btw... thanks for the response. I can list several benefits to the buyer of cfd... I was wondering what the benefits are to the seller... or is it mostly just providing enough benefit to the buyer to close the deal?
I look at that a little differently. I just sold a house on a CFD, and many of the potential buyers thought it was a L/O. When they found out that it was being sold on a CFD and they get all the deductions, many of them liked that idea better than no write offs. "I like this idea better."
I don't know what price range of houses you plan on dealing in, but if the monthly payment is $1500 to $2000 a month, most people would opt for some type of write off after spending $18,000 to $24,000 in payments every year.
And honestly speaking, there really shouldn't be an "option" to the buyer. The only options are the ones you give them. If you sell the house on a L/O, than that's the option they have. If you sell on a CFD, well, that's the option the are going to take. It's never an either or when I sell a house. It's a here, you want it, take it or leave it.
I agree with neb-d: L/O gives THEM the option--gives THEM the control over what's going to happen in the future, not YOU.
To me, the biggest drawback to L/O as a seller is that now I am a landlord as well as a seller. While a good lease contract stipulates repair cost limits, etc., you can be sure you'll hear from a "tenant"/buyer about something that's broken.
In a CFD, the buyers are BUYING the house--they just don't get the deed for some period of time. "Owner"/buyers are responsible for the house...period. Of course, I'm aware that it's possible for some to come back claiming "pre-existing condition" of a problem, but if the CFD spells out "as is", then it's still their issue to deal with.
As a seller, I just make sure they pay my note on time (so I can pay the orig. mortgage), that they are happy with the place, and that my mortgage broker can help them refi before the CFD is up...I want to be just a seller, not a landlord.
Andy
PS: I've seen your other posts, so I know you're aware that most CFD buyers tend to feel they own the home and take better care of it than a renter.[ Edited by arytkatz on Date 05/27/2004 ]
Well, I certainly understand those perspectives.
Thanks, Nebulousd, I certainly wasn't actually planning on giving the buyers a choice... why introduce too much to think about... just trying to guage how they would choose if they could... what the preference would be. It stands to reason that if they thought they were getting no deductions, and they find out they are that they'd be happy. I just meant that I bet if you then gave them the choice of 86'ing the deductions, but lowering the monthly, they'd choose the latter.... my guess anyway. Like car sales. The unsophisicated buyers are all about the down and the monthly. Dealerships make their $ by making those two elements desirable and messing with everything else.
Of course, it doesn't come down the pike that way because you present one or the other, and the monthly is what it is for the one you present.
I've been trying to get a grasp on wording in L/O contracts to see just how much responsibility (repairs, etc.) you can put on the TB's. I guess I have a gut feeling that a lot of this stuff boils down to your people skills. if you can leave the TB FEELING like an owner, then I'd think they'd tend to behave that way. If you treat them and make them feel like a tennant...
I've read John Locke's posts about uhaul $ to payoff a buyer in default, and clearly good people skills can go a long way there too. I guess it's the loss of control that doesn't sit well with me. Yes, most times I could probably pay them off and get them out, but what if they have a cousin who's a lawyer or file bk, etc. I don't have the funds to wait them out.
Then again, maybe this is no different for L/O's here. I guess I should have started by saying I'm in FL which I understand is a judicial foreclosure state. I'm not sure of the implications with regards to L/O's, though. I keep hearing people saying that it depends on which state you're in for how L/O's are likely to be treated if they go to court if, for instance, the TB tries to force foreclosure vs. eviction. Is Florida a friendly or unfriendly state for being the seller in a L/O? How so?
My plan is to buy one house a other month to L/O. The first year I buy 6. The second year I buy another 6 but approximately 3 from the previous year are sold. Next year I buy another 6 (up to 15 now) and maybe 5 are sold. Planning on this giving me long term appreciation and income. If they buy the house great, if they do not buy the house and move on, I adjust the selling price upward for the next tenant/buyer. I also have in my option the ability to adjust the price upward by some percentage if they do not purchase the house in the first ____ months.
With the contract for deed, you do not get to ride the appreciation. You are the bank and you make a steady monthly amount. Contract for deed also makes me nervous with the DOS clause. I know that the DOS claus is supposedly never called (I have a personal RE friend who it was called), but to makes me nerveous to have a long term wealth building strategy on that assumption. What happens to my 15+ CFD houses when the interest rate rises 5 percent and the banks start calling.
Brenda
Student,
Don't know, don't do them, but evictions happen somewhat quickly in Florida. Depending on the terms of the rental agreement, that will determine how long it takes to get a renter out.
And I never feel like I lose control of the property after I sell it. The proper documentation will aid in this. Just make sure the lines of communcation are clear and open, "Shay haello ta my lil fren," you shouldn't have a problem.
Just joking.
[ Edited by nebulousd on Date 05/27/2004 ]
Brenda
"With the contract for deed, you do not get to ride the appreciation. "
-----Some would beg to differ. I do capture the 2 year appreciation.
"Contract for deed also makes me nervous with the DOS clause. "
------The DOS is a favorite topic here on TCI and I have had many discussions on this so I won't even bother today, it gets redundant after awhile. However, I buy using the Subject To method so the DOS "supposedly" is an issue anyway.....right? I'm not concerned with it, I can always refinance the house if it became that big of a deal to the bank. Just as you have your friends experience, I have my mother who is a branch manager at a Washington Mutual and she doesn't find anything wrong with what I'm doing.... We talk about the DOS from time to time and "why create a headache if don't have too" is what she always tells me. And trust me, her loan officers love their commission on the loans they write and as long as the loan continues to preform, everyone is happy, me, my buyer, my mother, the loan officer, and the corporate office.
"What happens to my 15+ CFD houses when the interest rate rises 5 percent and the banks start calling."
-----Calling who? First they have to know who to call and why. Secondly, your speculating and that's all it is. I'm in and out of a property no longer than 2 years, my quickest has been 6 months. If the rates rise 5 percent great, I think the banks will capitalize on all the adjustable rate mort. they have written. They will also have more foreclosures because people won't be able to pay. But they will be delighted to get my check every month because I'm not giving them a headache....
This thing can go both ways and we can debate both sides of the coin, but the bottom line is, you are always going to see heads and I'm always going to see tails.
[ Edited by nebulousd on Date 05/27/2004 ]
Quote:
"Shay haello ta my lil fren,"
Dang! I suppose that'd work too.
I personally am not concerned about the DOS. Not now. If I were holding a lot of properties and interest rates had risen sharply, I'd start being concerned. I don't think that's speculation any more than saying the tide is likely to rise and fall tomorrow. It's just paying attention to history. Regardless, it's no concern of mine at the moment.
Right now, I don't see heads OR tails personally, just trying to see the big picture in both cases. Obviously there are people very well entrenched in both camps, and I'm learning a lot from listening to them debate the pros and cons.
nebulousd,
the DOS only bothers me if you plan on keeping for the long term - say more than 5 years.
Let's start by breaking down your points.
1) A L/O will not avoid "dealer status" (btw, there is no such thing. Each transaction is separate.). If your intent is to sell, whether that be outright, on a L/O or a CFD, then you enacted in a dealer transaction. While some people use their L/O's as "passive income" vehicles (ie rentals), by definition, they aren't, and the tax man may come to collect. The benefit of a L/O over a CFD is that the deal doesn't become a taxable event (except for the monthly payments) until the option is actually exercised (the property is sold). By contrast, using a CFD is considered "sold" so ALL of the profit (even that which hasn't been collected yet) is taxable.
2. L/O do allow for evictions. It would be a very poorly written lease and option agreement if a judge ruled against an eviction. However, depending on how they are written, you can essentially "evict" with a CFD as well, though generally speaking, you must give the buyer more "late payment time" than with a standard lease agreement.
3. My L/O contracts make improvements and actually close just as well as my CFD's did. Bottom line here is if they believe that they can buy the property and that it is "theirs" then the tenant/buyer will keep it up and improve it.
4. Again, aggressive tax advisors/investors will try to do 1031's with L/O's, but using the strict definition of a 1031, they would not qualify.
5. How do you figure that? If your CFD buyer moves in and a week later the heatpump gives out, who do you really think is going to be footing that bill? Sure, you could wave the contract around and say, "but you bought 'as is' and your responsible for it." Doing that will cause one of 3 things to happen. 1) Nothing. It won't get fixed, and neither will anything else, so more damage is caused 2) The "buyer" will simply give up and leave. 3) The buyer will sue you. In my opinion, none are a real good outcome.
As far as the DOS goes, here it is. In most cases, the CFD is NOT recorded, so the only way for the lender to know of the sell is for someone to tell them. That would rarely happen and the lender would usually still need something more to make it worthwhile to start a foreclosure (that is what calling the DOS clause actually is after all).
This also brings up another point. Since the CFD is not recorded, there is no interest deduction for the buyer. In order to qualify for a mortgage interest deduction, the loan must be a valid, RECORDED mortgage loan.
Roger[ Edited by rajwarrior on Date 05/27/2004 ]
raj,
Just trying to understand one point you made. With the CFD, there is one recorded mortgage, the one that I took sub2. Someone still gets to claim that interest. In this case, the buyer. Right?
If that's correct, then the amount that is the difference between the CFD interest payment and the Mortgage interest payment is not something that anyone can write off, Correct?
Jeff
Jeff,
If you, as an investor, bought the property Subto with the intent to resell, rent, etc, then the payments you make on the property are a business related expense and the interest is a business loan interest expense, so you can deduct all interest that you pay on the property. Make sure that all of the end of year interest statements are forwarded to you instead of the original homeowner, as they would no longer qualify for the deduction anyway.
Any interest that you charge your buyers is counted as income to you, and you will be taxed on that income.
As far as your buyer is concerned, under the current tax laws, they cannot claim any interest deduction from an unrecorded contract for deed, land contract, or any other installment sale method. Again, to qualify as mortgage interest, the loan must be a valid mortgage type loan (which CFD is) and recorded (which most CFD's are not).
Now, some investors still send a 1098 interest statement to their CFD buyers every year, and let the buyer decide to file it or not. But, if your buyer is ever audited and fined, can you guess who will be one of the first to hear about it?
Roger
Hello fellow investors'
Just a thought...if what you want is to give incentives and options to you LO buyers why not to give them the option to a Tripple Net Lease vs a reg lease using a Land Trust where beficiary interest is shared- Say 90/10
That will justify higher paymnets for they will have to pay all taxes and insurance plus maintenance yet they will be able to write it off as a regular purchase.
I know we are not too concern with DOS but some times sellers might be if they had ever read their mortgage documents. The Land Trust will also take care of that to calm their fears.
Just my 2cents!
[addsig]
Does anyone know that if you do an installment sale, are you responsible for the tax on your gain the year of the sale? It seems to me that this was discussed at one of our REI meetings. All I remember taking away is that if you ever sale on installment, to make sure to get enough to cover your taxes. One guy told of selling on installment, getting about 20k down and still having to come with money out of his pocket. If it is true you must pay tax on the year it is sold, wonder if CFD is considered sold when you sign the contracts?
Brenda
RVATX,
Glad to meet you,
"If the seller ever has to read their documents", are you reffering to the paperwork where they initial each page and then sign they read and understand the paperwork when they purchased the property or is there some other paperwork you are reffering to they don't read concerning the purchase of their property?
Just for clarity sake here.
John $Cash$ Locke
OK, That's giving me a headache... here we go...
Quote:
Many investors are generally familiar with the concepts lease option and contract for deed (aka “installment land contract”). Many investors confuse the two, and this article will help you understand the tax, legal, and practical issues between the two.
Lease options First, let’s start with the lease option, which is really two things, a lease and a purchase option. A lease is a contract for the use and possession of land, creating a landlord/tenant (or “lessor/lessee”) relationship. A purchase option is a unilateral agreement wherein the optionor (“seller”) agrees to give the optionee (“buyer”) the exclusive right to the purchase the leased premises.
The option price is generally set at a fixed price at the inception of the lease, although it does not have to be. At any time during the option period (which generally corresponds to the lease period), the tenant can exercise his option to purchase.
An option is not the same as a regular purchase contract, which is a bilateral agreement. A bilateral contract legally binds both parties to the agreement, whereas an option only binds the seller. An optionee is not bound to buy; it is his option do so (or not to do so).
A lease with option arrangement is not a sale, but rather a landlord-tenant relationship. In rare cases, a court may re-characterize the transaction as a sale if it looks like a sale. Furthermore, the IRS does not classify a lease option as a sale until the option is exercised (see, Tax Court Memorandum 1999-11).
Contracts for deed A contract for deed (aka “installment land contract”) is an agreement wherein the buyer makes installment payments on an arrangement similar to an automobile financing. The seller holds legal title to the property as security for payment, while the buyer has “equitable” title. When the buyer pays the full amount due under the contract, the seller delivers legal title to the buyer. Equitable title gives the buyer the right to live in the property, improve it, rent it and otherwise enjoy all of the benefits of ownership. However, since the buyer does not have legal title, he cannot use it as collateral for a home equity loan (although in some states, banks will lend against an equitable interest in a contract for deed).
The IRS generally treats a contract for deed as a sale, which means the buyer has the tax benefits of ownership. Thus, the payments of interest that are made by the buyer in possession are deductible as “mortgage interest,” even though the buyer does not have legal title to the property.
A contract for deed seller must report the transaction as an installment sale on form IRS Form 6252. Once sold, the seller cannot claim depreciation or any other tax benefits of the property. If the buyer defaults on the contract and the seller exercises his legal option to reclaim the property, the tax code treats the transaction as a foreclosure.
The legal process for repossession of the property is not entirely clear in every state. Some state statutes (e.g., IL & PA) clearly spell out the process, which is somewhat more involved than an eviction, but clearly less burdensome than a full-blown foreclosure. In most states, the process is not clearly defined, so courts deal with a buyer’s default on a case-by-case basis.
Which is better? In summary, the lease option is a landlord-tenant relationship until the purchase is complete; the contract for deed is a sale at the inception of the agreement. In rare cases a court may re-characterize lease option transaction as a contract for deed, but this is limited to situations where the transaction looks like sale (as in the case of a long-term lease option with a declining balance purchase price).
Which formula is better? It depends on the situation and your goals. A lease option transaction is not a sale, so you will benefit from market appreciation if the tenant declines to exercise his option to purchase. A contract for deed sale will allow you to get more a down payment from the buyer, since it “feels” more like a sale. In higher-priced neighborhoods the rents may not command enough rent to cover your underlying mortgage payments. A contract for deed sale will allow you to collect interest payments, which are generally more than you could collect in rent.
On the other hand, a property sold is already sold for tax purposes; thus, you cannot use a 1031 tax-deferred exchange on a property sold by contract for deed when the buyer pays off the debt balance. The entire balance paid on the contract will be due as a capital gain, which can be a huge tax liability if you have a low basis in the property. Furthermore, a defaulting buyer on a contract for deed is generally harder to get out of the property, particularly in a court proceeding.
The pros and cons In summary:
The benefits of lease options are . . .
• Legal control of the property
• Ability to claim depreciation
• Ability to defer gains by 1031x
The downside of lease options are . . .
• Less money down
• Less of an incoming payment
• Continued landlording responsibility
The upside of the CFD is . . .
• More money down
• Higher monthly income
• No landlording headache
The downside of the CFD is . . .
• Potential tax hit
• Transfer tax due at sale
You must decide on a deal by deal basis which transaction works best for you in terms of work involved, tax issues and, most importantly, cash flow.
[ Edited by thestudentisready on Date 05/31/2004 ]
Someone posted earlier:
"While I can't make heads or tails of the tax disposition (1031, etc) with L/O's, I will assume at the least that I am able to defer taxes on the option consideration (a nice benefit in itself) "
My assumption has been that this is not correct, and the option payment is a taxable event. Someone's buying something (the option) from you, and that purchase price of the option is income. Anyone care to comment?
Lots of replies and not clear winner.
Some states offer better rules for LC/CFD then other states. So that might be a factor depending on where the property is located.
One fundamental that has sort of been covered but I want to make clear.
L/O - you are the owner and the landlord. Follow the rules for being a landlord or you run into problems. Maintenance obligations are the key factor that some folks miss. The owner can not shift all maintenance to the renter even if there is an option saying so. The judge will throw the requirement. Evictions will not work in that case if the tenant points out the failure to maintain.
CFD - You have sold the property and are just waiting to be paid off. The buyer does get some tax advantages. Maybe CFD is better for a buyer when the monthly interest payment is large.
As this thread shows you can more or less get close using either. Hence the choice it not completely obvious for folks.
John
[addsig]