Archive for Shared Equity

Thinking of Renting Out a Property? Make It Easier with Shared Equity

Renting your real estate can be a wonderful way to increase your cash flow. However, rental properties can also cause you headaches and add a lot of responsibilities onto you, as landlord. After all, in order to rent your property, you have to deal with tenants and handle their needs. However, it turns out there is a way to share some of that ownership responsibility with your tenants. It’s called shared equity, or a rent-to-own agreement.

The Benefits of Rent-to-Own

Typically, as landlord you are 100 percent responsible for the upkeep of the property. You also take on all of the risk, such as being responsible for a mortgage when you have a vacancy. But, when your tenant shares in the ownership of the property,[1] you keep many of the advantages of owning a rental property and also gain additional benefits.

The benefits aren’t one sided, either. Your tenant shares in equity on the home, as well as putting a down payment on it. And, they get a wonderful opportunity to carefully inspect a home before committing to the purchase (and build equity while making their decision!). The tenants also receive tax deductions that they would not be entitled to as typical renters.

If your agreement gives you 65 percent ownership and the tenant 35 percent ownership, then the tenant pays you rent for your 65 percent. You can treat your share just as you would any other rental property. This arrangement is approved by tax law.

Here are some reasons to consider a rent-to-own situation:

  • The tenant shares responsibility for property upkeep. Normally, as a landlord, you would be responsible for any necessary repairs, including scenarios like an unexpected breakdown of the refrigerator that needs urgent attention. With shared equity, however, tenants have their own interest in keeping the property in shape, whether they exercise their purchasing option or agree to sell the property with you. The tenant has become tenant-owner, and they should be expected to provide most of the day-to-day repair work, like lawn care. So, you won’t be getting calls in the middle of the night about urgent repairs! In addition, they are less likely to cause damage to floors, walls, or other parts of the property because increasing the property’s value is now their goal as well as yours.
  • You don’t have to worry about vacancies, which cost you money. Aside from the lost influx of money, you’re also out the money and time spent finding a new tenant and preparing the property for them. If vacancy goes on for several months or more, it’s going to cost you a lot, but a rent-to-own situation ensures that your tenant is in for the long-haul. They’re not likely to just give up their share of the equity in a home they live in.
  • You have no management fees. Management fees are an optional expense, but for many landlords it becomes necessary, especially if you have another job or business. Typically, management companies are hired to take care of things like property inspection, advertising for tenants, and providing or scheduling repairs. With your tenant-owner, none of this is necessary. You have a long-term renter who will more than likely take good care of the property themselves.
  • You tenant has more reason to make their payments on time every month. In a shared equity situation, your tenant is paying towards an end-goal, whether it’s to own the property in entirety or to own their share of the equity at the time of sale. This means that for the duration of the agreement, you know how much rent you will receive and for how long. You also know the possible scenarios for when the rental term comes to an end. Basically, you have a much better idea of your financial outcome than most landlords do.

Your Tax Situation

But, what about the taxes? Here’s something you don’t hear very often. Tax law regarding shared equity is very straightforward. In fact, for the more than 30 years it’s been on the books, there’s only one private letter ruling to use as an example (PLR 8410038). In this ruling, the landlord made a 20 percent down payment and took half the mortgage; the tenant took the other half. At the end of five years, their agreement allowed for the tenant to buy out the landlord by 1) reimbursing the down payment and 2) paying 50 percent of what the equity increased by since the beginning of the agreement to the landlord. During those five years, the tenant paid the landlord both a rental fee and 50 percent of the mortgage.

The sharing of expenses is, likewise, straightforward and laid out in tax law. Any tax benefits must be divided according to ownership interest. In the above case, both the landlord and the tenant-owner would receive 50 percent of the tax benefits.[2] In addition, for most shared equity situations, the relationship between parties is considered tenants-in-common. That means you’ll have to follow state tax laws, which typically require expenses such as repairs, taxes, and interest to also be divided according to ownership interest. Since your tenant will likely be completing repairs, they do have the right to request reimbursement from you for half the cost. Regardless of whether they pay 50 percent or 100 percent, the tenant only gets tax benefits for their vested interest (as do you).[3] Of course, you’ll want to check your particular state’s tax laws in this area.

Pay attention to how you agree to divide expenses in your equity-share agreement. In one court case, the landlord owned 50 percent of the equity but paid 100 percent of mortgage interest and property taxes on two properties.[4] It didn’t matter how much he paid; he could only deduct 50 percent from his taxes. Just because each party pays 50 percent of the mortgage doesn’t necessarily mean your ownership percentage is 50 percent each. Other factors, such as down payment, can come into play. Always check with an attorney when signing an equity-share agreement.

Calculating the Rent

Tax law also specifies that you and your tenant will need to come to a rental agreement based upon “fair market rent”.[5] All of this planning in advance should make you one happy landlord. You’re getting a written guarantee of how much cash you’ll be receiving for years to come.

As you know, any situation that deals with tax law requires proper documentation. So, be sure to keep a file with all the necessary information. One thing you will need to provide is evidence that your rent price is fair. Some ways to do this are to clip ads for other rentals in the area, print online ads for your area, get a written opinion from a consultant or rental management company, or get information from nearby tenants on what they pay for rent (including their names).

You’ll probably do some of this research anyway in order to come to your determination. The key is to hang on to your research documents. Research you performed but didn’t document don’t count for anything with the IRS, and as landlord, you bear the burden of evidence.

Following the Rules

Once you’ve found the perfect tenant-partner, you’ll want to follow three rules in order to comply with tax law.

  1. The equity-share arrangement must be detailed in a written agreement.[6] This document must include details regarding ownership of the residence by two or more people; agreement that one of the parties must occupy the dwelling as their primary residence; and, agreement to rent payment.
  2. The relationship must be one of joint ownership. According to tax law, both parties will own the property even after the rental period ends. The tax law technically stipulates a period of 50 years of ownership, but what you really need to know is that you both must, in fact, own the property.[7]
  3. Tax benefits are earned according to ownership. As stated above, you can only claim benefits for your share of ownership in the property.

Before entering a shared equity situation, plan accordingly. You’ll want to choose someone trustworthy to enter into a long-term ownership with. Hire a real estate attorney to help make sure you consider all the possible scenarios, and get everything in writing. And, always, always keep your records. If you do rent-to-own right, you can make renting your property both easier and more profitable.

  1. IRC Section 280A(d)(3)(C)(ii)(I).
  2. Prop. Reg. Sections 1.280A-1(e)(5)(iii)(B)(3); 1.280A-1(e)(5)(iii)(C) Example.
  3. Estate of Boyd v. Commr., 28 T.C. 564 (1957).
  4. Joseph J. James v Commr., TC Memo 1995-562.
  5. IRC Section 280A(d)(3)(B)(ii).
  6. IRC Section 280A(d)(3)(C).
  7. IRC Section 280A(d)(3)(D).

You Can Deduct Rental Losses by Qualifying as a Real Estate Professional

Do you manage rental properties on the side? Even if real estate is not your primary profession, you can benefit from tax advantages by qualifying as a real estate professional. Rest assured, your primary employment does not necessarily inhibit your ability to qualify; however, qualification does depend upon how many hours you put into property management versus other employment. You can even gain the same advantages if your spouse qualifies as a real estate professional (if you file taxes jointly).

What Are the Benefits?

Once you are classified as a real estate professional, you are eligible for passive loss tax deductions. These require the government (as your partner) to pay their portion of the taxes. When you have the proper tax advisor helping you to plan accordingly, you have a good chance of getting your IRS partner to provide their portion earlier. This means you’ll have more money free to invest and build your profits with.

As a qualified real estate professional, you can deduct your rental properties’ passive losses immediately, regardless of each property’s income level. If you do not qualify, you may not be able to deduct rental property losses until after the property is sold (unless your joint income is less than $150,000).

How to Qualify as a Real Estate Professional

Qualification depends on your rental property management spending for the course of the year[1]. You or your spouse will qualify if you:

  • Spend greater than 50 percent of your personal service work time participating in real property businesses that you materially take part in or in real property trades; or,
  • Spend greater than 750 hours of your investment analysis and personal service work time participating in real property businesses that you materially take part in or in real property trades.

Here’s an example. Let’s say you work 926 personal service hours throughout the year managing your properties and 920 hours on your W-2 job running your law firm (not including sick days, holidays, or vacations). In this scenario, you would pass both requirements to qualify as a real estate professional. That means you if you materially take part in your rental properties, you may deduct their losses. Just keep in mind that time spent on investment analysis counts toward the hours requirement but not the greater than 50 percent requirement[2]. Also, one spouse must completely meet the requirements. You and your spouse cannot combine your hours together. However, tax law deems that if one spouse qualifies, then both are considered real estate professionals for tax purposes[3].

What Exactly Is “Real Property Businesses or Trades”?

You may have noticed that the requirements hinge on your time spent in real property businesses or real property trades[4]. The terms apply not only to rental properties. In fact, any of the following count toward your service hours:

  • Rental
  • Leasing
  • Conversion
  • Management
  • Operation
  • Brokerage trade or business (including real estate agents)
  • Construction
  • Development
  • Reconstruction
  • Redevelopment
  • Acquisition

Please note: Any work performed as an employee does not count towards the service hours requirement. The exception to this is if you, as an employee, are a five percent owner in the business[5] (i.e., you own more than five percent of your employer’s capital or profits interest, outstanding stock, or outstanding voting stock.

How Do You Prove It?

Now you know what the requirements are, but the IRS obviously requires proof on your part. They will not simply take your word for it that you spent X number of hours working on your business and trades. Fortunately, the IRS has an audit guide for rental properties that lists two proofs an examiner will check for[6]:

  1. You must log the hours spent and services performed during those hours, and provide this documentation when requested. The requirement to track your service hours is discussed in Reg. Section 1.469-5T(f)(4). Acceptable forms of evidence[7] include identification of provided services and approximate hours spent based on narrative summaries, calendars, or appointment books. Just find a way that works for you to track your time and stick to it.
  2. You must provide documentation detailing the amount of time logged in other activities. This allows the examiner to see whether the claimed hours make sense.

To sum things up, you can increase your legal share of government subsidies pertaining to your rental properties. One way is for your total income to be below the threshold. In that case, you can deduct losses up to $25,000. Otherwise, you must qualify as a real estate professional.

  1. IRC Section 469(c)(7)(B).
  2. Reg. Section 1.469-9(b)(4).
  3. IRC Section 469(c)(7)(B)(ii).
  4. IRC Section 469(c)(7)(C).
  5. IRC Section 469(c)(7)(D)(ii).
  6. IRS Passive Activity Loss Audit Technique Guide (ATG), Training 3149-115 (02-2005), pp. 2-5, 2-6.
  7. Ibid., p. 4-7.