by Tod Snodgrass
There are (at least) five stages of real estate investing maturation: bird dog/property scout, wholesale contract flipper, fix/flip (buy/rehab/sell), buy & hold, note holder. Not every Real Estate Investor (REIer) gets involved with all five stages.
For example, “newbies” often start out as bird dogs (property scouts) in order to learn the ropes of how to identify and qualify potential investment properties; after some success, the next logical step is to try your hand at being a wholesale contract flipper. The next step up the REI food chain are fix/flips. Here you wind up temporarily owning the property, during the time you are rehabbing it, and before selling it (hopefully for a profit). You will probably be required to bring money to the table, i.e. say 25% as “skin in the game” required by the hard money lender to be able to acquire the property.
Eventually, many REIers wind up owning rental properties, collecting rents, etc., a.k.a. “buy and hold” since it provides passive income that we all need in later life as we head towards retirement. However, after several years of acting in the capacity of a landlord, many REIers tire of the four T’s associated with rental property management: trash, tenants, taxes and termites.
Once you come to that point, you have some key decisions to make about what comes next with property you own. For example, you can undertake to do a 1031 tax free exchange. However, that means you are effectively transferring the “4 T’s” issue from one property to another. You can sell the property for all cash, but that may trigger a major tax payment to Uncle Sam and your state government.
Which brings us to the “owner financing” (or end game, note) option (assuming you have no debt on the property): You put it on the market for sale, and offer payment terms to the buyer: Good sized down payment with monthly payments spread over several years. You are essentially acting as the bank. You receive a first position note/deed; the buyer receives a grant deed to the property. Obviously before undertaking such a sale, it is strongly recommended that you enlist support and advice from professionals who can help you get the best deal possible for yourself: a realtor who is very familiar with non-owner-occupied investment properties; a real-estate savvy CPA; maybe a real estate attorney.
Two advantages of taking back a note, via owner financing, include:
1. Limit your tax liability (by undertaking to do an installment sale vs. all cash sale)
2. Maintain needed cash flow via the monthly payments from the buyer of your property
Conceivably, you can accomplish both with owner financing. For example, take the down payment (DP) amount involved. Done the right way, you very well may be able to secure a sizable DP with limited tax ramifications to yourself. This can be accomplished by carefully adjusting how much DP money you receive. You first need to start with the Adjusted Tax Basis (ATB).
The ATB is arrived at by adding up all the costs you have incurred with the property during the entire time you have owned it, less deprecation you have taken against the property. Roughly speaking, you can take a down payment from the buyer for an amount that equals the ATB (DP, payments, repairs, etc.), less deprecation.
Example: Selling price: $500,000. ATB: $200,000. Depreciation: $100,000. DP: somewhere between $100,000-$200,000. Balance the buyer owes you: $300,000 ($500,000-$200,000 DP) spread over say, 15 years at say 9.9% interest. Net result: Depending on how the numbers shake out, you may very well be able to keep a good chunk of the $200,000 down payment tax free. (NOTE: If you want to pay less in taxes, then reduce the DP and increase the amount you are financing.) Subsequently, the payments you receive (on the $300,000 note for 15 years at 9.9% interest) should equal about $3,025 per month. Yes, you will have to pay taxes on the monthly payments you receive from the buyer, but since it is spread over many years, the tax bite in any one year should not be too draconian.
Risks: It always possible that the buyer will run into trouble and quit making payments to you. Should that happen, you can always foreclose (take the property back), and sell it to someone else. NOTE: Should that occur, you get to keep all the monies he has paid you to date: the down payment and all the monthly payments he made over the years.
What happens if you need cash, sometime during the 15 year term of the note? No problem. You can sell the note at any time—possibly at a modest discount from face value—for cash if you need the money sooner.
Another advantage to offe