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Rental accounting question (long post)
Old 03-04-2009, 12:45 AM   #1
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Rental accounting question (long post)

I think we're about to be offered what I believe is a deed in lieu of sale contract (if that's the correct term) for our rental. I've read about them but I've never actually seen one, and I have no idea how to handle the accounting or taxes. Any recommended references?

Last month when we posted our rental home for sale or for rent on a military housing website, we also listed it FSBO on Craigslist. (We're not desperate enough to try Craigslist renters yet.) We got a call a couple weeks ago from a "We buy houses for cash!" entrepreneur, who says his business model is buying houses for less than 75 cents on the dollar.

I'll say that from the start he's raised my spouse's hackles. He wanted to meet for an hour (or more) to go over how he approaches a deal, and she tends to feel slighted by implications that the property could be discounted from its sweat equity. Plus there's an element of vulture capitalism that could make the sellers feel as if they're being pressured. But she agrees the problem is hers, not him.

To my nuclear way of thinking, I can empathize with a guy trying to make a fast buck from desperate sellers. His typical client is an idiot, or drowning in debt, or overwhelmed by a family crisis, or frantically trying to raise money ASAP for [whatever]. This buyer swoops in with cash, closes in 48 hours, and totally eliminates the hassle. Born & raised local, professional appearance, one-man entrepreneurial shop, grateful heartfelt testimonials, the whole package. Smooth but not slimy.

I think he's a great practice negotiation for an eventual sale, so I engaged him. He asks a lot of financial questions that could be interpreted as personal (more spouse hackles). "How much is your mortgage? What's your monthly rent? What do you spend on maintenance & repairs? What do you pay for property taxes/excise tax/association fees? What's your tax bracket for cap gains?" and so on. "Gosh your expenses sound too low, the national averages are much higher than yours. Where are you getting the numbers from?" His questions seem intended to determine if he's dealing with the blissfully ignorant or with idiots. Once he learns what's important to the seller, he pitches the appropriate offer. He doesn't come right out and say "I'll give you 75 cents for your $1 house to close in 49 hours." Instead it's couched as a sales tactic-- "What would you expect to get for your place? Would you sell if your monthly cash flow stayed the same? Do you prefer lump-sum cash or a monthly check?" And so on. Questions designed to elicit more info without necessarily revealing his intentions. Perhaps some attempt at building reciprocity or commitment. I've just finished reading a book on the psychology of sales influence, so I'm hanging tough.

I used an old "selling the rental" thread to refine a spreadsheet of how much we'd bank for various sale prices and how much we'd get each month by investing our after-tax profit in CDs. I think it covers all the details-- deferred cap gains from a 1989 sale, depreciation recapture, fed/state cap gains, AMT. What it boils down to is that he agrees a conservative estimate of our sweat-equity landlording is now giving us $xx/month. However to achieve that monthly yield in a 4-5% CD would require a sale price of about 95 cents on our dollar. No way could he do it for 75 cents, even if we took back some paper in excess of 6%. We have no compelling reason to sell, we expect to rent the place in the next couple months, and we can play defense for a long time. We've told him that we don't think we're his type of customers and that while we don't enjoy landlording emotionally, it makes compelling financial sense. Thanks, we'll reconsider in a few years if the tenants move out.

So we spent 45 minutes on the phone tonight going over the income & expense numbers, which we both agree on, and on a sale's rough before-tax/after-tax amounts. No controversy there. But instead of working on a sale price or a sale with taking back paper, he asked how we'd feel about turning the property over to him in exchange for a monthly check. We'd get enough in that check to pay all our current expenses (including the mortgage) and have our $xx/month left over, while he'd essentially sublease the place. Maybe subleasing isn't the right term-- perhaps it's an installment sale or some sort of rent-to-own contract.

Our motivation would be getting our current income without landlord hassles. His motivation is that he'd get a rental property for nothing down, taking all the risk to keep whatever's left after paying us. We'd continue to pay our 5.5% mortgage, which financing he can't get on his own. If our arrangement lasted for 5-10 years then eventually he'd raise the rent (perhaps pocketing the difference) and maybe buy us out at some pre-agreed value which he'd then flip for its appreciation. I don't have any objections to that idea. But it sounds too good to be true.

What I'm not sure about is the legality of the contract. The rental's mortgage has a "due on sale" clause which we'd clearly be subverting by the intent (if not the language) of his proposal. Our homeowner's insurance policy might not cover us for this type of contract rental. As a landlord I can deduct Schedule E expenses (including mortgage interest & depreciation) but surely I'd give some of that up by contracting with this guy. He'd want to take his own deductions from the arrangement, and if I lose them then I'm getting the same amount of before-tax money but paying higher taxes on it.

He said he'd crunch his numbers and get back to us in a day or two. Meanwhile the military rental list is chugging along, most of the available properties have dropped off the site after a couple weeks, and our posting is probably close to getting a phone call. If we get a nice military tenant then we'd shelve any idea of selling for at least a couple years.

Anyone heard of this type of deal before? Any IRS pubs, websites, books, or articles I can read up on it? Any pitfalls? If it's legit, what protections do I need to make sure of?
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Nords Rental/Sale
Old 03-04-2009, 01:21 AM   #2
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Hi Nords,
I'm a new poster, long time lurker, lifetime real estate investor. Run like hell from this time wasting person trying to make a buck. Keep doing your thoughtful, conservative landlord stuff. You'll be fine.
PauHana
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Old 03-04-2009, 01:22 AM   #3
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Nords,

No advice, but it sounds like the equivalent of selling on contract - with no money down. Probably a great deal for him since he can walk away and give you the place back - in whatever condition he or his renters leave it.

Did a contract sale back in the early '80s. Got a decent down payment but still lost sleep thinking about what could go wrong. It worked out as the buyer eventually got a conventional mortgage and paid off the contract in full. Maybe I don't understand your arrangement with this guy. If I'm off base, feel free to ignore.

In any case, good luck.
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Old 03-04-2009, 08:15 AM   #4
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Sorry, I do not know anything about this type of arrangement. However, my gut instinct is not to do it. I do think that it sounds too good to be true and you know how that goes. I also know that in another thread you talked about how meticulous you were with your rental house and I think that if things went south, you would probably get the rental house back in much worse shape. Be careful and good luck!
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Old 03-04-2009, 09:06 AM   #5
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Tried contract sales and lease with option to buy ... always came down to the fact that without a hefty down payment, the risk is still yours. Same for any sale.

If he sticks to a no cash deal I'ld stick to craigslist.

Sure it's legal ... and the mortgage company will never find out about it (nothing is filed with the registry). Yes you keep your schedule E but it's greatly simplified. You own the property until he executes his option to buy in some predetermined time and price. He wants to lock the price and terms then let time work in his favor (ie. appreciation) during the rental period. With no $$ down this is really a no-brainer for him. If it appreciates he executes his option ... if not, he walks.

Also, don't expect him to maintain it like you would. He'll be trying to squeeze every cent every month.
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Old 03-04-2009, 09:15 AM   #6
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No Upside, All the Downside Risk

So other than "selling" the property what's in it for you ?

Are you better off than having a property manager ?

It goes without saying that should the market get worse, your buyer will walk away from this deal after extracting as much as he can get.

What will you do when your flaky buyer's creditors come calling ?

This deal could get really ugly !
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Old 03-04-2009, 09:39 AM   #7
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We had a tenant approach us with a rent to own arrangement. I'm so thankful that we didn't agree to it. Basically the risk is all yours (the property) and the buyer gets to lock in a price now, and then decide later whether or not they want to exercise it. I would strongly advise against this kind of arrangement, as an earlier poster mentioned you'll lose sleep over this because the risk is still there.

In our case the tenant was a dirty pig that skipped town and didn't pay their last month's rent and left the place filthy (can you say poop ground into the carpets?). Currently have a claim hearing with them this month, I expect to win but I doubt I'll ever see my money.
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Old 03-04-2009, 09:47 AM   #8
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Currently have a claim hearing with them this month, I expect to win but I doubt I'll ever see my money.
I would expect they don't show ... and the default judgement is worthless against these types. I stopped chasing those things years ago (steam clean the rugs and move on).
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Old 03-04-2009, 09:57 AM   #9
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Getting off topic here (sorry original poster), but I have a feeling they will show up to the hearing, he isn't that far away (30 min drive) and I just get the feeling he'll show by the way he wrote his statement. The best part is is that they forged a fake 'invoice' for work they had done, and I have proof it is fraudulent. I went to the company that allegedly did the work and they've written a letter stating it was never done the invoice was forged. He doesn't know I have this proof. I can't wait to see the look on scumbag's face when I tell him I'm very tempted to press attempted fraud charges

I know I'll never see the money, but making scumbag's life as miserable as possible is my hobby now.
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Old 03-04-2009, 02:56 PM   #10
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I would agree, run from him....

First, he is 'buying' the property based on a contract, not paying you outright... but is he getting title to the place? I think not the way your wrote your post...

The one good thing on your post is that you still pay your own mortgage... I have heard that some of those vultures 'took over payments', was pocketing the rent and not paying the mortgage... so when it came crashing down, the original homeowner was still on the hook..

He can rent to anybody he wishes... because he is not as concerned as you what happens if they tear the place up... as long as he rents for higher than what he is paying you, he wins.... and if he can not, he just stops paying you and you still own the place...

My Dad, back when he was alive, was a slum lord for a bit (part of his real estate broker bit)... he sold a number of houses on contracts.. all but one blew up at some point and time.. where we had to either evict them or lower what they paid... because now YOU are the mortgage company...
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Old 03-04-2009, 04:25 PM   #11
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As has already been said, without a SUBSTANTIAL Cash down payment, you are taking ALL of the risk. What happens if HIS tenant does not pay, tears the place up beyond a reasonable repair cost, a fire, whatever. What I suspect would happen is your contract holder would surrender the property to you (probably with the tenant still there). What happens if he just has some other financial or family problems, gets sued (and loses) for some other stuff he may or may not be doing? Same thing, since you are holding the bag (risk) you WILL get it back (unless someone can lay claim to the property through some default suit arising from something else he did/does). I can see several issues in this where you may be even be better off holding it vacant for an extended period (since you would be doing the necessary upkeep). Yes, I would trust the DW feelings, and RUN this fellow off. JMO.
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Old 03-04-2009, 08:11 PM   #12
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My gut feeling is don't do the deal. As far as the details, states vary on how to paper these things up, when title passes, and the rights of the parties. If there is a default it may or may not be time consuming or otherwise problematic to cancel the contract.
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Old 03-04-2009, 10:06 PM   #13
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My gut feeling is don't do the deal. As far as the details, states vary on how to paper these things up, when title passes, and the rights of the parties. If there is a default it may or may not be time consuming or otherwise problematic to cancel the contract.
Martha (and others)- if one has a place where most of the value is in the lot with minimal harvestable timber value, and you get a good sized downpayment- like 1/3, are there still reasons to avoid a land contract rather than record a sale and take back a note secured by a trust deed?

Ha
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Old 03-05-2009, 09:16 AM   #14
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Welcome to the board, PauHana. Great poster name!

Thanks for everyone's advice. We're with you guys. Part of the issue is that spouse and I are anal-retentive obsessive compulsive control freaks accustomed to exerting a large degree of autonomy & influence over these situations. We find it difficult to deal with an intermediary who might not necessarily do it our way to our standards. It's one of the reasons that we do a lot of our own landlording, our own home buying/selling, and a lot of DIY projects. So we're learning that this doesn't even pass our "sleep at night" test, let alone our financial ones.

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My gut feeling is don't do the deal. As far as the details, states vary on how to paper these things up, when title passes, and the rights of the parties. If there is a default it may or may not be time consuming or otherwise problematic to cancel the contract.
Same here. One of my other concerns is taxes. For example, I'm pretty sure that we'd be paying depreciation recapture on the day the papers are signed, which requires us to pony up our own cash as well as to continue paying our mortgage.

He's taking over the landlording while waiting for lots of appreciation. He's also hoping that the interest rate he'll pay today will look cheap when inflation comes roaring back and one-year CDs are yielding 7%. Of course he's also investing in real estate at the beginning of what could be a repeat of the 1990 slide, which lasted 10 years and pretty much wiped out a decade of appreciation.

Finally, he's attempted to create a one-way info flow. This annoys the heck out of spouse, who does not tolerate what she feels is a waste of her time. (But she doesn't spend my time on discussion boards!) Every conversation has consisted of him asking "What do you pay for this?" or "What would you want to get?" without him reciprocating. Every discussion ended with "So you'll find out about that and let me know?" I finally decided to play his game with gusto and dug into the numbers with him for another 45 minutes. He's attempting to use the worst-case and best-case local/national averages as they suit him instead of focusing on the particulars of our situation. But I can gab about finances for a very long time and I think he finally decided that he had to cough up an offer.

Setting aside the emotional considerations, here's his numbers:
Offer #1: All cash offer of $418,000.
Offer #2: $312,000 @ 6% amortized over 30 years with monthly payments of $1870.60 with 10 years balloon; subject to the underlying mortgage of $132,169.
Offer #3: $326,000 @ 6% interest only payments of $1630 with a 20 year balloon; subject to the underlying mortgage of $132,169.

Updating our other thread on selling this rental, (Selling the rental property?), our tax assessment is $605K and we're asking $599K. We expect that in a year the local prices will have declined to about $525K-550K, maybe over the next decade dip down into the $400Ks and then rapidly appreciate. Over the next 20 years it'd probably be net appreciation at the rate of inflation. In our neighborhood experience and our comps research of the half-dozen sales over the last three months, we're fairly priced today. As a FSBO sale we could probably take another 5% off our $599K for cash and a quick close. We'd have to pay off that 5.5% 30-year mortgage with its balance of $132K. Our cost basis is $330K and we've accumulated $63K in rental depreciation.

If the place sold for $599K, then after taxes we'd be left with about $425K. A 4.5% CD would throw off about $1590/month before income taxes. We're probably not going to see this fantasy. $550K, $360K, and 4% would yield $1200/month before-tax. That seems to be the lower bound.

Our rent, also fairly priced for this model/neighborhood, is $2800/month. We've been watching the military website and we expect to rent to an active-duty tenant (with a healthy housing allowance) within the month. After subtracting the mortgage, excise tax, property tax, HOA fees, and a 10% estimate for vacancies/repairs, we net about $1400/month before income taxes. If we hired a property manager, we'd pay about 10% which would reduce our monthly net cash to about $1120. Speaking as a nuclear engineer, the 30-year-old house is in stellar condition and needs nothing now. New carpet in five years, new paint in seven, possibly refacing the cabinets in the master bath. Its energy-efficient features also mean it needs no A/C and has total utility bills under $150/month.

So looking at the three offers, we're not interested in selling for 70 cents on the dollar. For the 2nd & 3rd offers, I need to verify that he's effectively the homeowner/taxpayer and we're the banker, so we'd only be paying our mortgage. That means offer #2 reduces our net monthly income to 108 payments of $1060/month and a balloon payment of $267K. Offer #3 drops it to 228 payments of $820/month followed by $326K.

Of course we're being lowballed and the only question is what to counteroffer. I'd counter no less than $550K cash, which he would probably decline. I'm going to have to spreadsheet the other two offers and show him how we'd need a minimum of $1120/month before we'd give up control and appreciation.

Any other issues or pitfalls we need to consider?
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Old 03-05-2009, 01:07 PM   #15
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Why are you even dealing with the guy? He has been pumping you for information that only helps HIM and has even stated to you he only buys on the cheap...

List the house with a realtor and sell it outright... that is the only way to go...

Do NOT take a note.. it is not worth the hassle and the default possibilites... I think the rating would be "F"...
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Old 03-05-2009, 03:56 PM   #16
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Why are you even dealing with the guy? He has been pumping you for information that only helps HIM and has even stated to you he only buys on the cheap...

List the house with a realtor and sell it outright... that is the only way to go...

Do NOT take a note.. it is not worth the hassle and the default possibilites... I think the rating would be "F"...
What he said - yikes - I'm with the spouse, my time would be too valuable to waste with this guy. You must *really* want to figure out this guy's angle or approach. I'm of the opinion that if (and I'm sure it's true) the house is in as good a condition as you say it is, your wait for buyers will be short. Additionally, you've already said you are willing to keep renting and wait out this particularly 'depressing' market. You are not the desperate customer that this man preys upon.

Is the surf that flat??
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Old 03-05-2009, 08:25 PM   #17
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Martha (and others)- if one has a place where most of the value is in the lot with minimal harvestable timber value, and you get a good sized downpayment- like 1/3, are there still reasons to avoid a land contract rather than record a sale and take back a note secured by a trust deed?

Ha
Depends on your state. In Minnesota it is no big deal to take a contract for deed (or land contract as they are called in some places) as there is an straightforward mechanism in place to cancel the contract that does not require the court system. In Wisconsin, it is more of a PITA and a judge will end up deciding a number of issues, such as how long will the buyer have to "redeem" the property.

But yes, money down is important.
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Old 03-06-2009, 12:42 AM   #18
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Depends on your state. In Minnesota it is no big deal to take a contract for deed (or land contract as they are called in some places) as there is an straightforward mechanism in place to cancel the contract that does not require the court system. In Wisconsin, it is more of a PITA and a judge will end up deciding a number of issues, such as how long will the buyer have to "redeem" the property.

But yes, money down is important.
Thanks Martha.

Ha
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Old 03-06-2009, 09:04 PM   #19
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Why are you even dealing with the guy? He has been pumping you for information that only helps HIM and has even stated to you he only buys on the cheap...
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Originally Posted by deserat View Post
What he said - yikes - I'm with the spouse, my time would be too valuable to waste with this guy. You must *really* want to figure out this guy's angle or approach. I'm of the opinion that if (and I'm sure it's true) the house is in as good a condition as you say it is, your wait for buyers will be short. Additionally, you've already said you are willing to keep renting and wait out this particularly 'depressing' market. You are not the desperate customer that this man preys upon.
Is the surf that flat??
I guess I got dragged into this negotiation because he was one of the first to respond to our Craigslist ad. I also wanted to learn the latest tactics in case we got more than one of these offers. And hey, I enjoy talking real estate.

As far as sucking info without reciprocation, IMO it's not much different from a discussion board. The more info you can share, the better the advice. Instead of holding a spreadsheet against my chest, I'd rather lay it on the table for him to read and then say "Here's what you have to beat!" And the fact that he's spent more time "sucking" than "offering" has established his credentials better than I could have ever determined on my own.

And yes, the surf is not only pretty flat but it's all the way down into the (*whimper*) mid 70s. Not that I've been able to do anything about it, between cleaning a rental property and fixing just about every moving object in it. But it's finally move-in ready.

I asked him more questions and it turns out that this is indeed an installment sale, although with a unique (I hope) twist:
Quote:
Although every transaction for us is structured differently, we typically try to keep things very simple. In this situation the best way to look at it is you being the bank aka Purchase Money Mortgage. Just as if we went to any bank for conventional financing, you would have a secured position on the property by way of a promissory note and mortgage at closing.
The only difference in this situation is that we will be leaving the underlying loan in place, which means you would be in second position. As we had discussed, this could trigger the "Due on Sale" clause of the first mortgage. All loans since around 1988, have this clause. We feel this is a non issue, especially in today's climate. The reason is that every banks primary goal is to receive their monthly interest spreads, not to take back homes. As long as the payments are being made, that's all they really care about. On top of this, we have certain strategies that we employ to prevent this from happening. With that being said, if for some reason they call a performing loan due, (as opposed to lowering payments as well as principle to keep people in their home) we would then refinance them out, without an issue.
In other words, we're being asked to either cash out at less than 70 cents on the dollar or to carry out a 10-20 year installment sale. And if we do the installment sale, we're being asked to keep our original mortgage despite the fact that it's not assumable and indeed "due on sale". I don't know a title company or escrow company on this island that would arrange a deed transfer and title insurance with an outstanding lien. I can see a number of reasons that this would get off to a bad start and go steadily downhill.

Spouse and I have been with NFCU for over 30 years. While they don't necessarily go out of their way to engender customer loyalty, they treated our kid well with her first checking account and we've enjoyed the benefits of membership. I don't think I want to poison those waters by daring them to send us a due-on-sale payment demand.

Meanwhile we've been getting calls from prospective tenants. The first family we showed the place to (before the tenants had moved out) ended up renting another place closer to his work. Today's family, however, was pretty happy to see a clean & empty place. They were even more excited to hear that we'll take pets (a chocolate Lab and two older/declawed cats) and they (the family, not the pets!) should be signing a lease within the week. As a landlord, I'll take pets over toilet-training toddlers any day...
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Old 03-07-2009, 04:59 AM   #20
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Sounds great, hope the new tenants sign as anticipated. Sounds like it has all worked out for the best. I enjoyed the thread and your long and informative posts.
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