Equity Sharing in
Florida
By:
Jonathan Alper
Published:
December 1984, Florida Bar Journal
What is Equity
Sharing?
With interest rates again approaching levels that threaten to
make home ownership an impossible dream to many, a new financing
arrangement is spreading across the country that effectively
reduces interest rates. This new financing technique, known
as “equity sharing,” is an arrangement between a
homeowner, who wants a house to own as his residence, and an
investor, who contributes money in exchange for tax benefits
and a share of the appreciated value of the home. Equity sharing
financing has become popular in California and Washington, D.C.,
but it is just now beginning to appear in Florida.
The simplest form of equity sharing is an intra-family arrangement.
For example, a parent may take title to his child’s residence,
rent the property to the child, and claim the tax benefits associated
with rental ownership. The child may contribute as much of the
down payment and monthly payments he can afford, and the parent
contributes the balance of the money needed for the child to
live comfortably in the property. Gain from the sale of the
property is allocated between the parent and the child.
Real estate professionals have expanded the simple parent-child
equity arrangement to arms-length sharing between profit-oriented
investors and unrelated homeowners. There are two basic types
of equity sharing arrangements that benefit the homeowner and
the real estate investor. In the first type, the investor contributes
all or part of the down payment toward the purchase of a home.
In this case, the homeowner can move into the home with little
or no cash, but thereafter is responsible for most or all monthly
expenses. This type of equity sharing appeals to the younger
couple who is unable to accumulate sufficient cash to enter
the home ownership market. Although this couple shares some
of the home’s appreciation with the investor, this arrangement
is preferable to the alternative of continued renting with no
equity accumulation. In the second basic type of equity sharing,
the homeowner is responsible for the entire down payment, and
the investor contributes a significant portion of the monthly
carrying cost. The investor’s contribution lowers the
homeowner’s effective interest rate and other monthly
expenses to the point where the homeowner can live in a home
otherwise unaffordable in today’s high-interest rate environment.
This type of equity sharing arrangement appeals to the couple
who has previously owned one or more homes, who has sufficient
equity in their present home, but who cannot afford to move
into that new home because of the monthly expense associated
with today’s interest rates. This type of equity sharing
might appeal to elderly homeowners who wish to retire in Florida.
The typical retiree seeks a home which he can afford comfortably,
and he may be willing to give part of the home’s appreciation
to an investor because the retiree might not be concerned about
accumulating equity for subsequent home purchases.
Benefits of Equity Sharing Arrangements
To illustrate briefly the benefits for both the homeowner and
investor in the second type of equity sharing arrangement, consider
the hypothetical purchase of a $100,000 home with a $20,000
down payment and financing of the $80,000 balance at the fixed
interest rate of 13 percent. Assuming an interest-only monthly
payment of $867 with an additional $100 paid monthly for real
estate taxes and homeowner’s insurance, the monthly carrying
costs would amount to $967. Also assume that the value of the
home appreciates at an annual rate of 6 percent. In this example,
the homeowner has enough money for the down payment but wants
an equity sharing arrangement to help reduce his monthly carrying
charge; therefore assume that the investor contributes $300
each month toward the monthly carrying cost, and the homeowner
contributes the balance of $667. In this example, the homeowner
and investor agree to share equally future appreciation, if
any, in the value of the home.
The equity sharing arrangement can be structured so that all
the current tax benefits, including depreciation, from the ownership
of the home can be allocated to the investor. In this example,
the investor has no initial capital contribution, but is responsible
for paying $300 cash each month. In return, the investor is
allocated all the current tax losses, which on a monthly basis
consist of the $967 expenses, including interest, taxes, and
insurance, and depreciation which amounts to $444 on a monthly
basis. Thus, the total monthly tax loss allocated to the investor
is $1,411 ($967 plus $444). Partially offsetting this tax deduction,
our equity sharing structure, discussed below, will allocate
$667 of monthly rental income to the investor. Thus, the investor’s
monthly net tax loss is $744 ($667 less $1,411 of losses). As
the investor’s monthly cash requirement is $300, this
arrangement gives the investor more than a 2:1 tax writeoff
($744 loss compared to $300 cash requirement); and for an investor
in a 50 percent tax bracket, this produces a net monthly tax
saving of $70. Moreover, if the home appreciates at a 6 percent
annual rate as assumed, the investor is accumulating long-term
capital gain through appreciation at the rate of $3,000 per
year.
Once an investor and homeowner have decided to enter into an
equity sharing arrangement, it is the attorney’s task
to structure a deal that protects the parties’ interests.
Nationwide, there is little law directly applicable to the equity
sharing concept. In Florida, in particular, there is a scarcity
of statutory or case law regarding shared equity arrangements.
On one hand, the absence of legal constraints provides the opportunity
for creativity and diversity in the structuring of shared equity
arrangements, but, on the other hand, it means that almost any
equity sharing structure is not supported by legal precedent
and is subject to challenge. An attorney representing the investor
should always be conscious of the possibility that the homeowner,
who is initially eager for financial assistance through shared
equity financing, might take a different position when the time
comes to sell or refinance the home and share the profits with
the investor. In short, from the investor’s standpoint,
the equity sharing structure should maximize the investor’s
tax benefits and should offer maximum protection against loss
of capital investment and share of appreciation.
Structure through Partnership
With these objectives in mind, the best way to structure shared
equity financing is by means of a partnership between the investor
and homeowner. The partnership would hold the legal title to
the property. This equity sharing partnership could be either
a general partnership or limited partnership with the homeowner
as limited partner. There are advantages and disadvantages of
each alternative from the investor’s standpoint. In the
general partnership, the homeowner and the investor would both
be personally liable on the mortgage financing which would help
the partnership qualify for financing the property.
The homeowner may insist on being a general partner for psychological,
as well as legal reasons, because he believes that he should
be a full and equal partner in “his house.” Having
the homeowner as a general partner, however, means that the
homeowner has the power to bind the partnership without the
investor’s knowledge or consent. With the homeowner as
a limited partner in the equity sharing partnership, the investor
alone must support a financing application, but gains more legal
control over the property. All things considered, an investor
should prefer that the “homeowner” be a limited
partner.
The first and most important element in structuring an equity
sharing arrangement is a partnership agreement that clearly
spells out the relationship between the parties. The partnership
agreement should provide that the partnership holds legal title
to the property, and that the partnership leases the property
to the “homeowner/lessee” for a term consistent
with the term of the partnership. The agreement must specifically
state the parties’ responsibility to contribute capital
to the partnership. In the above example, the homeowner would
be required to contribute the down payment, and the investor
would contribute money required above the rental receipts to
pay the mortgage, taxes, and insurance. In the example, the
monthly rental payment would be $667 (the amount paid by the
homeowner), and the investor’s monthly capital contribution
would be $300.
Additional provisions in the partnership agreement, as well
as in the lease, should cover the contribution of capital to
pay for repairs, capital improvements, and miscellaneous cash
requirements. The investor may ask the homeowner to pay for
all repairs and home improvements, although the investor should
consider giving the homeowner credit for part of the incurred
expenses of home improvements.
An important provision in the partnership agreement is the term
of the equity sharing arrangement. Of course, the homeowner
wants a long term arrangement, similar to a long term, low-rate
mortgage from a bank. The investor, on the other hand, even
though he is enjoying current tax savings, will want a short
term arrangement. The length of the equity sharing arrangement
is a sensitive subject that must be negotiated simultaneously
with the allocation of profits from appreciation. A homeowner
who wants a long term sharing arrangement probably will have
to relinquish a larger share of the appreciation to the investor.
There should be specific procedures in the partnership agreement
for terminating the equity sharing partnership. To begin with,
the homeowner should have the option to have the house sold
any time prior to the end of the partnership’s term. If
not sold, then at some time prior to the end of the partnership’s
term (six months is reasonable) the property can be appraised;
thereafter, the homeowner can be given the right to buy the
house from the partnership at a percentage discount from current
fair market value.
If the homeowner does not exercise this option, the investor
should have the right to sell the house to anyone at the expiration
of the equity sharing partnership and to divide the profits
according to the partnership agreement. This provision gives
the investor the right, one way or another, to realize a share
of the appreciation at the end of the agreed term of the equity
sharing partnership. To be fair to the homeowner and to avoid
possible conflict, the investor may consider giving the homeowner
the right to extend the agreement, and his lease, in exchange
for either an increased rental payment or a greater share of
future appreciation.
Next, the partnership agreement must address specifically the
allocation of taxable income and losses between the investor
and homeowner. As previously mentioned, the intent of the arrangement
is to allocate net taxable losses, including depreciation, to
the investor. The simplest and fairest way to accomplish this
is to provide that net taxable income or loss will be allocated
to the investor for tax purposes. This special allocation of
income and loss must have a substantial economic effect.
One widely used provision for special allocations is that the
allocations affect the partners’ capital accounts and
that all distributions shall be made by the partnership in accordance
with capital account balances. Thus, the equity sharing agreement
should provide that special allocation of losses to the investor
shall reduce this capital account, and that when the property
is sold at a profit, gain will be allocate to the investor until
the specially allocated deductions previously taken are offset.
The law regarding special allocations is complicated and care
must be taken to draft properly this aspect of an equity sharing
partnership agreement in order to afford the maximum tax benefits
to the investor.
The partnership agreement must protect the investor and the
homeowner in the event either party defaults in his obligation
to contribute capital or to otherwise perform. Either party
can be faced with unexpected costs of carrying the property
if the other party fails to contribute capital as required.
The temptation is to provide for the total forfeiture of the
defaulting party’s interest in the property or in his
share of the appreciation. It is unlikely, however, that total
forfeiture provisions would be upheld in court. The better alternative
is to provide that in the event of a default the defaulting
partner’s share in the partnership will be sold, first
to the remaining partner, and then to the public, and that the
proceeds received for the sale of the partnership interest will
be given to the defaulting partner.
The lease agreement between the partnership and the homeowner/limited
partner is an extremely important document, which must be carefully
drafted. Some of the important provisions of the lease have
previously been discussed. In short, from the investor’s
standpoint, the lease should burden the homeowner with all the
responsibilities that he would otherwise have if he owned the
home outright. Hence, all repairs, utilities, and special assessment
should be the tenant/limited partner’s responsibility.
The purpose of equity sharing is to provide an advantageous
financing arrangement, but it is not intended to assist the
homeowner with other costs of home ownership.
Protection of Investment
There is one other legal device which the investor could use
to protect capital investments in the equity sharing partnership.
The homeowner or the partnership could grant to the investor,
or a trustee for the investor, a lien to secure the investor’s
initial and periodic capital contributions to the partnership.
The amount secured could accrue interest at a relatively low
interest rate. If possible, the validity of the lien should
be insured. A mortgage lien on the property could protect the
investor’s capital investment against subsequent legal
attacks on the equity sharing arrangement by the homeowner or
by a third party. If the equity sharing partnership is successfully
challenged in court or is otherwise declared to be illegal,
the investor or his trustee could proceed to recover the investor’s
capital investment, plus interest, by enforcing the lien on
the property.
Although there is little law directly relating to equity sharing,
there are some legal and general business guidelines that the
attorney should follow in structuring an equity sharing arrangement.
On July 21, 1983, the Internal Revenue Service issued proposed
regulations applicable to shared equity financing. The proposed
regulations create two tests to determine a valid equity sharing
arrangement. First, the regulations state that the party occupying
the dwelling must pay a “fair rental.” Of course,
in an equity sharing arrangement a fair rental may arguably
be less than the rent that could be obtained from a third party
tenant, because the tenant is responsible for repairs and other
expenses, and the tenant is an owner-occupant and, therefore,
is a good rental risk. The second proposed criterion is that
both parties to the equity sharing arrangement have a “qualified
ownership interest,” which is defined as an undivided
interest for more than 50 years in the entire unit and the land.
It is unclear whether an equity sharing agreement that requires
the property to be sold after several years qualifies as a “qualified
ownership interest.” It is reasonable to argue that the
arrangement will qualify so long as the parties, as a matter
of state law, have interests in the property for more than 50
years. The agreement to sell the property in a shorter period
of time should not affect the real property interest, because
it is only a contractual agreement. Unfortunately, the proposed
regulations do not address this issue.
In general, parties entering an equity sharing arrangement must
recognize that, although this arrangement is beneficial and
secure economically, there are legal risks involved because
of the newness of this financing concept. To help protect against
future legal attack, the attorney representing the investor
should insist that the homeowner be represented by legal counsel,
or at least sign a waiver of this right. The attorney should
carefully prepare disclosure documents that state the homeowner
is relinquishing part of the equity in the home, and that a
default under the partnership agreement may cause a loss of
an entire equity position. These disclosures should be made
and questions addressed early in order to avoid a misunderstanding
that could lead to litigation.
The equity sharing concept, like all new ideas, involves some
legal uncertainty. This uncertainty, however, is more than offset
by the economic benefits to the homeowner and the investor.
Equity sharing gives the homeowner the opportunity to substantially
reduce the monthly expense of home ownership. Equity sharing
gives the investor an equity position in a relatively low risk
asset, a Florida home, and it provides current tax savings through
ownership of a rental property with an owner-occupant tenant.
With these and other advantages, it is inevitable that the popularity
of equity sharing will soon spread throughout Florida.
Note: This
article was written prior to enactment of the Deficit Reduction
Act of 1984
