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