How Uncle Sam Relates to Close-Knit Families : Shared-Equity Plans Help Parents, Children Benefit From Real Estate Transactions
It’s in mute testimony to the dictum that “the family that pays together, stays together,” that thousands of intrafamily real estate deals are struck every year--parents helping children buy their first home and children helping parents get some liquidity out of their paid-for home.
Until relatively recently, however, such cross-pollination of funds was almost exclusively in the form of outright gifts and loans with their limited, if not non-existent, tax advantages for either party.
Today, however, the shared-equity pros are moving into the field to let Uncle Sam pick up a part of the tab--packaging the contractual arrangements between family members to satisfy stringent Internal Revenue Service requirements (the pitfalls, otherwise, can be sticky) and prearranging lines of credit between lenders, insurance companies (where applicable) and participants.
Few, if any, however, have gone into it as ambitiously as the Oakland-based Family Backed Mortgage Assn.--into all 50 states and “working both sides of the street,” (parents helping children/children helping parents). On the basis of a monthly loan volume that has doubled in recent weeks, the association is projecting $1 billion in closings this year.
For senior citizens with a hefty equity in their home, but with a pressing need for more spendable income, the association’s Kenneth T. Rosen has put together a sale-lease-back-annuity program (generically known as the “reverse annuity”) involving parents, children and insurance carriers called Grannie Mae. And, for children needing parental support in the purchase of their first home, he has designed a shared-equity procedure called Daddy Mac.
Real estate economist Rosen is chairman of the Center for Real Estate and Urban Economics at UC Berkeley and, 10 years ago, was the developer of the Graduated-Payment Mortgage (the GPM, or “jeep”) program. Radical at the time (“it was four years before anyone took me seriously,” Rosen recalls today), the GPM was devised for the first-time home buyer who couldn’t otherwise qualify for conventional financing, and is a mortgage with below-market monthly payments during the early years, but increasing annually as the young buyer’s income also rises until they level off in about the seventh year.
Under Rosen’s new venture, FBMA, the company’s remuneration is exactly the same for both the Grannie Mae and Daddy Mac program: a one-time $250 fee for, essentially, the package and a seven-year analysis of before-tax and after-tax cash flow for each participant, plus 1 1/2% of the 3% origination fee levied by the lender.
Under Rosen’s Grannie Mae program, the children buy the parents’ home in which the parents have at least an 80% equity. The parents immediately use the proceeds from the sale to buy a life annuity (guaranteed for the lifetime of both parents) providing them with a monthly annuity and, simultaneously, lease back their own home at a fair market rental price. The monthly annuity, plus the property tax and insurance savings--two responsibilities taken over by the child-buyer--less the monthly rental, give the parent(s) a net spendable income they would otherwise not have.
For the child-buyer, of course, the home that he has bought and leased back to his parents immediately becomes a piece of income-producing real estate with all of the attendant advantages--depreciation and the tax deductibility of mortgage interest, taxes, insurance and maintenance and, ultimately, any appreciation in the value of the home. Rental income received from the parents, of course, is taxable.
(The parent-child arrangement could be impacted, of course, if President Reagan’s proposal to eliminate the deductibility of local and state property taxes becomes law. And, accountants are still divided on whether the proposed cap on interest deductibilty applies to such real estate investments.)
The example cited by Rosen envisions a 76-year-old widow who owns a home appraised at $100,000, free and clear. Selling the home to her child and applying the proceeds to the purchase of an annuity, the widow would receive about $12,600 a year from the annuity, and save $2,000 a year in property tax and insurance payments. She would pay roughly $6,000 a year in rent (based, depending on local conditions, on 4% to 9% of the market value of the house) which would leave her, net, $8,600 a year, or $715 a month, as spendable income.
To satisfy IRS requirements, Rosen adds, the rent must increase at the rate of 3% a year. At the same time, however, the annuity pay-out also increases (from 1% to 3% a year) for the actual life of the seller, or surviving spouse, whichever comes last.
While this presumes that the widow applies the entire sales price of the home ($100,000) to the annuity, Rosen continues, “there can be instances where the seller may need, or want, to spend part of the down payment for other things--a vacation, needed repairs, or what-have-you. In this example, for instance, she might take $15,000 of the down payment in cash for other expenses, leaving $5,000 of it to apply to the annuity (with the $80,000 balance of the sales price, of course). This would reduce her monthly annuity about 15%--from $715 a month to about $608. The only Grannie Mae requirement is that at least 80% of the sales price of the house must go toward the annuity.”
To date, he adds, “we’re using John Hancock Mutual Life Insurance Co. for our annuities east of the Mississippi and Transamerica Occidental for those in the West--although the annuitant, of course, is free to choose his own life insurance company. The rates are pretty comparable and these two were picked simply because they’re both licensed to write policies in all 50 states.”
Family Backed Mortgage Assn., Rosen continues, also has correspondent lenders on tap in all 50 states, such as United Jersey Bank (New Jersey’s largest), First Chicago National Bank (Chicago’s largest) and Phoenix’s First Federal Savings and Loan Assn. (Arizona’s largest S&L;).
“We felt,” the economist says, “that you can’t really conduct programs like this on a state-by-state basis.”
In this respect, and another important one, FBMA differs sharply from Prudential-Bache Securities’ recently announced entry into the reverse-annuity field: instead of using the FBMA approach through conventional lenders and life insurance companies, Prudential-Bache, with assets of $76 billion, is financing its entire program itself and is going national with it state-by-state, a process, so far, that has kept it unavailable except in a handful of states.
Additionally, Rosen adds, both of FBMA’s Grannie Mae and Daddy Mac programs have been approved by the Federal Home Loan Mortgage Assn. (Freddie Mac). While this is unimportant to Prudential-Bache’s reverse-annuity plan, since it has no intention of selling off the mortgages it acquires, it gives FBMA’s conventional lenders an essential ingredient: assurance that the mortgages they have underwritten can be sold easily in the secondary market.
Enter the Realtors
Of the two FBMA programs, however, it is Daddy Mac, the shared-equity package, that brings realtors into the picture in a critical role. As Jack Grigsby, president of Coldwell Banker Residential Marketing Services in Irvine, puts it: “Brokers aren’t really involved in the Grannie Mae program, but we’re quite enthusiastic about Daddy Mac--it makes for extremely solid paper. If the son (or daughter) can’t make it, there are always the parents to pick it up.”
Unlike Grannie Mae, where the real estate involved is already in place and the negotiations are directly between buyer, seller, lender and the underwriting insurance company--and, in fact, the services of a realtor would simply be an unnecessary expense--Daddy Mac casts the realtor in the key role.
Reflecting the importance that FBMA is putting on its shared-equity program, Rosen, in late May, announced the appointment of Richard Pontillo, formerly chief financial and administrative officer of the investment firm, Sutro and Co., to the post of president and chief executive officer of Daddy Mac.
For years--and especially since soaring house prices and high interest rates have left more and more first-time home buyers on the outside looking in--realtors have sensed the existence of a potentially rich market in shared equities, particularly among family members. The big bugaboo: the complexity of setting up such an arrangement to satisfy IRS conditions and the expense of hiring tax and legal experts.
What FBMA’s Daddy Mac program provides, essentially, is such an arrangement, prepackaged, but with the added plus of at least two nationwide realty firms--Century 21 and Coldwell Banker Residential Marketing Services--actively promoting it and, as mentioned earlier, participating lenders in all states.
To an even greater extent than in FBMA’s Grannie Mae, the Daddy Mac program is as stylized as a Chinese fertility dance because of the IRS’s no-nonsense insistence that--since Uncle Sam is picking up an appreciable part of the tab--all shared-equity arrangements between parents and children must be strictly business: no looking the other way if the child/occupant misses his rent . . . no unrealistically low rentals to favor the child . . . no inequitable division of expenses.
Here are the highlights:
--Parents (the owner/investor) and the child (the owner/occupant) split the down payment between them--normally 50/50.
--Ownership costs including closing costs, mortgage payments, property taxes and insurance are divided equally between the co-owners (if it’s a 50/50 arrangement).
--The owner/occupant pays fair-market rent on the parent’s interest in the home. (If the fair-market rent for the home, for instance, is $800 a month, the child would pay a rental of $400, reflecting his parent’s 50% interest in the house. The rent is non-deductible to the child and reportable income to the parent).
--The owner/occupant is responsible for the first $3,000 a year in necessary maintenance and improvements and half of any amount over $3,000 in a 50/50 arrangement.
--The owner/investor gets 100% of the depreciation on his share of the property (50% of the allowable depreciation if, again, it’s a 50/50 shared-equity). The owner/occupant claims none.
--When the home is liquidated, both the owner/occupant and the owner/investor get their down payment back in the same proportion in which it was made in the first place and any additional gain is, again, split proportionately.
Enjoys Savings
Under the Daddy Mac program, according to FBMA’s Rosen, not only is the child able to qualify for a mortgage far more easily (since his parents are, in effect, co-applicants for the mortgage), but, in the average case, the child enjoys an average savings of 27% over the cost of full ownership--even if he had been able to qualify on his own. And, when the home is liquidated, the owner/occupant can “roll over” his share of the sales proceeds, tax-deferred, into a new principal residence.
Nothing in life is entirely painless or without flaws and Daddy Mac is no exception--the parents, for instance, should be able to live with a negative cash flow for the life of the arrangement and their own tax situation, on review, may reveal other complexities.
But, FBMA feels, both Grannie Mae and Daddy Mac simplify two real estate procedures that common sense has long dictated should be relatively painless, but that reality has frustrated at every turn.
To date, both programs are strictly family oriented although, Rosen says, “our plans for the future are to put together some small syndications bringing in outside investors as investors and without any regard for family relationships.”
Further information on either program is available from Family Backed Mortgage Assn. at (in California) 800-232-3262, or (outside California) at 800-323-3262.
