When it comes to negotiating, some people are under the misconception that it must be adversarial to the point where there is a clear winner and a clear loser. This isn’t the case. In real estate, if buyers and sellers are clear about their must-haves and willing to compromise a little on their would-likes, both sides can come away happy. If you haven’t already, consider picking up the book Getting to Yes by Roger Fisher and William Ury. It’s a quick and fabulous read.
If you’ve been thinking about jumping into the real estate market, now is a great time. Rates recently dropped by half a percentage point, which may not sound like much, but on an average home in Ukiah (which costs about $450,000), the difference between a 30-year, fixed-rate mortgage at 7% and the same loan at 6.5% translates into an extra $23,500 in purchasing power. That means that if you need bank financing, you can get a bigger loan without spending more money.
Sometimes, bank financing isn’t the best option. I was recently talking with friends who own rental property in Southern California, but given the cost of maintenance, taxes, insurance, and the time required to manage the rental, the income isn’t keeping pace with the expenses. They own the home free and clear and the tax basis is close to zero since they’ve owned it so long. Its market value is about $1.8 million, but it’s barely generating $35,000 per year after all the taxes, insurance, vacancy and turnover, etc.—that’s an annual return of about 2%, not great.
In cases like this, I often recommend a 1031 exchange, where you can avoid capital gains tax by, in essence, trading properties with someone who has property you want and who wants what you have. Unfortunately for my friends, they’ve been unable to find property they want to acquire. So, we started talking about whether they could divest themselves of the property while increasing their financial return by providing seller financing.
Before you consider seller financing, you need to look at all the options. If the 1031 exchange doesn’t work, you could always sell the property to a buyer who chooses conventional financing (a bank loan). In that case, a sale price of $1.8 million would provide you with about $1.2 million in proceeds after paying state and federal income taxes of about 35% (yes, you must pay $600,000 to the government for the privilege of selling your property). If you plan to invest the proceeds in a certificate of deposit or similar financial instrument, at 4% interest, you’ll collect about $48,000 per year in interest. It’s better than holding the property, but still not optimal.
On the other hand, if you sold property and carried the financing, you could provide a great deal to a buyer and still come out ahead. To make the math easy, let’s assume the buyer has collateral to back up the loan, so they don’t need to put any money down, making this a $1.8 million loan. If you do an installment sale, you only pay taxes on the cash you receive, and the buyer is thrilled to get a loan at a below-market rate, say 6%, with no loan fees, no appraisal fees, and no points.
By providing an installment loan, you collect interest on the principal of the loan, increasing your income from $48,000 per year (if you invested $1.2 million at 4% after a conventional sale) to $108,000 per year, more than doubling your cash flow. You’re happy. The buyer’s happy. This is what we call a win-win.
There are a few risks that can be addressed in a well-written contract. If interest rates drop and the buyer refinances, you’re left with a hefty capital gains tax bill. That risk can be mitigated by a pre-payment penalty clause (if the loan is paid off early, the buyer will pay a fee). Everything’s negotiable. And while an installment loan with seller financing isn’t a good option in all cases, it’s a great option in some cases.
One thing to keep in mind: if a married couple bought a property together decades ago, a current-day sale will likely lead to significant capital gains taxes based on the property’s appreciated value. However, if one spouse passes away, the property’s income tax basis is stepped up, that is, it is reclassified to fair market value. The surviving spouse can then sell the property without the capital gains tax bill.
If you have significant real estate and heirs you want to support, I recommend meeting with an attorney well versed in estate planning. This will allow you to make the best financial decisions for all involved.
If you have questions about property management or real estate, please contact me at rselzer@selzerrealty.com or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery.