CFD's, Sub 2's and wrap's .. oh my! - Posted by Tray Giddens, Houston

Posted by Brent_IL on August 20, 2003 at 11:46:37:

I couldn?t find the post that I was looking for, but then I remembered that I used some of that post in the outline I started to write for my wife, so this is a modified repost.

When I talk about a standard example, I?m talking about a $100,000 house, used so the percentages are more easily seen. I think this example was free-and-clear, but it works the same way with a wrap because the interest is spread over all of the underlying liens and not just the seller?s equity after a down payment.

Here?s the cut-and-paste.

?Read the following sentence twice. Most of the people living in the USA can make more money by reducing their taxes than they can by trying to make more money.

The rates established in the tax code are applied equally to all taxpayers regardless of their station in life. Little comprehended is the fact that there are effectively two tax rates in America. It doesn?t matter if you are rich or poor; black or white, or young or old. What determines how much you will pay in taxes is whether you are informed, or uninformed. Taxpayers that take the time to understand our system of taxation will pay lower taxes than will their peers who don?t bother with the effort. It?s very straightforward.

The following is an example only. I believe the concept is valid under current tax law and do not hesitate to utilize this technique personally. However, I?m not an attorney, or a CPA. The services of a competent professional should be sought before ever considering doing something like this.

O.K., that?s enough of a CYA disclaimer, let?s get to it.

This is a variation and illustration of the ?If I can get you the cash that you say you need, do you care what I call it if it will help us to get this sale done tonight?? taxation techniques.

The idea is to come to a mutual agreement with the seller using terms that allow you to give him or her needed cash by paying for items that are tax-deductible to the buyer/investor. Tax benefits, alone, under the current law can?t make a bad deal into a good one. Tax benefits can make a marginal deal into one worth doing by lowering your cost of acquisition. When done legally with the correct paper trail, tax benefits can be sold for cash.

Note well:

1 - Under the laws of the United States, tax evasion is a crime. Conspiracy to evade your taxes due is a crime. Re-constructing or restructuring events or documents after the fact to avoid taxes is a crime.

2 - Tax-avoidance is legal. However, in order to be deductible the actions you take must have valid business, or investment reasons other than ?I don?t want to pay the IRS,? and they must be reasonable in scope.

3 - The seller is not thinking about your taxes. You would not want him to. Don?t burden the seller with details that will send him running to a tax attorney. In transactions of this kind a deductible expense for you is usually taxable income to someone else. When properly motivated (It?s my way, or the highway; remember?), many sellers consider this to be a small price to pay for a sale that alleviates the challenging real estate problems that they?re facing. .

Our basic play is three-fold;

a) Purchase price allocations;

b) Interest rate(s) on seller-financed notes;

c) Side Agreements enduring after the sale escrow closes.

Some of these things may be recaptured at the time of sale because they affect your basis in the property. So what? Usually when these kinds of deductions are recaptured in the future at the time of sale, you are taxed at the lower capital gains rate. Since the money allocated for taxes was never yours to begin with, this is like getting a no-payment ?loan? from the IRS who will accept a discounted amount when the ?loan? is paid off when you sell the property.

The time to negotiate these items is when you are constructing a deal in person or in a counteroffer to the seller?s counter to your initial purchase offer. Never go back after the deal is written in stone and try to change things around. At that point you are no longer negotiating, but are trying to evade paying taxes. This is what leads to jail time.

Here?s an example of allocating the purchase price of the property;

Using our standard example, most of our fellow investor?s sales contracts would state that the purchase price is $100,000. In contrast, I would give the seller a reason to restate this as: ?This property is being sold and purchased for the sum of $100,000 and is allocated as follows: Building $75,000; Land $10,000; Personal Property $15,000.?

Almost all sellers will accept this to achieve a fast sale. When a seller asks me why I want to allocate the price in this manner, I reply, ?This is the way my accountant said to do things if I want to buy any more property. I dunno; something about future taxation.? Then I shrug my shoulders. That?s about all the discussion that it takes. Should the seller waffle, ask, ?Does this mean that I probably won?t be able to buy this house from you, tonight?? Sellers usually decide that it?s not a stumbling block.

Why do I bother with this, since the seller?s price is unchanged?

Land is not deductible and should be minimized to the lowest defensible amount. The deductible expense for depreciation of the residential building stays the same and, by law, is spread equally over 27.5 years. The remaining property, transferred by bill of sale, can be expensed, or deducted, usually over 5 years. This deductibility reduces the taxes on other income that would otherwise have to be paid. $15,000 divided by 5 years equals $3,000 per year, times, let?s say a 30% tax bracket, equals $900 in cash that doesn?t need to go to the IRS, but stays in your pocket every year for five years. It takes less than five minutes to ask for this when you are face-to-face with the seller.

After the sale, upon reflection, you may find that although your intent was to use this personal-type property for the production of income, it seems that you were overly optimistic about its condition and longevity. The seller was right; it?s a pile of junk, and should be replaced. The write-off stands as is, and if you actually replace those items the write-off will be accelerated.

This three-part division of the total purchase price is built into our purchase contract. We also use an addendum that breaks down the sales price into specific items if we intend to make a series of repairs that would eventually result in the de facto replacement of those items. This accelerates the write-offs into the current year.

N.B. When you?re considering a §1031 exchange, any personal property that you receive is considered boot and taxed accordingly. It?s o.k. to weigh the allocations toward personal property when we are buying, but when we are exchanging out, use an experienced and competent professional to determine what is what before you sign on the dotted line. You don?t want boot. Remember that reconstruction after the fact is tax evasion and illegal.

This next part of the example is of using a dual interest rate for the notes given to the seller when the property is being owner-financed. Same sales price, dual interest rate;

You have a not very motivated seller, but he?s willing to finance the FMV with 30% down. Terms requested by the seller are $30,000 cash down payment and a 30-year note for $70,000 at 8.00% interest with a ten-year call. Payments are $513.64 a month and a balloon of $61,407.29 with the 120th payment. This is unacceptable to you in its current form.

When mentally formulizing your offer, you realize that no one knows the subject property better than the current owner. You keep it in mind that it might be a good idea to enlist his help if you need it during the time of your learning curve with regard to this particular property.

Interest can be paid when due, can be deferred, or can be paid in advance. It is deductible only when you really pay it, and only if it was due at the time. You will now re-work the allocations in our first example proportionally and counter with an offer for a $70,000 purchase price. Zero down.

The seller may have initially thought of the $30,000 as a down payment, but he will soon be enlightened. The seller, after considering your ?talking points? has every right to ask for terms prevalent with ?hard money? lenders because you are unknown to him and your intentions might be suspect. Your counter offer should reflect the terms available in the relevant market place so you can defend them if questioned by an auditor. Someone who borrows ?hard money? for six months at 18%/yr, and is charged 6 points upfront is paying over 30% in interest. 18% and 6 points are not uncommon in the hard money marketplace.

You understand that the seller is taking a risk by doing a no-down payment loan, so you offer to pay 17.634644? percent interest for the first thirty-six months. After three years, when you have proven yourself, you are justified in insisting that the loan rate drop to (in this example) 8% per year. In return for a reduced sales price, you agree to pay 3 loan points, 2.055918 points as a pre-payment penalty during the first four years, and to pre-pay $20,000 in interest at closing to be applied to your monthly payments. Though the trustee holds title, the seller will hold this pre-payment. You also agree to a ten-year balloon and a prohibition that prevents you from paying off he loan earlier than three years from settlement.

This is one form of wording that will document your intentions regarding the dual interest rate.

?? payable as follows: A $70,000 note with accumulative interest thereon at the rate of 17.634644 percent per annum during the first 36 months of the term, and 8.000000 percent thereafter and with $20,000 payable at closing to be applied proportionately during the term to the interest accruing. Payment shall be applied to all unpaid interest accrued since the last monthly payment.?

We?ll continue this illustration with an example of how and why to use side agreements with the seller that will endure after the sale escrow closes;

Still thinking that it would be a good idea to have a person with first-hand knowledge available on-call, while you are making your offer presentation you offer the seller a six-month property management contract contingent upon your purchase of his house. The fee you offer to pay is $1,500. Seller agrees to be available for ten hours a week for 20 weeks on an as-needed basis. You?ll call him when you have questions or need advice. The services he will provide, i.e., availability for prompt consultation, are spelled out in a contract separate from the purchase contract.

You also express concern that the seller will buy an investment property nearby, and steal his former tenants, who feel comfortable with him, away from you. An empty building would hinder your ability to repay the purchase money mortgage. He would get his building back and you would lose your money. Regardless of the seller?s reassurances, you don?t want to take a chance on his good intentions. To get the time that you feel is necessary for the tenants to get to know you, you offer him $5,000 for a covenant-not-to-compete within a one-half mile radius of the property for a term of 10 months. You might even be willing to reduce the area to a one-quarter mile radius if the subject property is in a densely populated area. You will let him know that you are relying upon him to honor this agreement since you are not going to do a search for nearby properties that he owns.

After a little more explanation of the final outcome of this negotiation process, the seller accepts your counter-offer; both of you mutually agree on the terms of the management contract; and the various documents are signed.

All right, now. So what has happened?

When the seller made his first demand for a 30% down payment in his initial request, at the close he would have received; $30,000 in cash; a $70,000 note for 30 years at 8.00% interest with monthly payments of $513.64/month; and a balloon payment of $61,407.29 paid concurrently with the 120th payment.

By accepting your counter offer, at the close he will receive: $2,100 in loan points; $20,000 in pre-paid interest; $1,500 management fee; $5,000 for the non-compete; and a note for $70,000 with monthly payments of $1,069.19 per month for 36 months and then $513.64 until a balloon payment of $61,407.29 is due at the end of the tenth year. If you can only make payments of $513.64 throughout the entire period of the loan because the property won?t support more, or you have other plans for the money, the interest that is due will be deducted from the amount the seller is holding that was pre-paid at closing. If this is the case, and you make monthly payments of $1,069.19 per month by paying the $513.64 that you can afford and allowing the remainder to be credited to the pre-paid interest, at the end of the first 36 months the pre-paid interest account is exhausted. Luckily, the payments drop to $513.64 in the next month. By now you may be tired of paying all this money, and choose to refinance to pay off the seller?s loan at the end of the third year. You would owe him a pre-payment penalty of 2.055918 percent of the balance of $68,096.11, or $1400.

So the seller?s cash receipts are $2100+$20,000+$1500+$5,000 in the first year plus a possible $1400 if you pay off the loan amount at the end of 36 months, or a total of $30,000 in cash. In addition he will receive a cash payment of $513.64 every month. If the loan continues through term, his 10-yr balloon is $61,407.29

Isn?t it funny how things work out even though we negotiated each term separately? He got what he was asking.

What about you?

Well, points are considered interest and deductible. So is the pre-payment penalty. The $20,000 is deductible over a three-year period because it was used to pay interest that was due. The side agreements are prorated over the time of the contract. $1500 divided by 5 months equals a $300 per month deduction. $5000 divided by 10 months equals $500 per month. This is on top of the deductions you would normally associate with this property. These items are an expense. Your depreciable basis in the building is reduced when compared with the seller?s first offer because you paid 30% less for the house ($70K vs. $100K).

The $30,000 in write-offs might save you or money partner $9,000 to $12,000 in taxes. Again, it won?t turn a bad deal good. It will help a fair one get better. A cash cow that you are seeking as a potential partner will respond much more favorably to ?Give me $30,000, and you can deduct it legally? than he or she would to ?Give me $30,000.?

This sounds a lot more complicated than it is in real-life. Your offer doesn?t have to be exact, or match the seller?s pre-conceived ideas to the penny. This is one of the formulas that I have programmed into the HP19b II, so I don?t have to think about it when I?m responding to a seller?s comments. It?s easy to implement this if all you have to do is fill in the blanks. I just punch in the target numbers and copy the interest rate from the calculator to the space in the contract providing for dual interest rates.

Should you not wish to rewrite the contract for purchasing real estate that you personally use, you can write up a bunch of clauses in a check-the-box addendum. The seller only has to ?Press hard? a few extra times.

In the early 1980?s, I read a book titled, ?How to Write-Off Your Down Payment? by Nelson E. Brestoff. The ideas that were given in that book formed the original basis for many of the peculiar offers that I make today. My offers get more peculiar every year.

It?s just one more ingredient in the mix.?

CFD’s, Sub 2’s and wrap’s … oh my! - Posted by Tray Giddens, Houston

Posted by Tray Giddens, Houston on August 17, 2003 at 12:37:21:

i’ve been reading some of the archived posts on here regarding the CFD in Texas.

The major objections that i have gleened from reading these posts is that under the 2001 revisions there are merely mandated disclosures (such as is the water and sewer provided by city or well service), Financing disclosures which have to be met once a year, and providing a rudamentary Truth in Lending statement up front.
beyond that, the reforms provide for some buyer protections in the event the CFD is not paid off within 48 months with regard to breach of the CFD.

looking at it , it seems to me that being a buyer on a CFD is not a bad deal As long as there are provisions to prevent additional leins from being placed on the property…there’s the rub, you do not have the deed so what device do you use to prohibit future liens on your interest in the property

now , if i take the CFD method and compare the lease/option method. the difference seems to be very fine if at all…actually the only differences i see for non performance of the delivery of the deed are that the law allows for severe Statutory penalties for violations of the cfd .

when you look at cfd , lease purchase, sub2 and wraps there are strengths and weaknesses for all of these on the buyer and seller positions…

so, with that being said, the wife wants a 5 year old house or newer, we’re selling the current older one. we will have a little bit of scratch to play with. which of the above methods would you use if you were looking for your residence for the next 3-5 years?.. i’m a realtor and i can find motivated sellers in the area i want with the type of house i want, it’s the approach on the short term financing i’m curious about.

i deal with some people who do sub2’s… but then again ,aren’t all of these financing methods in practice subject 2 the existing mortgage? so, if that’s the case, i’m going to be taking a chance with the sellers DOS any way, so why not get the deed up front. so that throws out the lease option and the CFD as a most beneficial option , right?

o.k., with more thinking out loud, i know that on the mls we’ve got a financing option of “wrap” for searches and what not but not Sub-2… therefore , the question is begged, why bother with creating an additional note if the sellers only want to move or otherwise can’t make the payments? would the wrap then only be worthwhile if they wanted additional money for the home over the sellers financed amount. if that is the case, why not add a second lien on top of the original lien amount for the difference only, instead of wrapping the whole thing…?

some input or guidance on this matter would be greatly appreciated…

Tray Giddens

Re: CFD’s, Sub 2’s and wrap’s … oh my! - Posted by Brent_IL

Posted by Brent_IL on August 17, 2003 at 20:23:48:

As a buyer, you can use a wrap to adjust the deductable allocations and deductions to accelerate write-off’s into the current or close-by year. An early deduction is of more value than one that is spread out over a number of years.

Re: CFD’s, Sub 2’s and wrap’s … oh my! - Posted by Ronald * Starr(in No CA)

Posted by Ronald * Starr(in No CA) on August 17, 2003 at 14:49:20:

Tray Giddens–(TX)--------------

Won’t it be easier just to convince your wife to stay where you are?

Note, I am not an attorney. You might want to consult one in your area to be sure of what is the best way for you to go.

The CFD can be used when there is no financing to be assumed or take subject to. Of course, with newer houses, such as you mention, that is probably not very common.

The use of a wrap as opposed to just putting on a second loan. The issue is usually one of interest rate on the first loan. If you are a seller and there is a low-interest loan on the poroperty, you can get an “override” on that loan by writing a new “all-inclusive-deed of trust” or wrap around loan at a higher interest rate than the existing loan. Example: Sales price $200K, first loan $100K at 6%. You get $50K downpayment, create a wrap loan for $150K at 8% interest. Now you are getting 8% on the $50K of equity you left in the note, plus you are getting $2$ interest on the $100K of the first loan still in the note. Increases you income by about $2K a year. Thus you are getting $2K + 8% X $50K = $6K on the equity you left in the deal. That makes your effective rate of return 12% approximately. I say approximately, because there is also a difference in the amount of money going to amortize that initial $100K. The 6% rate to the lender is paying off faster than the 8% rate to you. So, when the owner resells and the first loan is paid off, you get more of the cash out.

I agree with you, it is better to get the deed. Subject tos can be risky because of the due on sale clause. If you go that way, I recommend hiding from the lender that the property has sold, using a land trust probably.

It seems to me that a deed and deed of trust back is better than a CFD. However, I don’t know enough about TX law to be sure. In some states the CFD can be foreclosed on or nullified much faster than the foreclosure on a deed of trust or mortgage. As a buyer, this is probably not what you want.

Good BuyingRon Starr*

I’m trying to locate an old post. - NTXT - Posted by Brent_IL

Posted by Brent_IL on August 20, 2003 at 10:46:30:


Can you give an example? - Posted by Lin (OR)

Posted by Lin (OR) on August 20, 2003 at 10:09:04:

Could you elaborate a bit and maybe give an example? I’m very interested in what you’re saying, but I don’t quite follow.