Seller Financing - Older Sellers
Often, acquiring real estate depends on overcoming the unvoiced objections of the sellers. In other words, you must read minds to figure out the problem, and then solve the problem. This article addresses one such situation.
Many older sellers are unwilling to sell because they want to take advantage of stepped up basis upon their death.
In case you do not know how this works, here is the explanation. Suppose Edna owns a piece of real estate with a "basis" of $10,000. Basis is an income tax concept. Usually, it is the original purchase price, plus any capital improvements, minus depreciation deductions taken over the years. If Edna sells that real estate for $150,000, she will owe taxes on $140,000. That is sales price of $150,000 minus basis of $10,000.
If Edna gives the property to a grandson Noah, and then Noah sells it, he will owe taxes on $140,000. That is because gift recipients have what is called "carryover basis." Noah's basis, for purposes of calculating taxable gain, is the same as Edna's basis.
When someone dies, however, the recipients of the property can take advantage of something called "stepped-up basis." The property is valued either as of the date or death, or a date six months later. The executor chooses which date to use. In a time of rapidly rising real estate prices, or if the property is under construction, the later date might be used. Whatever the value on that date, THAT will be the basis for the heir.
Suppose Edna died and left the property to Noah in her will. Noah immediately sells the property for $150,000. Most likely, the fair market value is also $150,000. That would give a FMV of $150,000, a basis of $150,000, and a sales price of $150,000. There is no taxable gain on that transaction. Sales price of $150,000 minus basis of $150,000 equals $0 gain.
Which brings us to older real estate owners. Many times they want to hang on to their property so their heirs can get the stepped up basis. But, often those same people can no longer manage their properties, so the values decline due to deferred maintenance and/or vacancies. They also have a need for some type of supplemental monthly income. Those owners are caught between a rock and a hard place.
You can acquire the property, and meet their concerns, with a simple owner financed style of transaction. It requires that you lease the property under a long term lease with several renewal options, with an option to purchase the property upon the owner's death. You should adjust the lease payments to reflect the tax benefits of the depreciation deductions the owner will enjoy and you will not be able to take until you buy the property.
BUT, any rehab expenditures you do can be depreciated by you. It's just the original improvements that can be depreciated only by the owner.
If you can explain this to older sellers, you will meet with greater success in buying properties.
Comments (6)
Structured properly, it works. I am not suggesting you do it as a seller.
Denise Evans, over 7 years ago
@Jeff Rabinowitz, You decide on a purchase price at the time of the agreement, not in the future. It is the FMV at that time. The lease payments after that are simply for the use of the property and the ability to sublease it to someone else and make money on the spread.
Certainly there should be annual escalators in the lease, but it should NOT be tied to the value of the property. That is because your efforts in maintaining the property and keeping tenants in place (or using it yourself) is a large component of the value. It would be unfair for your lease payments to go up every year because of your own efforts. The escalator should be a certain fixed percentage or the cost of living increase/decrease, whichever is smaller. These are matters of negotiation. If you are familiar with Rabkin and Johnson's Transaction Guides, or the Southeastern Transaction Guides, or similar volumes of legal books for other parts of the country, they include check lists of negotiating points for these types of transactions. You seem to be from Michigan. Your comparable set of books is the Midwest Transaction Guides. Virtually any law school library has them. You can ask the reference desk for help in finding the right section, and then photocopy the pages you need.
Denise Evans, over 7 years ago
It seems foolish for a seller to agree to lock in a purchase price at today's value 10 or more years (an indefinite time) in the future. Lease payments rise over time because of inflation--money is worth less over time. It seems foolish for anyone to lock in a lease price for an indefinite time. Your strategy will give the seller's heirs the stepped up basis at the seller's death but at a great present cost to the sellers.
Jeff Rabinowitz, over 7 years ago
I don't think you need an official appraisal, but I might be wrong. The instructions for Form 706 say, simply, "Explain how the reported values were determined and attach copies of any appraisals." That makes it sound like you could use some other method of valuing the property. An appraisal is safest, because it is less likely to be attacked by the IRS if there is an audit.
From advice on Inman.com, they say: "The IRS will accept a professional appraisal, local property tax assessor’s assessed value, insurance replacement cost, or other documented valuation. The best method is usually a professional appraisal, which typically costs $300 to $500."
IRS Publication 551 makes no mention of an appraisal. It says, simply: The basis of property inherited from a decedent is generally one of the following.
If a federal estate tax return does not have to be filed, your basis in the inherited property is its appraised value at the date of death for state inheritance or transmission taxes.
For more information, see the Instructions for Form 706."
Form 706 uses appraised values in its examples, but does not say anything about an appraisal being necessary for normal stepped up basis. It is required for some funky things like alternate valuations or conservation easements. This might be a question for an estate attorney or accountant.
Regarding disputes in valuation, I think as long as you have one appraisal that was not "made to order" but was independent, that is enough. I do not think the IRS would dispute a valuation unless it were obviously fraudulent. Such as, you value 15 acres of vacant land in the middle of nowhere at $20 a foot ($871,200 per acre) instead of the $6,000 per acre that nearby pasture land was selling for. Nine years later when subdivisions move into the area and you can sell the land to Target for $20 a foot, or $13,068,000, you report no taxable gain because of stepped up basis. That would certainly invite IRS scrutiny and an attack on the valuation. Unless, of course, your valuation was done in November 2007, then the real estate markets crashed and there was no more development, and then you finally sold the property in 2016 to Target. In which case, your $20 per foot valuation on date of death would be a legitimate and reasonable value at that time.
Denise Evans, over 7 years ago
I am not questioning how one determines the value for the IRS. I am wondering how you would determine a fair price for a purchase that may be a decade or more past the date the lease agreement is signed.
Also, does the lease agreement include an escalator clause? Does the lease amount increase periodically? Is the lease price tied to the cost of living, prevailing rates or the value of the property? Otherwise, that lease amount is likely to be woefully under market in several years and the seller's will be shortchanged.
Jeff Rabinowitz, over 7 years ago
How do you generally determine the purchase price at the owner's death? Is it by appraisal? If so, who chooses the appraiser? Appraisals can vary widely. Do you specify an average of two or several appraisals, one chosen by the purchaser and one by the heirs? How are disputes in the valuation handled?
Jeff Rabinowitz, over 7 years ago