Art Of The Deal – Equity Stretchers

Topics: Deal Stories

Where do you find profitable loans once needed cash has been located that you can use? Let me tell you about one situation.

It was 8 A. M. on a Friday when the middle aged couple came into my office with their sad story. After having made payments for 15 years on a parcel of ground, and obtained all the zoning up-grades and permits to start construction, they'd fallen on hard times and had allowed their mortgage loan to go into default. The bank was foreclosing within hours and it would take $50,000 in cash to pay off the loan and prevent the foreclosure.

A quick call to the bank confirmed their story, and the condition of the title to the land. The bank's attorney had also had an appraisal done which he FAXed to me along with his title search. The land was worth $400,000. All we had to settle were the loan terms. As I explained to the couple, I don't like to make loans; I like to buy property.

Rather than lend them money, I proposed an exchange whereby I would trade them two free and clear houses with a retail value of $140,000 plus $50,000 for their land if they would deliver it free and clear. In return, they could retain an Option to purchase half of it at their cost basis; provided that they found a cash buyer for the entire parcel.

The alternative seemed clear. Either they paid the banker off or they lost everything. If we completed the exchange, they'd salvage half of their equity with the cash and the two free and clear houses which they could either rent for income, or sell for cash, to meet other payments. And they'd also have an Option under the terms of which they could preserve the other half of the property's value. Furthermore, everything would be free and clear of all debt.

We balanced the equities in the exchange by letting them retain the above Option to buy a portion of their land back, but only if they could sell it all to a developer. Until that date arrived, to keep them hot on the trail of a buyer, the value of their Option was reduced by 1.5% per month and the value of my interest in the property increased by a like amount. (The equivalent of 1.5% per month compound yield on my investment.) Thus, the sooner they sold the property, the more they'd realize.

We made the deal, and in due time I received a recorded deed and title policy as agreed with the bank's attorney. What's so fancy about this little deal? Let's start with the two houses: These had been written down under ERTA over 15 years and were completely out of depreciation.

They were located 85 miles from me, and my manager had quit a month before. They had appreciated considerably. I didn't want to carry long term financing on an installment sale; and I was reluctant to share any of my substantial gain with either the FHA or VA lenders, or with the IRS.

When I added these houses to the deal to increase my portion of the land, my appreciated house equities gave me a bigger un-taxed slice of the pie which I'd realize in a future cash sale. Furthermore, if the land continued to appreciate faster than the houses had, I'd also have leveraged myself into an express escalator that had the potential to generate a larger profit than the houses, with a lot less effort.

By structuring the deal as an exchange, I avoided a lot of sale expense and taxes on my gain; and still received full retail fair market value for my houses. By adding cash to pay off the existing loan on the lot, I was able to free and clear it and avoid having to compete with other investors to buy it with a lot more cash at the foreclosure sale.

When we divided the equity through the use of the Option, to the extent that they'd oversold me on the quick sale potential of the property, if things dragged on very long, they'd reward me by giving up 1.5% in additional equity based on their portion of the Option .

Had I merely loaned them the money they needed, wrapping the two houses into the transaction, interest accruing on the loan would have been taxable to me as ordinary income. By structuring the transaction as an exchange, I saved taxes on the profits a straight sale would have produced. Best of all, my profits will get the benefit of 15% long term capital gains rates when I'm paid back.

This wasn't all one-sided. My purchase of the property enabled the tapped-out lot-sellers to protect an otherwise clean credit record. They wound up owning free and clear rental house equities that they couldn't lose simply because of their temporary loss of income. They had the choice of retaining these for rental income, selling them for cash, or borrowing against them as needed.

Despite the fact that any delay in finding a cash buyer for the property would cost them 1.5% per month of the total exchange equity value; their equity was still increasing because the land continued to appreciate rapidly in value as surrounding development boomed. Both of our interests in the property were continuing to become more valuable with each passing day.

To learn more, see the Art of the Deal Home Study Course

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