Options are an excellent way to obtain zero rate financing because they control an asset without any payment or interest other than the amount paid for the Option. It’s sometimes possible to get an Option without any payment at all. Aren’t listings, contingent contracts and non-recourse loans a form of Option, since the buyer can walk away without liability?
If I put up Mutual Fund shares as Option Consideration with the right to replace them with equivalent cash based upon current prices, haven’t I transferred the market risk to you on both house and stocks? I can make my contract subject to some contingency so I don’t have to close. If the stock goes up, I’ll sell it, giving you cash while keeping the profit. If it goes down, you’re stuck with the loss. I’ll close only if the property goes up. I get my deposit back if I don’t.
An Option is a marvelous tool that reduces risk while passing on to the holder most of the benefits that can be obtained from leveraged real estate. An Option can be used to pass on tax-free cash to a high-bracket seller, or to enable another seller to be able to cash out a personal primary residence tax free.
Options are ideal for building up tax free cash inside a Roth IRA which otherwise would be subject to tax if it invested in conventional debt leveraged assets. An Option can be used to extend the 45 day period allowed to identify a replacement property when doing a delayed tax free exchange. Options can also enable those who can’t find loans with which to buy property with a low down payment to nonetheless buy properties on the installment plan. Let’s take a closer look:
Anyone who sells a property within one year of its purchase pays ordinary income tax on the profit. Suppose a seller had an opportunity to sell a property for a quick windfall profit after owning it only 9 months. He wouldn’t want to turn down the offer, but would want to reap the benefit of the current 5% – 15% long term capital gains taxes rather than pay taxes in his ordinary income tax bracket.
Suppose, instead of selling the property itself, the seller sold an Option on it, then allowed the Optionee to close the Option only after a full year had passed. In this instance, he’d be able to receive the money tax free until the Option was exercised, and would only pay low capital gains tax on the sale. Alternatively, he could enter into a delayed Exchange and re-invest all sale proceeds tax free. That could be a real plus for market traders and real estate investors alike.
The same market timing strategy would apply to anyone who wanted to sell a primary personal residence that they had only lived in and owned for a period less than 2 years out of the most recent five years. In such case, a buyer could buy an Option, give them the Option money tax free; then complete the purchase and move in after the two year period had elapsed.
In special situations, such as where a home owner is selling a residence that he has bought under a lease/Option, he might have lived in the property for 2 years, but not actually owned it for two years. In this case, the owner might sell an Option to a buyer for a significant sum, and let him move in on a lease until the two years had expired. Both the Option consideration and the final payment would be tax free to the seller.
Pure Options can be purchased for cash or for management effort. They can be written to capture all or a portion of any price appreciation as well as loan amortization. The trouble with Roth IRAs is that it is difficult to accumulate much money from contributions and build up in values in any significant amount until several years have elapsed.
Suppose a Roth IRA custodian were to buy an Option on a house that was being rented by a non-related party in order to induce tire seller to lease the property rather than to sell it outright. The seller would receive tax-free Option consideration plus rent. The tenant would be able to enjoy a residence that might otherwise have been unavailable. The Roth IRA would have a highly leveraged investment with no risk. Let’s quantify this:
Assume a Roth IRA paid $10,000 for a 2-year Option to buy a $150,000 house that had recently been received in a property exchange by someone who didn’t like management. The Option would be conditional on an unrelated party, acceptable to the owner, paying $1200 per month rent for two years. Out of the rent, $100 per month would be credited toward the $140,000 Option strike price.
Let’s assume that house prices were rising at about 8% per year during this period. Each year the Roth IRA would see its equity In the Option grow by $1200 by virtue of the rental credit, and by $8000 through property appreciation. At the end of 2 years, the initial $10,000 investment would have grown to $18,400. That represents a 42% annual yield each year for two years.
Negotiating leases and Options require different approaches from buying and selling. When leasing, the best lease targets are people who have been unable to sell, or who are reluctant to place vacated properties on the market because of all the hassle. A vacant house can be a real burr under the blanket when payments must be made on it. So, the potential lessee would present himself or herself as a desirable, responsible long term tenant who would take good care of the property. One might even agree to pay rent payments annually in advance in return for a high discount.
Using the above $150,000 with a fair market rent of $1200 as an example, in a pure lease situation, the benefit to the lessee is in a cash flow spread between rent that is being receive from a sub¬-tenant and cash that must be paid out on the lease. The benefit to the owner is a hassle free, vacancy free, maintenance-free rental that he can write off while getting all the appreciation.
In a typical situation, the potential tenant would try to get 10% discount for paying the rent one year in advance. It could be pointed out to the owner that he could recover this discount easily in today’s stock market. Next, perhaps 5% additional discount could be negotiated for signing a five year lease. Just one month’s vacancy each year would be much more than that. Another 3% discount might be negotiated for taking care of all maintenance items under $100 per month, and as an override on any maintenance arranged on larger items. If you add all this up, the tenant winds up renting this house for 18% under market, or $984.00 per month.
Let’s assume that market rents on the sub-lease could be increased by 5% per year; the first years net rental spread would be $2592. The second year the annual rents would rise by $1200 and the spread would increase to $3312. The third year the spread would be $4068; the fourth $4860, and the fifth year, the tenant would be receiving over $475 per month for doing little more than managing one rental house. Do you suppose a person could manage more than one rental house?
Of course, in the real world, none of these number would work out. There would be expenses, vacancies, etc. On the other hand, if, as is spelled out in the rental agreement previously covered, many of these expenses were passed along to the tenant, it would be a very worthwhile endeavor for someone trying to find cash to feed a highly leveraged cash flow property. The monthly cash flow could pay for several Options too.
Options without leases are an ideal tool for relieving an owner’s cash flow squeeze when he doesn’t want to sell his property, or wants to move out and rent it. Using the above $150,000 house again, suppose the original loan dating back several years had been for $100,000 at 8% for 30 years and the current monthly payments were $733.36 plus taxes and insurance. Suddenly, the breadwinner is laid off and there’s no money in reserve to make the payments to protect the $75,000 equity.
A reasonable proposition would be to provide one third of the total payment each month for two years in return for one third of the equity. Thus, for about $300 per month for 24 months, or $7200, the Optionee would, using an Option strategy, be able to leverage into a $25,000 net equity without any management chores at all. Not a bad spot for the Roth IRA at all.
When you combine a lease/sub-lease sandwich with an Option in which a credit is given against the Option price for each payment, then the sub-lessee is actually buying the Option for you. There is a negative cost in this investment. There is nothing quite like this anywhere else in the investment world. Each payment that is credited against the ultimate cost has the same effect as any principal loan payment made to amortize a mortgage, but with a major difference. Option payments “amortize” at a much faster pace. Here’s what I mean:
Options are the ultimate OPM strategy. If you were to buy a $150,000 house with a 10% down payment, it would cost $15,000 down, plus closing costs. Payments on the $135,000 balance over 30 years would be $990.58 plus taxes and insurance. At the end of 5 years, you would still owe $128,344 on your loan after having paid in a total of about $59,435.
On the other hand, suppose you had made exactly the same payment on a lease/Option, but had negotiated a credit equal to 25% of each rental payment? First of all, other than your lease deposit, you would have made no down payment at all. Secondly, over the same 5-year period, almost $15,000 would have been credited against the purchase price. Best of all, this would have been paid by your tenant, not by you.
The only problem with this arithmetic is that the rental market could weaken, leaving you with a $990.58 payment to make each month you experienced a vacancy. Over 5 years, you could wind up paying a lot of money for this lease out of your own pockets. One way to limit your risk is to write your lease/Option for one year, with an Option to renew it each year for the next four successive years.
This way, you would only be liable for, vacancies that occurred in each year that you elected to renew the lease/Option. Of course, anytime you tired of leasing the property. you could either sell the lease to another entrepreneur who wanted the growing cash flow spread generated by rent raises; or sell the Option to a passive investor based upon the growing equity. You might sell half of the Option to the investor for cash flow, and keep half as your own investment. Or, you could simply exercise the Option and simultaneously sell the house itself to capture your growing equity.
Lease terms can transfer negative cash flow and risk from the owner to the lessee, while using the tax code to help both of you. A person who is already experiencing negative cash flow because he can’t or won’t manage a rental would be desperate to have another person come along and alleviate the problem. His only cost would be a share of future sale proceeds, and that wouldn’t seem very important weighed against current cash flow needs.
He’d have no vacancy, no management, all the tax benefits, and cash from the rents to help him make his payments. On the other hand, the lease/Option presents an outstanding opportunity for the entrepreneur who is able to garner equity through both the appreciation of the property and rental credits given against the Option price. It would be difficult to come up with a better arrangement.
Where do you find house owners who would be motivated to enter into this kind of arrangement? To locate motivated sellers, mine the newspaper ads for people willing to carry back installment payments and convert them to lease/Options. Prowl the neighborhoods looking for vacant houses. Scour the courthouse for eviction notices. The owner of a rental who has to evict a tenant is about as disenchanted with the rental house business as he’ll ever be, and as willing as he’ll ever be to hear your proposition.
If you’ve already got a source of cash for payments, you can offer additional cash flow in return for a much greater Option credit to solve cash flow problems for an owner who needs more money. In the above illustration on the $150,000 house with a $75,000 balance, instead of simply making the loan $990.58 payments for the owner, suppose you offered $1500 per month with an Option credit equal to 125% of the payment?
Let’s suppose that you were only able to rent this property for $1200 per month. Each month, you would be paying out $300 in negative cash flow, but getting a credit of $1875. This translates to a return of $22,500 each year against the purchase price at a cost to you of $3600. That boils down to a yield of 625% on you’re invested cash, taxed as capital gain, that you would realize when you sold the Option after a couple of years.
Hold on, this book is about creating positive cash flow, not negative cash flow. The solution would be to sell half of your Option to a private investor (Dare I mention Roth IRA?) who would be delighted to pay the negative for only a mere 100% return, leaving you with the remaining $17,300 in Option credit each year. The key is to find the person who needs this kind of deal.
Divorces present a rich source of Option opportunities. In a typical situation, when a household breaks up, the equity in the house is divided in such a way that the mother keeps possession while the father pays alimony and child supports. Quite often, there simply isn’t enough money to provide much of a life style for either party, thus, alimony payments to the mother become very unreliable.
Your solution is to get both parties to agree to an Option in which tax-free payments will be received by the mother with which to make house payments, and credited against the purchase price in lieu of alimony or child support payments paid by the husband. This technique solves a real financial problem for both spouses, as well as their children. And, with an appropriate percentage credited by the Optionee against the purchase price, it can be extremely profitable for him or her.
| From Jack Miller’s Money Matters Recorded Seminar which includes 23 videos, 14 audios, the workbook and an audio book of the workbook.
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