When there is plenty of loan money around, those who build houses, or who buy them to fix up for resale simply sell them to people who can get financing for them, and pay tax on the cash received. On the other hand, when both acquisition and take-out financing dries up, about the only way to stay in business is with private financing from investors, hard money loans, or creative financing. All of these dry up profits and increase risk to the person trying to make money as a dealer.
Before a house can be sold, it has to be bought; and for most people, this requires credit. The most logical source of private financing is from the seller who is trying to sell a house. I made a fortune buying houses with a combination of “subject to” financing and the existing financing. My profit was made by selling these houses on Installment Contracts with a spread between what I paid for them and what I sold them for; and also a spread between the interest rates and monthly payments I had to pay and that I required of those who paid me. That was then, and this is now; and the tax law pretty much eliminates doing business this way.
Now, when a dealer sells something and provides carry-back financing, he is taxed as if he had received all his profit in cash based upon the face value of the Note he carries back. Thus, he pays tax today in cash for profit that he might not receive for years.
As a practical matter, after he has paid his taxes, if the loan goes into default and he gets the property back, he doesn’t get his taxes refunded; he merely adjusts his basis in the property upward by the amount of the taxes paid.
By using leases and Options, dealers can still buy and sell with private financing without incurring the problem with installment sales.
Starting with acquisition, here are some ideas of how this might be accomplished:
Tom bought houses to fix up and resell. For example, if he customarily paid $65,000 for an un-rentable, vacant, run down fixer into which he would invest $20,000 to bring it up to a retail fair market value of $119,950. He raised the $65,000 from an investor or Roth IRA.
It would buy the property in a Land Trust, naming Tom the Trustee. Tom would use his own funds to fix up the property, sell it, and in the same escrow, buy it from the Trust for 15% more than the Trust paid for it, and have it deeded directly to the buyer. In the foregoing, Tom made about $30,000 net profit after costs of rehab and marketing. Out of this he paid $9750 in profit to the Trust on behalf of the investor, and netted about $20,000. By turning a house around every 90 days, Tom was making $80,000 a year.
Admittedly, in most retail markets, this is right at the bottom of the economic pile where most buyers have “bruised” credit, but in the permissive pre-Sub Prime credit markets, they were able to get low down payment loans.
When credit dried up for rehabbers, so did the investors. Tom continued to buy and fix up fewer houses using his own funds and selling them for cash. He was limited to about one house every 6 months because of the lack of funds, and his income shrank to about $50,000 per year even without having to pay an investor for the use of his cash. Then, starting with HUD, lenders began to impose “seasoning” requirements.
In most cases, in order to get a loan for a buyer so they could reap their full profit on a house that has been bought for resale, the dealer had to have held it for a year prior to selling it. That brought Tom to a standstill. Even with seller financing, without a cash take-out buyer, Tom couldn’t doing business as he had before. He had to make a change. Here’s what he did.
Tom stopped buying houses to fix up. Instead of using scarce funds to buy the houses, he began leasing them with an Option to buy at the pre-fixup value. His lease incorporated terms that allowed him to fix up the premises, but not to occupy the property until it has been fixed up enough to pass minimum housing and Landlord/Tenant law requirements. This is because most of the houses he bought at prices far below their eventual retail value were too far gone to occupy. Now the plot thickens:
We’ve previously covered Contract for Options. Tom doesn’t sell his fixed up house, he leases it to a qualified tenant and sells an Option to Buy on a Contract for Option. How is this different from selling a house on a contract? First of all, if a lease/Option tenant defaults on a lease, its much cheaper, easier, and faster, to evict to remove him than it would be to foreclose. Second, Tom is admittedly an dealer in houses, but he’s not a dealer in Options; so he can sell his Option on installments and pay his taxes as the money comes in.
But wait a minute. What about the owner of the house who has leased it to Tom. Tom continues to pay him rent as agreed in the lease; but he has no obligation to close his own Option until his own buyer can get a loan and cash everybody out. The net result is that Tom can ramp up his operations to their prior level, but at a much lower cash cost. Although he doesn’t get much cash to recycle into the market, he does have a growing income stream to fund future operations.