Definancing Bad Debt to Salvage Your Equity

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Topics: Financing

 De-financing” is a term that describes the process of reducing debt and increasing cash flow without the need for cash. Let me give you an illustration. In the last housing downturn, I had a “keeper” house that only had about 5 years remaining on a 5.5% loan. It was worth about $100,000. I also had 8 other houses that had similar loans with balances ranging between $8,000 and $12,000. The mortgage department of a single lender who had retained these loans in its portfolio had been shut down by bank regulators because of growing loan defaults. They were continuing to service all these loans even though the revenue from interest was minimal.

I approached the bank and offered to pay off 8 of these loans if they would agree to refinance the $100,000 house for enough to pay them off. Even though they were forbidden to originate any new loans, they agree to substitute collateral on eight of the houses with a single 9% loan on the one with the largest equity. In this single stroke, the bank paid off and eliminated all the loan servicing overhead on 8 mortgages and refinanced its 5.5% loan portfolio with a loan of equal magnitude paying 9%.

On the other hand, I freed and cleared 8 houses by loading all the debt onto a single house. I immediately sold this into the market by kicking the price up a little and offering seller financing on a wrap around loan to a buyer who could come up with $3000. My cash flow went from just a few hundred dollars a month to over $2000 in a market where others were being driven into bankruptcy.

Today, because of changes in the tax laws and appreciated values, it’s even easier to accomplish this maneuver. One person I know sold his primary personal residence for $325,000 and used the tax-free proceeds from the sale to pay off 20 low mortgages. He then proceeded to buy a distressed house for $415,000 with 100% bank financing.

As an owner-occupant a high income from his rents, and with a credit score in the 700s, he was able to get 100% financing on his new 5.75% fixed rate loan. When the smoke cleared, he had upgraded his life-style by moving into a finer home. He’d sold his old home tax free and used the proceeds to free and clear 20 houses. With this single maneuver, after subtracting his payments on his new home, his net cash flow increased by $87,000 while he picked up almost $75,000 instant equity in his bargain priced new home.

Yet another way to de-finance debt and creating more equity is by selling your “losers” fast by discounting their prices. You can avoid taxes by having the sale proceeds placed into the hands of a qualified exchange intermediary while you go shopping for deeply discounted “keepers” in the foreclosure market. This way, you can dump a lot of debt and potentially troublesome properties and replace them with better properties. When I’ve done this, I’ve usually sold three losers and replaced them with two better keeper houses. It’s true; by doing this my net cash flow may have been reduced, but so would my management effort and risk. When the total mortgages paid off are no more than any new debt that is acquired in the exchange, there is not tax. To the extent that there is any net mortgage relief, this is taxed at low long term capital gain rates.

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