We’ve all seen those red knives with the Swiss cross on them. They’ve got multiple blades, tools, even scissors to cover every possible situation. They’re easy to use, and readily available to anyone who might want to have one. The same thing can be said of real estate Options. Options can be used in virtually every real estate situation. Often, they’re the best possible choice. I’ll elaborate on why you need to understand and use Options. In only four pages, I can only scratch the surface of the ways Options can be used, so I’ll limit their exposition to five situations: Used creatively, Options can do the following:
1. Create maximum safe leverage and to hedge against an uncertain future.
2. Generate tax-free income and cash for years.
3. Act as an extremely private source of wealth that can‘t be liened.
4. Act as a timing device to make income and residential property sales tax-free.
5. Transfer assets to reduce the costs of estate appraisals and taxes.
If I’ve got your attention, allow me to elaborate: Options are intangible rights that can be conveyed between Optionors and Optionees. They are created by a legally enforceable unilateral agreement. If this is “assignable”, the holder can make a surprising amount of money with only minimal investment in a property. For example, a few months ago, a Broker showed a $200,000 house to a rehabber. He contracted to buy it with $1000 down. The balance was to be paid once the property had been inspected for lead paint, asbestos, and toxic mould. Within two hours, before his $1000 check had even reached the escrow company, he had “sold” his contract to another speculator for $5,000. He could have probably doubled that amount if he’d been willing to spend more time and money to market his Option position.
Options can be oral, but, in the case of real estate interests, in order to be legally enforceable, they must be in written form in accordance with the laws of the State where the Optioned real estate is situated. Options can be written as a First-Right-of-Refusal Option giving a buyer a right to buy only if the owner of a property offers the optioned property for sale. They can incorporate a pricing mechanism that tracks inflation, mortgage amortization, and interest rates for the benefit of either the seller or the buyer.
When recorded, Options can cloud title to property, but they are not in the chain of title; therefore, an Option position must be protected against subsequent liens that might attach to a property under Option. Options can be easily secured two ways: By having transferring title to optioned property to a neutral entity or a Trustee. Or by recording a Mortgage or Deed of Trust against the Optioned property to assure that the Option will be honored as written. Options can be used in conjunction with leases to convey rights of use, possession, and occupancy from a seller, or as stand-alone contracts which transfer amortization of debt and property appreciation to a buyer, but not use, possession, or occupancy. Having given you that short tour of Options, let’s look at the way we can use them:
LEVERAGE AND HEDGING: Options are ideal both for people without much money to pay down on a property; and for well-heeled cautious investors who want maximum leverage with minimum risk. A typical Purchase Option looks ahead to a possible future event to “tie up” a property for a tiny fraction its value. This gives the buyer time to either make things happen that will increase the value of the Option, or let them happen on their own. Speculators can hedge their risk by entering into an Option to buy a property that they think has future upside potential. On long-term Options, price and terms can be pinned down well ahead of sale closing, but the contract can be abandoned if (i.e.) re-zoning of a property isn’t approved; or construction of future roads that open up land to development can’t be funded; or any unforeseen event happens — or fails to happen.
TAX-FREE INCOME AND CASH CAN CREATE HIGH YIELDS
At various points in everyone’s life, the need for more income and/or cash arises. More often than not, this is when the would-be borrower discovers that his credit score is attractive only to voracious lenders. Paying high rates of interest to raise cash with which to consolidate payments or to pay down debt amounts to digging a financial grave with a silver shovel. The best way to get out of debt is to sell something and use the sale proceeds to retire debt. This pre-supposes that the financially pressured party has assets to sell other than his primary residence. For many people, selling a primary residence is a difficult choice because of the disruption in family life. This situation is where an Option shines.
Let’s take a closer look: In our first situation, let‘s say that a cash-poor landlord investor is hanging on by the skin of his teeth to a rental with a retail value of $150,000. The balance on his 5.5% loan is $100,000. It needs a $10,000 roof. His income is barely at a “break even” point. If he refinances the house to raise the money, he won’t be able to make payments on more higher-rate debt. His situation may confront many owners whose ARM loans are indexing upward.
He could try to sell the house, but he has several problems: It will be difficult to attract a retail buyer to a house in need of major repair. He can expect to receive only a fraction of the value of the property if he sells it to another landlord who must fix it up in order to rent it. In any event, if he sells the property to raise cash, the sale proceeds will be shrunken by closing costs, transfer fees, and capital gain taxes.
On the other hand, what might be the result if, instead of borrowing more money or selling his house, he sold a 10-year purchase Option on the property to an investor’s self-directed Roth IRA at today‘s full retail price, with the Option consideration to be credited against the down payment when the Option is exercised. The cash consideration given for the Option will be tax free until the Option is either exercised or abandoned. Although he will be giving up all or part of all future appreciation, he’ll be able to continue to receive income and to get the benefit of any loan amortization until the Option if exercised. The Investor will have a management-free investment which will generate high returns. If he becomes impatient, he can sell his Option contract anytime he can find a buyer for it.
An identical financial situation with a home-owner is similar, but the tax effects are not the same. Where a landlord who sells a house must pay tax on the Option advance as a part of the selling price when the house is sold, the homeowner has no such problem — so long as the total profit doesn’t exceed $250,000 per spouse. But, there could be social problems the investor need not worry about. Selling a homestead means having to relocate the family; possibly to less desirable quarters in a less desirable neighborhood. It might create problems with commuting and car-pooling, getting kids back and forth to school, and rob family life of many of its joys. By selling an Option on the home, the family stays put and in most instances there will be no tax ramifications at all when the house is sold and the sale proceeds divvied up, or if the Option is bought back by the homeowner.
What’s in the deal for the investor who puts up $10,000? First of all, in either case, he has a long-term, highly leveraged, management-free investment. What will the Option yield to his IRA? Let’s guess: Suppose for the next 10 years the $150,000 house appreciated at 5% per year in its very conservative area. Without regard to any amortization of the mortgage loan, the equity above the loan in the house at the end of 10 years will be $144,334. Fifty thousand less the initial $10,000 would go to the house seller. The Roth IRA would get $104,334 . That boils down to an annual compound investment return of over 26% without any effort at all.
The unique tax advantages of Options enable a high-bracket Optionor to reap tax-free cash while reducing debt. They make it possible for an IRA to reap very high tax-free yields. Even tax-paying investors only pay 5% – 15% in tax on profit if the Option is sold to a 3rd party or bought back by the seller later on.
LOW-PROFILE PRIVATE WEALTH
For several reasons, people who own a lot of rental real estate run much higher liability risks than those whose investment portfolios consist of cash, stocks, and bonds. For one thing, most real estate is leveraged with personal recourse debt. A loan default could lead to a deficiency judgment that would attach to all other personal assets. Another source of liability stems from the basic fact that any injury to tenants, their children, their invited guests, or anybody they hire to work on the property creates liability for the owner of record. There are myriad threats to equity value posed by unpaid zoning and code enforcement liens, tenant water and sewer bills, neighborhood association dues, other utilities, etc.
In the legal pecking order, most property liens will come ahead of a purchase Option. When a significant sum has been paid for an Option, one needs to protect the value of the Option interest. When possible, have a property owner place property into Trust with an independent Trustee or LLC rather than leaving title in individual name. Then, to further protect the Option, a Mortgage or Deed of Trust in the full amount of the estimated future value of the Option can be signed by the Trustee naming the Option-holder as the secured party. Recording this in the public records would create a prior lien in the chain of title that the Option alone can’t. It would precede most liens that might be filed subsequently.
The foregoing would protect the Optionee’s interest from incidents affecting optioned property, but what would happen if the Option holder were the subject of a million dollar law suit which resulted in a General Judgment Lien being filed against him? Personal liens are created when a judgment has been rendered against an individual and recorded in the public records. At that point, the judgment clouds the title to all real estate held in his name in any county where it was recorded. It would not attach to property that the Optionee held an Option, nor to any property or Option held in Trust under the name of a Trustee.
Legal pundits are quick to point out that a Trust alone doesn’t offer much protection for property, but that presumes that (a) the Trustee would be domiciled in the same legal jurisdiction as the property, subject to the rulings of any court there; and (b) that the law where the suit might be filed would supersede the law in a different State where the Trust might be legally sited. A properly constructed domestic Asset Protection Trust such as several States are now offering would make it nearly impossible, and extremely expensive, for anyone to be able to collect on such a lien. I would probably lead to a reasonable settlement offer. Once the protective apparatus is in place, let’s look at a situation in which the use of an Option could make a real estate fortune completely disappear from public view:
Suppose you owned $2,000,000 in free and clear property equally divided between development acreage and rental houses. Your tax basis is $500,000. You want to drop out of sight and move on to other pursuits. The problem is, that if you sell at fair market value, it will be difficult to find a cash buyer for the land and rentals; plus you’ll pay both capital gains tax and AMT on $1,500,000. Instead of selling at fair market value, suppose you sold out for $500,000 cash and held the $1,500,000 balance of your equity in the form of several “buy-back Option”? These would give you — or anyone you assign an Option to — the right to re-purchase each individual property at the price you were paid for it. Keep reading:
By selling out for cash at your tax basis, you’ve got $500,000 in tax-free cash to tide you over for a few years, and you’ve saved a fortune in taxes. You will have paid lower transfer taxes. This will mislead busybodies who try to calculate the value of your holdings by working backward from the amount paid on any transfer tax. The Option you hold will continue to appreciate to keep your invisible wealth growing management-free and risk-free for years until you sell an Option or use any particular Option to buy back one of the properties you sold. In the meantime, the buyer will enjoy a much higher yield from rents that will average out to market rates once the costs of holding idle land have been factored in. If the IRS deemed this to be a disguised loan, it would still be tax free to you.
TIMING CONTROLS TAX COSTS . . .
Options can be employed to stretch the holding period and to shrink the acquisition period so that property can be sold tax free. Here’s why: Taxes on house sales are based upon time. Long term capital gain rates of 5% to 15% require that houses — other than those held for sale in the ordinary course of business — be held at least 12 months. IRC Section 1031 allows sales of real estate and personal property held for investment or business use that qualifies for long term capital gain tax rates to be sold tax free if it is replaced with like-kind property within certain time limits. Likewise, IRC Section 121 allows your primary personal residence to be sold tax-free so long as it meets special time requirements. Certain gifts made to family members within three years of death are scrutinized closely when Estate Tax returns are filed. In all the foregoing situations, the timing controls the taxes that may fall due. Being able to meet timing requirements can make a big difference in taxes. Following are some specific illustrations:
LONG TERM CAPITAL GAIN: Suppose you buy a property at a bargain price and fix it up as a rental. Shortly thereafter, unsolicited, a buyer comes along who is willing to pay you twice as much as you paid for it. If you sell it outright, you’ll pay income tax based on high ordinary income rates. You‘ll also probably incur 15.3% payroll tax on self-employment income. Instead, you lease the property to the buyer with an Option to buy. The Option can’t be exercised until you are able to qualify for a tax-free exchange for one or more additional properties. You avoid being deemed a dealer in houses. What’s more, by Exchange-pyramiding upward, you not only avoid higher ordinary income and capital gain taxes, but also increase your wealth.
SECTION 1031 EXCHANGES: Exchanging one property for another boils down to using an independent Exchange facilitator to sell one property for cash, then buying a suitable replacement property. The transaction is tax-free so long as you wind up with debt equal to — or higher than — the debt on the property you sell. The catch is that you must identify at least one replacement property within 45 days following your sale, and close its purchase by the earlier of 180 days following the sale, or when your next federal income tax return is due; including extensions. Most people fail to complete their exchange because of greed. They can’t find a replacement property they like at a price they are willing to pay in 45 days.
The IRC allows what it calls “Reverse Starker” exchanges, but these are cumbersome and require you to pay for a replacement property before you get the cash from your sale. It’s easier and cheaper to go hunting for an acceptable replacement property ahead of your sale and to buy an Option on it. Then, when you complete your sale, you can do a simultaneous exchange for the Optioned property with a lot less fuss and bother. Conversely, if a buyer suddenly offers you a tempting price for your house before you have found a replacement property, reverse the process. Sell him an Option on your house, and let him close when you’ve found a replacement. Either way, using an Option will save you a lot of money otherwise spent on taxes.
