Related Party Transfers of Real Estate – Family, Corporate, or Partners

One of the things that has a lot of issues is any transaction between related people. Actually, this is not limited to purely family transactions, but applies also to transfers among partnerships and their partners, corporations and their officers

The market theory holding that the value of a property is what is agreed to between a willing buyer and a willing seller is subject to the proviso that neither buyer nor seller has a reason to inflate or deflate what the property is worth to them. If the parties are related, there is an obvious reason to think that this may not necessarily be the case. Parents do things for their children all the time, siblings for each other, and as you’re probably aware if you work in corporate America, major stockholders, investors, and executives often manipulate corporate versus personal transactions for less than wholesome reasons. Partnerships do the darnedest things, as well.

The issue, as far as the lender goes, is that they are trying to safeguard their money. Lending is a risk based business, and the lender wants to know that they are not taking more of a risk than they intend to when they take on this loan.

Let’s say Jane Jones is CEO of SuperColossal Corporation. She wants to manipulate her compensation, so she has SuperColossal sell her property for half its real value.

Now this is actually okay by most lenders, if not securities regulators, IRS agents, et al. The loan is based upon the purchase price, the appraisal comes in double the purchase amount, and the lender assumes less risk than they price the loan for. Remember, the property is valued based upon LCM: Lower of Cost (purchase price) or Market value. When market value comes in high, the lender is covered. What isn’t so cool is if Jane Jones sells SuperColossal the property back at twice its value. If the corporation gets a loan for 75 percent of value, that’s at least a third of the lender’s money they’re not going to get back in case of default, which becomes likely when Jane is fired and the new CEO asks why they are paying the loan when they owe half again what the property is worth.

Needless to say, the lenders want to guard against that. Many lenders will not do related party transactions, period. For the ones that do, they will want to be very careful on the appraisal, which has now become their only guard against getting into an indefensible position. Many times, lenders may require related party transactions to go through certain appraisers, they may require in house appraisers, they may require multiple appraisals, and they may require that there be no contact between principals and appraisers. Whatever their required precautions, they need to be followed, as failing to do so will cause the loan to be rejected.

I’m going over this to make a point. Many lenders have other requirements as well. Some may require full documentation only, others require that the loans have full recourse (they can come after you legally if they lose money). Each and every lender creates their own policy, and if your transaction is between related parties, it is probably more important to inquire about related party transfer policy and requirements than it is to get a good rate at a competitive price. Not much use having a great quote if you can’t meet the lender’s requirements. Even worse if it causes you to waste time with a lender whose requirements you cannot meet, and now your deadline for the transaction is here and you don’t have a loan, and so cannot complete the transaction.

Caveat Emptor

Probate and Foreclosure and Planning Ahead

This question brought someone to my site:

If my house is going into foreclosure but the house is also in probate, can the lender actually go forward with the foreclosure sale while the house is in probate?

The short answer is yes.

The Trust Deed (or Mortgage Note) that was signed by the now deceased undefined gives a security interest in the property to that lender in exchange for money. The lender lived up to their end of the bargain. That security interest is valid until the loan is paid off. It is not removed by the death of the person that signed over the security interest.

Probate takes an absolute minimum of nine months. During this time, the court will likely allow those members of your family to continue to live there, but they will not likely approve disposition of the asset except in an emergency, and that emergency is going to cost your heirs money for the courts, and money for the disposition. On the other hand, the lender still needs to get paid according to the terms of the contract, and they are entitled to foreclose if the terms are not being met. I’m not a lawyer, but I’ve never heard of an estate being permitted to declare bankruptcy, which some living folks use to temporarily stave off foreclosure, almost always to their eventual major detriment. Since your executor is claiming that your estate cannot pay its bills and rarely are you earning any more money, declaring bankruptcy would seem like an open and shut case of “the creditors get all of the assets and your heirs get nothing.” Probably not what anybody who’s part of the situation wants.

There are simple steps possible to avoid probate for major assets. A trust is probably the most flexible of these, in that the trust owns the asset and the successor trustee takes over the management and within the limits of the trust, does what needs to be done without the courts getting involved. Flexible, much cheaper than getting a probate court involved, and your heirs get control right away. But it requires planning ahead (which many people are loath to do, being in denial about the idea of death) and an upfront investment.

Given the fact that there is a loan and a Trust Deed against the property, somebody is going to have to make those payments until the loan is paid off, whether by outright payoff, refinancing, or sale. Given that in the absence of a trust, your heirs probably are not going to have access to any liquid wealth you left either as it is also locked up in probate, the odds are that your heirs are either going to have to come up with the cash out of pocket, or the property is going to be foreclosed upon.

Now there are some good options. If your heirs are wealthy and have the cash, perhaps some one or combination of them will make the payments in the interim if it’s been agreed they will be compensated later. Not likely, I’ll admit, and they’re likely to drive a bargain for larger eventual replacement. In some instances, the probate judge may agree to taking out a Home Equity Line Of Credit (HELOC) to make the payments, but somebody’s going to have to be able to qualify to make the payments, and a dead person is not on the list of options, which means somebody still living is going to have to do it. The rates on these are typically horrendous, and cost a lot more than a little bit of planning.

Another excellent option is life insurance. Life insurance passes (usually) tax free on death outside of probate to a named beneficiary. Therefore, it’s available pretty much right away to pay bills and stuff. It’s also leveraged money, so a few dollars now buys more dollars when you need them. The difficulty is that you’ve got to have it beforehand. There’s that planning thing rearing it’s ugly head again, and the upfront investment of the premium dollars for the life insurance policy. Finally, any money created by this becomes the property of those beneficiaries, and there is no way to compel them to spend the money on bills of the estate. If the beneficiary is the estate, well, the money is locked up in probate again, and you’ve got to get the probate judge to agree with doing the necessary.

Another option is the named beneficiary Transfer on Death feature of most investment accounts. These also transfer outside of probate to named beneficiaries. Problem is, they require the investment of those dollars beforehand, and they also require that you keep the beneficiaries current, and all of this requires, once again, planning. The money also becomes the property of the beneficiaries, just like life insurance, and if there’s no named beneficiary, it gets locked up in probate.

There is no free, no-planning-necessary, magic bullet. I strongly suspect it’s all part of the various Lawyers Full Employment Acts, but you’ve got to take the system as it exists. At the very least, you’ve got to do some planning ahead, and an upfront investment is probably going to return itself several times over. Remember, everyone is going to die sometime – I know of precisely zero exceptions thus far in the history of the world. Denial of this simple fact simply digs you in deeper, and puts your heirs in line to have to lose or waste a major portion of what you would have left covering for your deficiency, as is evidenced by the person who asked this question.

Caveat Emptor

Lump Sum Payments on a Mortgage and Alternative Investments

This one came from a search engine:

amortization of real estate loans early payoff based on a lump sum payment

This is one of the smart things you can do. Not necessarily the smartest, mind you, but smart. The question is if there’s a better way to get a return on that money, wither by paying down a higher interest debt or by investing the money in a new asset. If you owe thousands of dollars on a credit card at twenty-four percent when your mortgage is at six, why would you want to pay down a tax deductible six percent instead of a non-deductible twenty four?

Similarly, if you’ve can earn ten percent somewhere else with the money, why do you want to pay your six percent loan down? Net of taxes, a six percent loan costs you about 4.5 percent, depending upon your tax bracket. Even if the return is not tax deferred, the net return on ten percent is somewhere over seven percent for most folks. Say you are in the twenty-eight percent tax bracket and the ten percent is completely taxed every year. $10,000 over the course of 15 years will turn into $28,374 if invested. If it’s fully tax deferred, it turns into $41,772. For comparison with other numbers later on in the essay, at twenty-seven years the numbers are $65,352 and $131,099, respectively. Not half bad.

Suppose you’ve got the cash flow to instead buy another property? That puts the power of leverage to work for you, and if you can rent out one of your properties or something, possibly multiply your money by a factor of ten within a few years. When you put ten percent down, and your new property appreciates ten percent while giving you a few dollars per month of cash flow, that’s smart investing. At seven percent annual appreciation (historical average), you’ve doubled your purchase price in a little over ten years. A three hundred thousand dollar property will likely be a six hundred thousand dollar property in about ten years (It’s just numbers), while you’ve paid the loan down from $270,000 to about $226,000. Even if your expenses of selling are seven percent, your gross is $558,000, less the $226,000 you’ve paid the loan down to, and you’ve come away from the property with $332,000, not counting those few dollars per month you netted after paying your expenses. Sure there are places and properties that don’t pencil out, and being a landlord is a headache, but as you can see the potential rewards are substantial if it does “pencil out”.

Now, let’s say you do this every nine years on a three to one split, and 1031 Exchange the first two at least. After nine years you have $281,267 pre-tax, net in your 1031 account. You then turn around and buy three $600,000 properties. You end up with three loans of about $506,000 each. Assuming net zero cash flow on the properties, after nine more years, you have three loans at $434,100, netting you $1,775,286 into your 1031 accounts, which you then roll into three more properties each at $1.2 million purchase price. Your loans are $1,000,000 each, but you rent them for enough money to break even on expenses. After nine years, you sell all of these properties, and end up with just a little under $10,750,000 net of sales costs in your pocket before tax, which at long term capital gains rates (15%) nets you $9.13 million or thereabouts. Now, you did start with three times as much money, and nobody in their right mind sells off nine highly appreciated properties in one year, and you did have the headaches of being a landlord on an increasingly widespread basis for those twenty-seven years, but this illustrates the money to be made for the same investment. Patience and leverage working for you over time are far more powerful than any quick flip.

But assuming there are no better alternatives, it is a smart idea to pay down your mortgage. Here’s why: Let’s say your balance is $270,000 at six percent, and you pay your loan balance down by $10,000. Your regular payment was $1618.78, and it still is, but interest is $1350 of that. Only $268.78 would normally be applied to principal. Yeah, you’ve just sent them about six months of payments – but it just paid your loan down by three years of principal payments. Assuming you never sell and never refinance and never pay an extra penny again, you will be done in month 324 – saving yourself thirty-six payments for a total savings of $58,276. Not to mention that if you do refinance, you’ll pay lower fees. Not in the league of some of the alternatives above, but still a nice return on investment. Definitely beats spending the money.

Caveat Emptor

Losing Property Value with Highly Leveraged Properties

In one of my articles somebody wrote in the comments about going upside-down on their mortgage:

What happens if the property value falls and becomes far less than the loan ammount? (POP) Lets say you get a loan for $280,000 on a home that was $330,00 and then three years later is is only worth $150,000, but you still owe $250,000 on it?

Now “upside-down” in the context of a mortgage is just slang for owing more than the property is theoretically worth. This is a tough situation to be in, and there’s not much that can be done while you’re in it except get through it. Before, yes. After, yes. During, no.

I’ve predicted that this is going to be a widespread phenomenon over the next few years, and it’s going to cause a world of hurt, but it doesn’t need to include YOU, unless this has already happened, and I thought Sandy Eggo, where I live, to be on the bleeding edge of bubble problems, and appraisers are still able to justify near peak values even here.

Surviving being upside down is actually pretty easy if you have the correct loan. I bought near the peak of the last cycle, and was upside down myself for little while. If you take nothing else away from this article, understand that the only time your current home value is important is when you sell or when you refinance. If you don’t need to either sell or refinance, it does not matter what the value of your home is. It could be twenty-nine cents. It’s still a good place to live. You’ve still got the loan you always did. You should be able to keep on keeping on until the situation corrects. Prices will come back sooner or later.

The key is to have a sustainable loan. I did. I had a five year fixed period, during which time the market recovered and I paid down my loan. By the time I went to refi, five years later, things were better.

This is the real sin of the local real estate and mortgage industry. Yeah, the bubble’s going to pop, and everybody knows it. Actually, it’s already had significant price deflation. But if they had been putting folks into longer term sustainable loans, they’d be fine. Instead we’ve had about forty percent of purchase money loans being negative amortization and another forty percent being two year fixed interest only loans. The period of low payments for the former, and the fixed, interest only periods for the latter, are going to expire while prices are still down. That would be tolerable if the people could make the new payment, but if they could have made the new payment, they would have been in longer term fixed rate fully amortizing loans in the first place. What’s going to happen next is kind of like when Wiley Coyote looks down.

I’ve been telling people there are no magic solutions to the problem for over three years now. If you borrow the money, you’re going to have to pay it back. Make the payments now or make them later, and the later it gets the worse it will be. There is no such thing as free lunch, and those who pretend that there is are not your friends. The Universe knows how much more money I could have made by keeping my mouth shut and screwing the customer. $100,000 is a conservative estimate. Instead of struggling to convince people to do the smart thing these last eighteen months, I could have been glad-handing everyone in sight and making a mint off of ignorant people. But then there would be court dates looming in my future (those in my profession who were not so careful are going to be in for a hard time, and I hope you’ll forgive my schadenfreude when it happens. Those con artists masquerading as professionals stole a lot of money from me and from the people who became their clients by convincing them they could afford more house than they could, or by not admitting to the tremendous downside of what they were offering the client. “No, he just wants you to do business with him and he can’t do what I’m doing.” I could have gotten the loans, as I informed more than one of the clients I lost, and on better terms, but I wanted them to know the downsides. So I lost the business to the con artist who pretended there wasn’t one. There were downsides, but people want to believe the con artist).

What to do if it has become obvious you’re headed for the canyon? Figure out what your payment is going to do for the next several years. Determine if you’re going to be able to make that payment before it happens to you. If not, refinance now if you can, sell if you can’t. Pay the prepayment penalty if you have to, because given a choice between a prepayment penalty and foreclosure, the former is much better.

If you want to refinance, find a long term fixed rate loan. Minimum of five years fixed, fully amortized. Since thirty year fixed rate loans are actually about the same rate as 5/1 ARMS right now, I’ve been recommending the thirty year fixed for almost everyone. This is a loan that never changes, and you never have to refinance because the payment is going to jump.

The critical factor for refinancing is the appraisal. The Critical factor for the appraisal is how much value can be justified by the appraiser. In order to justify the value, there have to be comparable sales in your neighborhood. The appraisers don’t always have to choose the most recent; they have the option of choosing better matches for your home – provided they are recent enough. May the universe help you if there are model matches selling for less in your condominium complex, because there the lender is going to insist on the most recent sales. All the more reason to act now, while you can, rather than wait and hope.

If you’re already over the chasm and prices have fallen, consult some local agents about selling. Short payoffs are no fun, but in the vast majority of cases, they’re better than foreclosure if you’re not going to be able to make your payments. At least when they’re done, they’re done. Foreclosure is a hole that keeps on draining you long after you’ve lost the house, and after it’s cost you thousands of dollars more than a short sale (and if sale prices continue down, that 1099 love note from the lender after the foreclosure is going to be worse). As for waiting, well, if it’s an honest consensus that things are coming right back, but here in San Diego the Association of Realtors had not yet admitted there’s price deflation despite it going on for almost a full year. They’ve been playing games with reported figures to make it seem like things are rosy. There are obvious motivations for this, not all of which are explained by self-interested greed, but it’s not something you can paper over and ignore indefinitely.

Who’s to blame for the impending train wreck? I’m not really into blame, but here are several targets. Unscrupulous lenders and agents bear a lot of blame, but not the exclusive burden. Panic and greed on behalf of the buyers is certainly a significant part. And if several folks are telling you that the best loan they have is five and a half or six percent or even six and a half, shouldn’t a normal, rational adult be suspicious of an offer that’s theoretically at one percent? I can maybe believe somebody who offers something a quarter of a percent better than the competition. Half a percent might be just barely possible. Somebody who offers money, of all things, that’s less expensive by an interest rate factor of five isn’t telling you the whole truth. (Unfortunately, in this case, these loans are so easy to sell on the basis of minimum payment and nominal rate, it got to the point where these loans were what the vast majority of agents and loan officers were talking about)

As a final note, 125% loans do exist, but they are ugly. Very ugly. Not as ugly as Negative Amortization, but ugly, and the payments and interest rates aren’t any more stable than the real terms on those Negative Amortization loans. They don’t do stated income, either, or nonrecourse. You stiff those folks, they will get the money out of you.

Prices are going to come back up. It’s as predictable as the fact that they were going to fall. Can’t tell you when, anymore than I could tell you when exactly they would start falling. Doesn’t mean it won’t happen. The trick is to have a sustainable situation in the meantime, and this means a loan with payments you can make every month, month after month, indefinitely until the loan is paid off or you have the ability to refinance or sell. If you’ve got this, someday you’ll be telling yourself how happy you are that you bought that property. If you don’t have it, get it. If you can’t get it, get out.

Caveat Emptor.

Loan Rate Sheets: An example, and the games lenders play

This is something I probably should have covered quite some time ago, as it’s part and parcel of the system that’s abused. Here are sample rates from one A paper lender, picked at random, that were in effect a few days ago. These are Fannie and Freddie conforming 30 year fixed rate mortgages with full documentation of the loan. The first number is the cost for a 15 day lock, the second for a 30 day lock, and the third for a 45 day lock. A positive number means it costs that number of discount points to get the rate. A negative number means that the lender will pay that many discount points for a loan done on those terms. Now, I want to make the point that these are wholesale rates, but I didn’t feel like translating them to retail. I don’t work for free any more than anyone else, nor does any other loan provider.


(The rate sheet is very old, and out of date, from a random lender I picked)

5.625% 1.50 1.75 2.00
5.750% 1.00 1.25 1.50
5.875% .375 .625 .875
6.000% 0.00 0.25 0.50
6.125%-0.50-0.25 0.00
6.250%-1.00-0.75-0.50
6.375%-1.50-1.25-1.00
6.500%-1.75-1.50-1.25
6.625%-2.25-2.00-1.75
6.750%-2.50-2.25-2.00
6.875%-2.75-2.50-2.25
7.000%-3.50-3.25-3.00

As you should notice throughout, there is a 0.25 spread in costs between locking in any particular rate for 15 days as opposed to 30, or 30 days as opposed to 45. This is because it costs them money to have the money standing around doing nothing waiting for your loan to fund. The difference in costs between a 15 day lock and a 45 day lock at the same rate is half a point. For most people, the column you want to pay attention to is the thirty day column. Two weeks from a standing start is not enough to do a refinance, and even a purchase is iffy. But you want a rate locked in when you start the process, or you really have no idea whether it will be available when you get to the end of the process. Indeed, many providers work on a “promise the moon and wait and hope” basis, hoping the rates will drop. That’s why you want a written guarantee of a rate at a given price on a given loan type.

Now this is a fairly broad spread rate sheet, as the company is willing to take clients through a large range. On the other hand, at a 5/8ths point hit for 1/8th percent rate below 5.875, they are telling you that they really would prefer to keep their customer’s rates locked in for 30 years above that. On the other hand, since most people dispose of their old loans about every two years, most folks shouldn’t want to pay those costs, which will take much more than two years to recoup from the lower rate. It’s much the same phenomenon as insurance companies guarding against adverse selection (only those folks who have major health problems buying health insurance, for example).

Which loan is the best for you? Don’t know without more specifics. It depends on approximate loan amount, your life plans, your proclivities, and your financial situation.

But the devil is in the details, and one of the most common devils is details is a provider forgetting the adjustments. Adjustments generally mean that the loan will be more costly than the basic rate/cost tradeoff outlined above, so “forgetting” to post the adjustments on a Good Faith Estimate or Mortgage Loan Disclosure Statement is one of the easiest and most effective ways to lie in order to make your loan look more attractive by comparison. Since most providers don’t guarantee their estimates, they can do this with basic impunity, but make no mistake – they know what the price is really going to be. If they won’t guarantee their estimates, ask them why not. Here are the possibly applicable adjustments for this category:

Loan amount under $60,000: half a point

Loan amount $60k up to $100k: quarter of a point

cash out loan, 70-80% LTV: half a point

cash out loan, 80-90% LTV: three quarters of a point

Investment property 50-75% LTV: one and a half points

Investment property 75-80% LTV: two points

Investment property 80-90% LTV: two and a half points

No Impounds fee: quarter point

2 units 90-95% LTV: half a point

Manufactured home: three quarters of a point (they also have an absolute maximum CLTV of 80%)

Loan distribution

80/15/5 quarter of a point

75/20/5 quarter of a point

Interest only one and one eighths points

if CLTV over 90%: additional quarter point

97 percent of purchase price financed: three quarters of a point

100 percent of purchase price financed: one and a half points

2/1 Buydown two and a half points

Stated income FICO 680-699: half a point

Stated income FICO 700+: quarter of a point

(actually, these are small hits for stated income, indicating to me that I can likely do better elsewhere for a full documentation client!)

So let’s see. If you are doing a cash out to 75 percent loan stated income and have a credit score of 690, you add one point to the costs listed above.

If you have an investment property duplex at 90 percent LTV, you would add three points (investment property loans are relatively expensive, as you can see, and it isn’t restricted to this lender. They are riskier loans)

Doing 100% financing on a $50,000 home: Two points.

One hopes you get the idea. To leave these out is a tempting omission for the less ethical providers. Just because they are left out does not mean you won’t pay them. You will. Usually they will spring them on you with the final closing documents and hope you don’t notice. Surprise!

(Between this profession and being a controller for twelve years, people should not wonder why I think that’s one of the ugliest words in the language).

Indeed, during my six weeks at the Company Which Shall Remain Nameless, I had no fewer than three screaming arguments with my supervisor over telling prospective clients the truth about adjustments. They didn’t want me to. I have this thing about telling clients the truth as best I know it.

Why do they do this? At signup, you have little emotional buy-in. At final loan docs, you are signing so much stuff that even a marginally skilled person who’s trying to distract you will be successful a lot of the time. The industry statistics say that over fifty percent literally never notice, at least until much later, after the transaction is irrevocable. And somewhere around eighty five percent of those who do just want the process to be over so badly that they will sign anyway, not to mention the fact that in the case of a purchse, they probably don’t have any choice at that point. They need the loan to get the house, without which they lose the deposit, and there is no more time remaining in the contract with which to go out and get another loan. In order to combat this, do the smart thing, and apply for that back-up loan at the beginning. With two loans ready to go, your bargaining position is much enhanced, and the odds are much better that one of them will honor the original quote or something similar. If you can’t find a backup loan provider, an alternate tactic is to find someone who will guarantee their loan quotes in writing, but very few will. A quote that is not guaranteed is so much hot air. They might intend to deliver, but the reason they won’t guarantee it is usually that they don’t intend to deliver it.

Caveat Emptor

The Basics of 1031 Exchanges

Section 1031 of the IRS Code has to to with tax treatment on the exchange of one parcel of real estate for another. It’s similar to Section 1035 which covers most non real estate exchanges. Car for a car. Boat for a boat. Business for a business. But section 1031 allows indirect exchanges so long as you follow certain guidelines. After all, how often do folks want to trade two parcels directly? It happens, but not very often. Usually, if A is buying B’s parcel, then even if B wants to replace it with another piece of real estate, it probably isn’t owned by A.

Why would you want to do this? Taxes. No other reason but taxes. If the taxpayer makes the exchange according to the provisions, they defer the gain. But we’re talking capital gains, not ordinary income, so keep in mind it’s not worth going gonzo over. The maximum long term capital gains tax rate for most folks is 15 percent. Still, getting to keep 100 percent of your gains instead of 85 can be worthwhile, and when we’re talking sometimes about multiple hundreds of thousands of dollars, that’s quite a bit of motivation. It’s nice to be able to invest and use those (potentially) tens of thousands of dollars, rather than basically forking them directly to the tax man.

Your primary residence is not eligible for 1031. Second homes are severely limited in eligibility (general rule: You can’t occupy it more than 10 percent of total occupancy, although you get up to fourteen days per year. Check with your accountant for details. Matter of fact, check everything with your accountant. This is just a basic overview, and the devil is in the details). Section 1031 is for investment property, of whatever nature.

Section 1031 is not for “flipping”. I am not aware of any explicit minimum general holding time, but the IRS looks hard when the held period is less than a year. 1031 Questions are good jumping off points for general audits. Be careful. If the properties are being sold between related parties, there is a two year minimum holding rule, and nobody can end up with cash. For this reason, 1031s with a related party transaction are tough. If it’s a property you bought as investment that you later made into a personal residence (or vice versa) the minimum holding time is five years.

There are some significant complexities in duplexes where one unit is for personal use, or personal use dwellings where there’s a home office. I’ve just gotten to the point where I don’t understand the attractiveness or value of a home office deduction for many people, but they keep insisting upon trying for them.

Basically, there are three requirements for a standard “forward” 1031 Exchange. You can not have constructive receipt of the funds. You must designate replacement properties within 45 calendar days of the sale of the relinquished property, and you must consummate the sale within 180 days or before you file your tax return, whichever comes first.

Constructive receipt is a fancy way the IRS has of saying control of the funds. If escrow sends you the check, or if the check is in your name, you have constructive receipt of the funds and the 1031 will be disallowed. So what happens is that you need to pay an accomodator (most title companies have one) to act as trustee for the money, and the actual transaction is done in the name of the accomodator. If you see something about cooperating with a 1031 exchange at no cost to you as part of a sale or purchase, this is what it’s about. Makes no difference to the other party in the transaction, but the Grant Deed has to be made out to (or by) the accomodator entity, not the people who are actually taking part in the transaction.

There are three rules I’m aware of to use in identifying replacement property. The 3 property, the 200 percent, and the 95 percent. Keep in mind that this is investment property, often commercial in nature, and that even within major metropolitan areas it can be difficult to replace the property with something similar within the time frame. This is one situation where the law is a lot more flexible than most of the people. As long as it’s real estate within the United States not held for personal use, the law doesn’t care what the use of the property you replace it with is, but lots of folks are trying to find something as specific to their purposes as possible. Also, in hot markets, there may be difficulties created with finding a property you can afford and that the seller will agree to sell to you in that time frame.

Keep in mind always that we’re not necessarily talking a straight one property for one property exchange here. It can be multiple relinquished properties for one replacement (in which case the sale of the first relinquished property starts the clocks), it can be one relinquished for several replacement properties, or any mix of A properties now and B properties later, where A and B are nonzero, whole, and positive. Counting numbers, to use the technical mathematical name. For every additional property in the exchange, you can expect to spend more in fees to the accomodater, exclusive of all other costs to the transaction.

The first method of designating replacement properties is what’s called the 3 property rule. You may designate up to three properties of any value, and as long as you actually acquire one or more that fits the parameters within 180 days, you’re good to go. The second rule is any number of properties but no more than 200 percent of value. The final rule, 95 percent, is basically worthless and a good way to get in trouble, because unless you only designate one replacement property, you’re not going to be able to acquire 95 percent of the total value of the designated properties. Identification of these properties must be precise and unambiguous. “Land at the corner of First and Main” won’t work. You need something like a legal description or an Assessor’s Parcel Number (APN).

Finally, you need to acquire the replacement property within 180 days of selling the property (or before filing your tax return for the year – this can require you to be forced to extend your taxes)

Where the person making the exchange wants to buy the replacement property before selling the relinquished property, that’s called a “reverse” 1031 exchange. It’s basically the same concept switched around. You have 45 days to designate which property will be sold (usually not difficult), and 180 days to actually sell it, which may be a problem in slow markets. Reverse exchanges are also more expensive, as they require accomodaters to take title to an actual piece of land, and they are not, in general, for the weak of wallet. Any financing must be non-recourse financing, because the accomodater is in title and they’re not going to agree to be on the hook for the value of the loan if you can’t sell the property. This can also cause a requirement for larger down payments.

There are also “partial” 1031 exchanges, where you end up with a replacement property but something else you didn’t have before. In general, the replacement property must cost at least as much as the relinquished was sold for, the equity in the replacement property must be at least as large as the equity in the relinquished was, and the loan must be at least as large as the previous loan. If any of these three conditions is not satisfied, you’ve probably ended up with what the IRS code calls “The part of a like kind exchange transaction which is not like-kind exchange” but most accountants and other people in the real world call “boot,” as in “you’ve got this, and that to boot.” Boot is taxable, so if there’s a lot of boot, it may defeat the purpose of a 1031 exchange.

There are a lot of pitfalls, and with typically large amounts under consideration, the IRS is notorious for being hard nosed about all the particulars of 1031 exchanges, whether they are forward or reverse. Don’t try this without the aid of a tax professional, and for real estate purposes, an agent who has a good understanding can save your bacon. But if you do fulfill the requirements, it can be a good way of keeping money in your hands that you can continue to have invested in your new property, reducing your mortgage on that property, further saving you money, where otherwise nobody would be happy but the tax collectors.

Caveat Emptor

Joint Loans

First off, let me say that your site has been very informative and helpful. I stumbled across your blog looking for information on ARM vs. 30 year fixed loans and ended up reading every article.

One issue I have never really seen addressed is joint loans. When a couple, married in this case, gets a loan, which FICO score do they use?

Right now, my wife is a nursing student, when she graduates in August we want to buy a new home that is significantly more expensive than our current home. Our combined salaries at that point should be somewhere around 120K. I have been told by a mortgage professional in our first phone conversation that being a student counts for “years in
line of work”, but we would have to wait until she receives her first paycheck from her new job before we could count her income. We just accepted an offer on our current home last week, and will have enough cash to put down 10% in the price range we are looking at (200-300 K). If we want to buy before she is employed, but has an offer so we know
her salary, what are our options? It seems to me that we would be in a situation where we are doing a Stated Income type loan.


The answer to this is that whoever make more money is the primary borrower. This works with a couple as well as other arrangements. It’s a very simple answer, but you’d be amazed how often I have to repeat it for trainee loan officers. Of course we all want to use whichever score is better, but it’s the person who makes more money whom the lender will consider to be the primary borrower.

Now as far as A paper goes, it’s kind of academic. If you want to use both incomes for the loan, you both have to qualify. This can be an issue when one spouse forgets to pay bills and the other is as a-retentive as I am about it. Over time, spouses credit reports tend to track one another more and more closely, as they switch from single credit accounts to joint accounts. If it’s a joint account, doesn’t matter who forgot to pay the bill – you both take the hit. On the other hand, even long-married spouses don’t tend to have exactly the same score, and in many cases they have intentionally segregated the credit accounts for precisely this reason, that one spouse is better about paying bills. So one spouse has a 760, and the other spouse has a 560. Ouch.

It is to be noted that the superior solution is to have the responsible spouse pay all of the bills, which results in two high credit scores. Why is this important? If one of you has a 760, they may qualify A paper. If the other has a 560, you have a choice: go subprime, or have the high scoring spouse be the only person on the loan. In other words, when you’re talking about A paper, you both have to meet the credit score minimums, or you don’t qualify as a couple.

This has implications. Suppose you have a 760 score spouse who makes $3000 per month, and a 560 score spouse who makes $5000 per month, you have a choice: Qualify based upon $3000 per month, go stated income, or drop to subprime.

$3000 per month doesn’t qualify for a lot of house most places. So if you’re thinking 3 bedroom house, you can be stuck with small one bedroom condo – if you want the best rates.

The second alternative is going stated income. This only works if the necessary income for the loan is believable for someone in that occupation. Somebody who makes $3000 per month is not likely to be in a profession where $8000 per month is a believable income, and most people tend to overbuy a house rather than underbuy, regardless of the fact that underbuying is a lot more intelligent in most cases.

The third solution is to go subprime, where you’ll qualify, but get a higher rate. A single borrower with a 760 credit score gets a better loan, with less of a down payment, than the couple in this case – the primary borrower has a 560 score, remember – but they just won’t qualify for as large of a loan because they can’t afford the payments.

You might also go NINA, which is a “here I am – gotta love me!” approach where income is not verified, nor employment history. The loan you get is based totally upon your credit score and equity picture (how much of a down payment you make, in the case of a purchase). The rate is higher than stated income and the restrictions on equity is greater, but you’ll get a better loan at a better interest rate in most cases for a NINA A paper loan than even a full documentation loan for a 560 score.

Now, as to what you were told, student does not, in general, count as time in line of work. As a question to make why this is obvious: How are you going to compute her average income over the last two years? That is the way full documentation loans are justified. Some subprime lenders will accept it (not the better ones), or the person who told you this could just be planning to substitute a stated income loan based upon your income. The fact is, that unless you’re talking ugly subprime, they’re not going to accept your wife’s income until there’s some time actually working it. Many people graduate school and never work in the field. They don’t pass licensing, or they decide soon after they start that it’s not for them.

In this case, you are talking stated income unless you go subprime. It’s just the way things are computed. Sorry.

As I keep telling folks, there are a lot of shysters out there in my profession. The easiest way to get people to sign up is to promise the moon, and until you get the final loan paperwork you have no way of knowing whether they intend to deliver what they said.

Caveat Emptor

Company Stock in Retirement Accounts

Most of what you read on financial planning in the media is garbage, but here is one of those occasionally useful pieces: IRA Rollovers Could Have Tax Implications.

Here’s the idea: You keep company stock in your qualified plan aside from any rollover you may do. Leave it with the company. Convert it to non-qualified money, which means you take the hit for ordinary income at whatever you paid for the stock, or its value at time of acquisition(consult a tax professional. There used to be some circumstances where you could substitute other assets of equal value, and avoid the ordinary income hit altogether). Hold them for one year or more after conversion.

Now, if you sell them, you’re talking about long term capital gains, rather than ordinary income tax, a much lower rate, and subject to your control as to when you realize it.

Because it’s no longer part of your IRA, you are not paying ordinary income tax rates on the whole amount as you take it out of the account. Nor is it subject to Required Minimum Distribution (RMD) rules that the IRS has. You pay only capital gains tax when and where you redeem them, as you redeem them. Capital gains is a much lower tax than ordinary income, provided you hold for at least one year.

This is not for every qualified account. Since Roth 401s are after tax accounts, the whole thing is rather self defeating if the assets should be held in one of those, or in a Roth IRA for that matter. Why would you want to do this to conserve taxes if there are no taxes due if you just do nothing?

Now, by and large, I recommend moving your money to an IRA of equivalent nature when you leave a company. Traditional 401k to Traditional IRA, Roth 401k to Roth IRA. But as you can see from this, there are exceptions to that general rule.

Caveat Emptor

(Postscript: My wife is the IRA clerk for a fairly large local institution. You would be amazed how often people get bad advice from generic tax farms, and how often theoretically competent professionals do the rollover forms wrong. This highlights the fact that just because they work for Famous Well Known Corporation, doesn’t mean they know what they’re talking about. Matter of fact, I’ve regularly seen people working for Famous Well Known Corporations give awful advice that cost clients money, and would lose the business permanently to anyone else. But people cut Famous Well Known Corporations way too much slack. It is a better strategy to consider the individuals who will be performing your services.)

“Banks Give Better Deals Than Brokers”

Better deals for the bank, that is.

Ken Harney has a recent article Study Shows Loan Brokers’ Better Side

But now a new, independent academic study has concluded the opposite: According to a team of researchers headed by Georgetown University’s Gregory Elliehausen, home mortgage applicants with less-than-perfect credit pay lower financing costs when they obtain their mortgages through brokers rather than from loan officers directly employed by lenders. The same pattern holds true for African American, Hispanic and low-income borrowers.

The study was limited to subprime borrowers, but the results are not surprising:

Overall, broker loans cost 1.13 points less for first mortgages, 1.98 less for second mortgages

For borrowers in predominantly black areas, the difference was 1 point and 1.9 points, respectively.

For borrowers in predominantly hispanic areas, the difference was 2 points and 2.4 points. The explanation as to why this gap is larger is probably as simple as the fact that many of these folks limit themselves to dealing with Spanish speakers.

Skolnik added, though, that the data overall could reflect that “brokers in general operate in a much lower-cost structure” compared with banks and retail mortgage companies that carry heavy overhead and employee costs. Moreover, he said, “brokers are far more agile and nimble than retail” lenders, when pushed to compete on pricing and terms.

That and any given lender may have anywhere from a dozen loan programs to fifty, all intended to hit specific niches and priced for given underwriting assumptions. A 3/1 is different from a 7/1 is different from a 30 year fixed, stated income is different from full doc is different from NINA. That’s nine programs right there, and this is A paper stuff. Subprime is even more varied. It doesn’t matter if you barely meet guidelines or soar through them. If you find a program with tougher underwriting guidelines that you still qualify for, than that lender will give you a better rate on the loan, because they will have fewer of them go sour, and therefore get a better rate on the secondary market. You can go around to all the lenders yourself – or you can go to a broker.

Furthermore, even if you’re one of those so slick that you fit into the top loan category of the toughest lender, brokers can typically get you a better price. Why? Two reasons. First, the lenders don’t have to pay broker’s overhead, making it more cost effective for the lender to do the same business through the broker. Second, and more importantly, when you walk into a lender’s office, they regard you as a “captive” client. Brokers know better. Brokers are not captive to anyone, and they know that you’re not captive to them. A good broker’s loan officer will price with at least a dozen lenders. I’ve shopped fifty or more for tough loans. Furthermore, there’s an efficiency factor at work. After a while, a good loan officer learns which lenders are likely to have good rates for a given type of client. Which do you, as a client, think is likely to be the best use of your time and resources? Going to all those lenders yourself, or going to a few brokers?

This article of mine is also highly relevant to this discussion.

Caveat Emptor