Equity-sharing--a technique that could help hundreds of thousands of would-be home buyers qualify for a purchase--should get a major boost under newly proposed federal tax regulations.
After nearly 18 months of internal debate, the IRS has released guidelines for home buyers, relatives and private investors interested in jointly acquiring residential property. A financing concept authorized by Congress and signed into law by President Reagan in December 1981, equity-sharing works like this:
A home buyer who doesn't have the full down payment to qualify to purchase the house he wants, or who doesn't have the income to handle monthly payments at regular-market rates, can join with an equity investor. The investor--who is often a relative or friend--puts up all or a portion of the down payment cash necessary to secure a mortgage. The investor may also agree to make additional contributions to the monthly debt service and taxes, if that's necessary to swing the deal.
The purchasers--typically younger, first-time home buyers--get to live in the house and use it exclusively as their principal residence. In exchange for the financial contribution by the non-resident investors, the resident co-owners generally agree to 1) pay a fair market rental to the investors, monthly, quarterly or annually, and 2) give up some percentage of their ownership equity to the non-resident investors.
The investors' equity share or stake in the unit can range from a minority proportion--say 5 or 10 percent--to 80 percent and higher, depending on what the parties agree.
The periodic rental payments from the occupants to the investor are then based on that equity percentage. The occupants pay rent, in effect, for their use of the co-owners' part of the home. If that share is 50 percent, the occupants pay half of the going rental rate for the house by local market standards. If the non-residents' share is 25 percent, the occupants pay one-quarter of what would be the going local rental amount.
The equity investors thus get periodic rental income from their unit, plus the tax advantages of owning residential property. They can depreciate their share of the home using the rapid write-off schedules of the 1981 Economic Recovery Tax Act. They can deduct their proportionate share of all business expenses--such as maintenance and repairs, depreciation and utilities--plus any property taxes and mortgage interest that they actually contribute.
When the time comes for sale of the house, or a "buyout" of the investor's share by the resident co-owners, the investors can also enjoy their fair share of any capital gains picked up by the property.
Informal equity-sharing among relatives has been part of the American home-buying scene for decades. But until Congress amended the federal tax code in 1981, the "rich uncles," aunts, parents and outside investors who contributed portions of down payments couldn't take valuable rental-property deductions--particularly depreciation--on their loans.
The new proposed regulations, released July 20, clear away many of the question marks and taxpayer concerns that have surrounded IRS treatment of equity-share participants since Congress changed the law.
Here's a quick rundown on some of the issues clarified by the proposals (final rules aren't likely until late 1983 or early 1984):
* IRS has chosen to keep its nose out of most of the details of transactions between equity share co-owners. Rather than setting up strict guidelines regarding what deductions or equity shares an investor may take in exchange for a certain level of investment, the government's proposed rules leave that up to the participants. (For example, if a home buyer agrees to give an investor a 95 percent ownership stake in a unit in exchange for a 40 percent down payment contribution by the investor, the IRS apparently won't challenge the transaction.)
* The proposed rules make clear that a fair, proportionate rental amount will be required from residents for the use of the investors' share of the house. But the regulations give wide latitude to the co-owners in defining precisely what constitutes rent. Services rendered by the residents, such as maintenance and repairs on the investors' share of the space, could be quantified and included in the regular rent.
Partnerships that invest in equity-share arrangements won't have the IRS breathing down their necks, unless they seek to make highly creative "special allocations" of the tax benefits. For example, a partnership that seeks to take all the possible depreciation deductions for a unit but demonstrably owns only a 50 percent share in the property could come under scrutiny at tax time.
(Readers who wish more information on the equity-sharing rules, or who are interested in Kenneth R. Harney's forthcoming book on the subject, "Equity-Sharing Profits and Pitfalls," can write to Box 4038, Chevy Chase, Md. 20815.)