One of 1984's hottest marketing concepts for selling new houses could get homebuilders and consumers into tax and legal troubles they never dreamed of.
The sales technique -- advertised prominently in many markets in recent weeks -- offers home buyers a deal that's hard to resist: Sign up for a house and at closing you will receive a free interest-earning, long-term bond. When the bond matures, it will be worth the same dollar amount that you paid for your house. You'll get 100 percent of your money back -- in hard cash -- and essentially will have acquired your home for nothing.
For example, if you bought a $100,000 house under the plan, you'd be handed a so-called "zero-coupon" bond that would be worth $100,000 at maturity 30 years from now. The bond might be a highly rated, tax-exempt municipal or a federally guaranteed Treasury issue. Its interest rate might be from 9 to 11 percent. Like all zero-coupon bonds, however, the one that came with your house wouldn't pay out a cent in interest until it matured.
Rather than distributing annual interest earnings to their holders, zero-coupon bonds are set up to accrue or retain their interest earnings. Through compounding of that retained interest, the bond grows rapidly in cash value as the years go by. A bond that may have been purchased by a builder for a sales promotion in 1984 for $5,000 may be worth more than $100,000 30 years from now, thanks to interest compounding, for instance.
The zero-coupon-bond home-buying concept not only sounds attractive, but it also has been offered by high-quality, respected building firms in many areas. Half of Southern California's largest 20 homebuilders, for example, have been selling single-family dwellings and condominiums with "cash back" bonds since the summer, according to Robert Mons of the Beverly Hills investment banking office of Drexel Burnham Lambert.
Well-known firms in Maryland, Texas, Florida, Arizona, Illinois, Virginia and elsewhere have been actively involved with the concept.
Unfortunately, zero-coupon deals may be too good to be true.
They have tax, securities and real-estate-appraisal complications that should flash warning lights to consumers and builders contemplating using them.
The tax problems were spelled out in an opinion letter requested by the National Association of Home Builders from the Washington law firm of Colton Boykin. Attorney Peter W. Segal warned that unknowing home buyers who receive zero-coupon Treasury bonds at closing "may have phantom-income problems" with the Internal Revenue Service in coming years.
Although their bonds may not pay them any interest, federal law requires that they pay taxes on their accrued interest year by year, just as if they had received cash in their pockets, Segal explained. Buyers receiving zero-coupon, tax-exempt municipal bonds could have a different IRS problem, according to Segal. Federal law prohibits the deduction of interest on a loan when the loan proceeds are used to purchase a tax-exempt security. The IRS could well construe the bond as part of the economic cost of the house.
The buyer's mortgage, therefore, would in part be used to purchase a tax-exempt security. That, in turn, could throw the home buyer's annual mortgage-interest deductions into question with Uncle Sam.
In a separate opinion letter, Segal warned NAHB of securities law problems surfacing around the country that could put the homebuilders into hot water. Because participating builders buy large blocks of zero-coupon, tax-exempt bonds for the program from investment bankers, and then pass them on retail to home buyers, they could violate state securities-registration rules regarding "broker dealers." According to Segal, authorities in Louisiana already have issued a cease-and-desist order against one program. Officials elsewhere are reviewing zero-coupon-bond promotions for possible "deceptive trade practices," he wrote. Adding to the tax-and-securities-law wrinkles, the Federal Housing Administration has raised a red flag on another issue: the impact of the program on home valuations. In a letter to mortgage lenders, FHA Assistant Secretary Maurice Barksdale said that the cost of any zero-coupon promotional bond must be subtracted from the sale price of the property. That, in turn, can mean a lower maximum mortgage amount for the home buyer using an FHA-insured loan.