Let's say you now own one house - a single-family home or maybe a duplex -
and you've spotted an apartment building you'd like to own. You've sized it up
and are sure it would be a sound investment. Now your problem is to find the
best way of buying it - the way that will maximize your income and your profit,
minimize your cash outlay and your tax liability.
Creating a mortgage, with the property owner's help, can be a
solution. In other words, the owner might be willing to let you buy his property
on credit. He, instead of a lending institution, might take your IOU.
It can be a strikingly simple deal. You just pick up some standard forms from
a stationery store, put them in a typewriter, and type out a note and mortgage
in favor of the apartment house seller. You make the interest rate, repayment
schedule, and other terms of the note whatever you and the owner negotiate
between yourselves - instead o the tougher terms that would undoubtedly he
dictated by hard money lenders.
This lender, who want you to buy the property he owns, might still ask 8
percent interest. Or he might settle for 6 percent rather than let the deal fall
through. And as to repayment terms, he might let you make payments of principal
and interest at the rate of 1 percent per month until the entire principal was
paid, instead of 1 percent per month with the balance due in one huge lump at
the end of three to five years.
Furthermore, if you ask him in advance, he's quite likely to let you write
into the agreement a clause permitting you to pay off the whole loan at any time
without a prepayment penalty, or to let some other investor assume the loan when
buying your property.
Such a deal between you and the apartment house owner would cost you perhaps
$300 as a fee to an attorney or escrow company for help in preparing the loan
documents; maybe $200 for the essential title insurance (don't ever skip this
coverage); and a few dollars to the county recorder for putting the documents
into his files. And that's all.
Obviously, you're much better off this way than you would be if you converted
part of your equity in your own property into cash by taking out a new first
mortgage or by getting a second mortgage through a private lender or a mortgage
company.
"But wait a minute," you may be thinking. "Would any seller of
an apartment house seriously consider taking a second mortgage on a house instead
of a cash down payment?"
The answer, more often than not, is yes.
A properly secured second mortgage is a worry-free investment at a high rate
of return; the worst that can happen is that the debtor doesn't pay, in which
case a foreclosure will get the seller his money back. Where else can a lender
be sure of making from 6 to 8 percent on his money with essentially no downside
risk, as stockbrokers call it?
Another reason it may look attractive is the tax angle. In selling his
apartment building, the owner must think about the likelihood of an immediate
capital gains tax. But if he takes a newly created second mortgage instead of
cash, generally no tax at all will be due immediately. Instead, his taxable
gains will be spread over a period of years and thus taxed at lower rates. To a
seller in a high tax bracket, this can mean a saving of thousands of dollars.
Of course some sellers urgently need cash, for one reason or another. They
won't even talk about taking a note instead. These aren't the sellers with whom
you're likely to strike an advantageous deal, unless you happen to have plenty
of spare capital.
But there are some sellers who let you know from the beginning that they'll
take a mortgage and would even prefer this to a cash deal. Sometimes this is
stated in their "For Sale" advertisement. Sometimes the broker will
know about it, or can easily find out, and will tell you.
Accepting a created mortgage. As you go farther with realty investing,
and sell more properties as well as buy, you're likely to be asked to accept a
"created mortgage" as the down payment on a property you want to sell.
This may confront you with a problem, if you need cash - or if you want to use
the proceeds of the sale as a down payment on another property. How can you
solve this problem?
One solution - not a very good one, usually - would be to sell the mortgage.
As we've seen, this would trigger immediate tax liabilities for you.
Furthermore, no one is likely to pay you full face value for the mortgage. So
you'll lose two ways in order to get some cash in hand.
You could sign the mortgage over to the seller of a property you're buying.
He may accept it instead of of down payment. And he may take it at its face
value, instead of at a discount. But the Internal Revenue Service will regard
this as equivalent to having realized the gain the mortgage represents, just as
if you'd gotten cash for it. And the seller, too, will have to treat the fair
market value of the mortgage as payment received in figuring taxes n any gain
he's making on the sale. If he's at all knowledgeable, he'll certainly consider
it carefully before he accepts your proposal.
So what do you do? You keep the mortgage. You use it either as security for a
cash loan, or as security for your IOU - your personal note - which you give to
the seller as down payment on the apartment house you're buying. This way, neither
you nor the seller gets hit with any immediate tax bill. You are simply
borrowing, not raking in a taxable capital gain. And the other fellow is taxed
for capital gains only as he gets them, from the payments you make to him on
your note.
Do you see how this basic idea can save your money on both purchases and
sale, helping you close transactions that otherwise would be out of your reach?
Few sellers will accept your unsecured personal note instead of, or as part of,
a down payment - but many sellers will be glad to get the same note secured by
an existing mortgage you own or, for that matter, a chattel mortgage you might
personally write on your car, a house trailer, a boat, livestock, or other
personal property valuable enough to assure the seller he will get his money out
of it if he should have to foreclose on you. Even your intangible assets might
make good collateral for your personal note: assets such as contracts, patents
or royalty rights, or investment securities.
