The focus of this article is advanced strategies for experienced real estate investors who want extra protection for your investments. The use of the strategies I’ll cover will depend upon your investment strategy. Also, they may not be solutions you’ll commonly use, but you’ll have the knowledge you need should you decide to employ them. It’s always good to have more weapons in your investment arsenal!
The Fundamental Protection of the Memorandum of Option A primary negative of lease options concerns financial difficulties of sellers. These problems can result in liens, delinquent property taxes and other similar hassles. For the investor, this can result in a considerable amount of time and money spent on resolving these issues before the property can be sold.
That’s why you need the Memorandum of Option. It’s an indispensable protection because it’s a public document that’s a record against the title of the property. Always record a memorandum because it lets everyone know that you have an interest in the property.
The memorandum has an important purpose–to prevent an unethical seller from selling the property out from under the investor’s nose to someone else. It also provides protection from bad faith sellers trying to squirm out of their obligations. My advice–always record a memorandum of option!
Advanced Strategy 1-the Deed in Escrow You may think that the term escrow refers only to the deposit of funds by one party for delivery to another party upon completion of a specific event or condition.
However, the definition also includes the deposit of deeds and other written financial/legal instruments. I recommend placing the deed in escrow at the time the memorandum of option is filed. In this case, the seller signs the deed along with the other contracts, but the deed is not recorded on the title at this point. Instead, it’s held in escrow by a title company or attorney, and they’re provided with instructions for its release.
Now, this action doesn’t protect against the filing of liens against the property. But, its effect is to reinforce to sellers that they’ve actually sold the property. This, in turn, creates reluctance on their part to try to back out on a lease option agreement.
It also has another advantage: It allows you to close on the property without the seller being present! With the deed in escrow, you should specify how and when the deed is to be released and recorded. The instructions can be simple, such as this example: “When Sam Smith pays $200,000 in certified funds to John Jones, the deed will be released to him. By (date), these funds must be paid.”
Advanced Strategy 2: The Performance Mortgage This is a method whereby the seller pledges the property as collateral for the lease option agreement, ensuring good faith performance by that seller. When the mortgage is assigned to you, it prevents the seller from selling the mortgage to other people. (It replaces the filing of the memorandum of option.)
The performance mortgage permits the seller’s insurance company to put the buyer’s name on the owner’s policy as another insured. It shows as well that the buyer is a lien holder and requires that he or she be notified if any type of foreclosure action is taken.
Of course, some sellers don’t like the idea of a performance mortgage and won’t agree to this deal! If a performance mortgage is agreed to, have your attorney review the terminology of the mortgage to make sure the appropriate, specific clauses are included.
Advanced Strategy 3: The Land Trust Land trusts are formed by organizations established to hold land and to administer use of that land. You’ll find that this technique is very useful with subject-to’s because a land trust minimizes your exposure to litigation.
It accomplishes this by hiding true ownership. The actual owner or beneficiary is not recorded in the public records, just the name of the trust. This means potential litigants find it difficult to identify someone to sue.
Keep in mind that land trust contracts tend to be complicated and long so you’ll definitely need an expert lawyer to draw them up.
Advanced Strategy 4: Get a Partner In some cases, you may want to consider subject-to high-end properties (in terms of rapidly appreciating value). With these properties, there’s more risk. Since there is more risk, you can spread that risk by taking on the seller as a partner. In this case, the buyer and the seller share the profits.
Here’s an example: Assume a property is worth $800,000 and the monthly rental is $3,500. Under normal circumstances, you’d likely back away from this deal. However, let’s assume that you discover this home might be sold for $200,000+ in profits. This deal makes good financial sense for both you and the seller. So, you agree on a 50-50 partnership (or another percentage arrangement), and you both end up happy.
Ironclad rule: If you use this method, insist that the seller cover all the risks.
Advanced Strategy 5: Refinancing Refinancing is a great tax-deferment strategy. Here’s an example: Assume you have a house worth $300,000, and $230,000 is owed on it. Through a new mortgage, you can take out some or all of the $70,000 in equity, and it’s not a taxable event. The result-you can use that money to reinvest in other properties while still holding on to your original property.
It’s a good idea to check with lenders and brokers in your area to find out what refinancing programs are available and which ones best suit your needs.
Tax Concerns With any of the strategies I’ve just described, IRS regulations have to be met. So, you and your tax person should stay up to date on those regulations. They do occasionally change, and those changes can affect the legality and profitability of deals. One area to really be on top of is capital gains.
Capital gains are the profit on the sale of a property. Currently, a person can sell his or her primary residence (the one actually lived in, not investment properties) every two years.
If a person is single, he or she can keep the profits up to $250,000; if a person is married, he or she can keep up to $500,000. In both instances, the profits are tax free. If the seller of a property lives in his or her home for two out of five years, then that property qualifies for a tax-free gain. The seller can rent the home out for three years - and not a single day more.
My Advice Never stop learning! Keep advanced strategies in mind as you grow your investment portfolio. It’s not likely you’ll need them for the majority of investments (especially early in a career), but, as is often said, knowledge is power. With that knowledge, you’ll be able to apply it quickly and easily when the right investment situation arises.
Key Point: Always get the lenders written permission. Study advanced strategies in depth, so you can make use of them at the appropriate time for maximum protection of your investments.