As house prices and mortgage rates rise, young couples struggle with down payments and loan qualifications. 1031 parents who have business or investment real estate can help them purchase a principal residence while still receiving all the advantages of being a real estate investor and completing a 1031 exchange. The investor-parents (the exchangers) can exchange from their current rental, investment or business property and co-purchase an interest in the young couple’s desired principal residence as the 1031 exchange replacement property using a shared equity agreement. If the investor-parents maintain their investment ownership status, they can perform another 1031 exchange out of their interest in the real estate to another replacement property when the time arises.
Shared Equity Agreements are sometimes used in the following ways:
- to help a child purchase a home
- occupying co-owner does not have the down payment needed to purchase a home but has enough monthly income to pay the monthly mortgage
- co-owner can afford to purchase a home but cannot qualify for the mortgage independently
The purchase of an undivided interest in the investment property with a third party who will occupy the property as their principal residence (referred to as occupying “co-owner”) can qualify as Section 1031 Exchange replacement provided the 1031 investor (co-owner) meets certain criteria in written “shared equity” financing agreement.”
Under a Shared Equity Agreement, the investor co-owner receives Fair Market Rental income based upon their ownership percentage. A shared equity financing agreement is defined in IRC Section 2801A(d)(3)© and IRS publication 527.
Fair Market Rent (FMR) needs to be paid to the investor co-owner by occupying co-owner based upon their ownership % by the occupying co-owner. For example, if the FMR rent is $2,000 and the 1031investor-parent owns 30% interest in the property. Then the child or co-owner must pay $ 600 each month to the investor-parent.
The Written Agreement must define in detail the financial relationship including Who is Responsible for: repairs, maintenance, property taxes, hazard insurance, HOA dues, and other ownership costs.
If there is No Written Agreement and - or the occupying co-owner does not pay fair market rent or stops paying rent the IRS will classify the property as the investor co-owner’s second home.
A well-drafted share equity agreement, along with a recordable memorandum of the agreement, will provide the investor-co-owner with protections and the right to sell if the occupying co-owner does not pay agreed-upon costs. Investor co-owners should seek advice from knowledgeable tax and legal advisors who can prepare the necessary written agreements.
Annamarie Kooning is a local 1031 exchange expert and NW Division Manager at Asset Preservation, Inc., a leading national 1031 qualified intermediary. Contact Annamarie at 206-701-1887 or annamarie@apiexchange.com.