Activating Equity without a 1031 Exchange
Good for you! You’ve been investing and you have a nice piece of rental real estate where you’ve built up equity. But you have noticed that the return on that equity is not the best each year. Traditionally, you would say it’s time to sell and use a 1031 deferred tax exchange to move the money into a new property. There are rules, of course, for how to handle the sale and purchase: rules about timing, about the cost of your next property, and the amount of debt you must have. And darn it, you kind of like the property. It is in a good area, continues to appreciate, and it has a special place in your heart. Going to a bank to get a loan against it may be challenging if it doesn’t cashflow like a champ. Is there another way?
Well of course there is another way. In fact, there are many ways to handle this, but I would like to focus on one that not too many people think of in creatively structuring deals: Creating Your Own Note (CYON). In a nutshell, you will create a loan secured by your property on terms you are happy with and you will use that note as a down payment on a new property.
Perhaps you think that creating a note is some arcane process. Perhaps you wonder who would accept a note for real estate. But as a real estate investor, you have used notes in your real estate transactions. After all, what are dollars but certificates of debt? Even the term ‘banknotes’ indicates that they are nothing but a claim on an obligation. You are not the government or a bank. But companies also create notes (they call them bonds).
To create a note secured by real estate, you usually need two documents (this will depend on what State or Country you are in and the local laws). The first document is a promissory note that outlines how much currency the note is for, the interest rate, payments, terms, etc. The closer to market rates you make these terms the more attractive your loan will be to note purchasers or to sellers who might accept the note as a down payment. The second document is a mortgage or deed of trust that secures the loan with your property. This mortgage says that if you don’t pay the promised payments, the note holder can foreclose on your property. The two documents together provide a secured note that will be attractive to those who buy such things. And, lots of people buy them.
Now you have created a note secured by your property. You, of course, pay yourself while you are figuring out how to use the note. You’ve got to keep current on those payments and show the note is performing. But you are literally taking money out of your right pocket and putting it in your left. If you do this for some months, the note is ‘seasoned’ (i.e., it has a history of on– time payments). That also makes the note more valuable and salable. As an interesting side benefit, your property now looks as if it has much less equity in it making it and you a less attractive target for lawsuits.
The note is typically worth it’s principal value (if it’s a note to repay $500,000, the note is valued at $500,000). But sometimes notes are worth less than their face value (e.g., if they are non-performing) or more than their face value (see any detailed discussion of corporate bonds). To keep things simple, we will say a note to repay $100,000 is worth $100,000.
Why would a seller accept a note as a down payment for their property? Don’t they prefer cash, which we already decided is also a note? Actually, any seller with a brain would rather have the note. The one thing we know about a dollar (or a euro, yuan, or yen) is that it will be worth less next year. Every government in the world manages their currency so that it will depreciate about two to three percent per year. Governments do this so that the debt they take on will be paid in future currency that is worth less. But a note is a dollar with an interest rate. It’s pre-invested to make money for the seller and is secured by a property that is not the one the seller is selling. Many sellers want nothing to do with the property they own (they are selling to get it out of their psyche). But a note secured by another property is a different animal.
The end result is you keep your current property. You activate your equity on terms that you can tailor to your situation. And you leverage that equity into a new property to allow you to continue to build your wealth. How cool is that?