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08/12/08: Keeping The Family Home For Investment

HOUSING COUNSEL

By Benny L. Kass

Q: My sister and I inherited our family home. It has no mortgage debt. We both agreed to sell it but my husband suggested that we might buy my sister's half and use the property as a source of rental income. My sister is agreeable to this arrangement. This brings up several questions. How would we find out if this would be a profitable investment? We would have to finance a loan through the bank. Some repairs would need to be done before we could rent it. If we buy my sister's portion of the property and do not use an agent how do we give her a fair amount?

A: It was nice to hear that you and your sister are in agreement about the family home. All too often, sibling rivalry results, when one of the owners want to live in the house and the other wants to sell.

My first question: have you considered keeping the house in both of your names? Does your sister need money now? Since you are talking to each other, it may be a good idea for both of you to start a partnership, and use the house as a potential long term investment.

How do you decide if it is a good investment? That's a tough question with no easy answer. Do you know the neighborhood? Have houses appreciated in value in the last 5-10 years. What is the average age of the residents in the area? Have younger married couples with children moved in – or moved out – of the area? Where are the local schools, shopping centers, and transportation facilities located?

Unless you have knowledge of the area, you will have to do your homework. The US Census Bureau has a lot of documentation which may be useful to you. Local governments have Planning Offices that should be able to assist you. And you can also talk with a number of real estate brokers, who will be able to provide you with comparables and statistical histories.

If your sister does not want to join you in this venture, you have to reach agreement on the buyout price. Presumably when you inherited the property, there was a probate estate and someone obtained an appraisal of the property for tax purposes. If a lot of time has not elapsed, you can use that appraisal. Alternatively, you and your sister can hire an independent appraiser to give you an estimate of what the house is worth.

Often, when faced with the situation where one party wants to sell high and the other wants to buy low, we use what is known as the “three-appraiser method”. You and your sister each hire separate appraisers. If their respective valuation does not differ by more than 10 percent, the agreed upon sales price will be the average of the two numbers.

If, however, there is a greater difference, then the two appraisers hire a third one (at your joint expense), and the agreed upon sales price will be the average between all three appraisals.

Let's assume that the agreed upon market price is $500,000. Does that mean that you would owe your sister $250,000 to buy her out? Not necessarily. You do not need a real estate agent for this transaction and thus would not have to pay the 4-6 percent commission. So I would deduct 4 percent ($20,000) to reach the sales price of $480,000.

Although you are sisters, and appear to be friendly, I recommend that each of you retain your own attorney. There are many closing costs that are involved in this transaction, and perhaps the most expensive is the recordation and transfer tax which – depending on where the property is located – could be as high as 4 to 6 percent of the sales price. You will have to enter into a sales contract, which will spell out all of the terms and conditions of the sale. If you have to borrow money from a commercial lender, they will insist on reviewing that contract.

How will you pay your sister? In our example, you will owe your sister $240,000, less any closing costs on which you have agreed. If you have the cash, you can just write her a check – but I don't think this is a good idea. You have property with a lot of equity so why not tap into that equity instead of depleting your own savings.

Your sister can give you a deed to her half- interest in the property, and take back a mortgage. For example, you can give her $40,000 and sign a promissory note, secured by a deed of trust (the mortgage document) in the amount of $200,000. The two of you will have to work out the terms and conditions of this transaction. Will you pay interest only for a number of years or will the note be amortized – and if so, for how long? What interest rate will you pay on your note? You can pay the market rate, but since this is a family transaction, you can also pay what is known as the “applicable federal rate” (AFR). These are interest rates which the Internal Revenue will allow without challenge. They can be found on the IRS website (www.IRS.gov).

If your sister wants the money now, you will have to obtain a mortgage loan. While investment loans are becoming harder to obtain in todays economy, I do not believe you should have any difficulty, especially since you will only be asking for a loan of approximately half of the value of the house. Lenders look at the loan-to-value (LTV) ratio, and the more equity in the house, the greater chances you have to get a loan – and at favorable rates.

Your lender will require that you have adequate insurance coverage on the property, which you should have regardless of whether you obtain a mortgage.

You indicated that some repairs would have to be made. You and your sister should obtain at least two bids from licensed contractors. If you have to buy your sister out, half of this cost should be deducted from the sales price.

Your lender should also be willing to increase the amount of your mortgage loan so as to cover these repair costs. And if you will not need to obtain a loan to buy off your sister, you should also consider obtaining a line of credit from your bank so as to give you the moneys necessary to make the corrections to your house.

If you decide to rent out the house, make sure that you understand all of the local Landlord-tenant laws in the jurisdiction where the house is located. For example, the District of Columbia has very strong tenant-protection laws, and you should consult an attorney for specific advice. Your lawyer can also provide you with the appropriate lease forms that you will need to rent the property.

Do you want to handle the tenant issues on your own or do you want to hire a property manager? Not everyone wants to be a landlord. It's not fun getting midnight calls that the plumbing or the heating system is malfunctioning. Talk with a number of property managers to determine what they can do for you, and what their costs will be.

Finally, you should consider creating a limited liability company (LLC) that will hold title to the property. Depending on where the house is located, it may cost you a lot of money to transfer the house to that company but in my opinion, the benefits of having the protections offered by an LLC outweigh the costs. If you play by the rules – do not commingle your personal funds with those of the LLC, and always sign legal documents as the “member” of the LLC and not in your individual capacity – your personal assets should be protected in the event there is litigation involving your investment property.

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