How will I fund a land investment?
Those beginning the process of purchasing land usually have a general idea of how they plan to pay for the investment. However, I have seen many buyers change their method of funding because they became educated on an option that was previously unknown to them and offered them some distinct advantage. Some may simply not understand the process or what they can afford. Following is a brief explanation of the most commonly used methods to fund land transactions.
Cash – Most land transactions that I work with are cash transactions. This is not to say that I work with only the independently wealthy. Most people that pay cash for a property have recently sold some other type of investment and are simply moving that investment into a property that works better for them. Many investors prefer this method as it is the most hassle-free and gives the buyer a negotiating advantage—The general thought is that a cash offer is stronger and that because the terms of the offer are stronger, the investor can offer a lower price.
1031 Exchange – 1031 exchange, Like-kind exchange, Starker exchange, Tax-deferred exchange—all refer to a method of exchanging a property or properties for other similar properties without the realized capital gain being recognized as taxable by the IRS. This is only available to those who hold the property for a business purpose. In the past few years, this has become very popular with investors seeking to grow their investment portfolios without taking cash out. For example, if you sell a farm that you have operated in Texas, you can utilize a 1031 exchange to move that money into a timber property in Alabama. There are many special conditions that must be adhered to in order participate in a 1031 exchange. You should consult your attorney regarding a potential 1031 exchange prior to accepting an offer from someone to sell the property you will be selling in the exchange.
Home Equity – In most of the land deals that I work with, the buyer is purchasing a property that will not be, at least immediately, their primary residence. Most of these buyers also have signifigant equity in their current primary residence. A home equity loan on the buyer’s primary residence offers many advantages over a traditional land loan. First there are the tax benefits from using the interest on the loan on your income taxes. Also, when a buyer is using a home equity loan, that buyer can go through the loan process prior to making an offer. Since the buyer then knows how much money he or she has avialble for the purchase, they can make an offer as a cash offer, which strengthens the buyer’s postion in negotiations. Many times you can get more favorable terms on a home equity loan than on traditional land loans as well. It also makes your investment in land more liquid since to sell it, you will not have to then pay off a mortgage on it- so if the right opportunity comes along, you can liquidate your invesment and roll that money into whatever it is that you wanted…just like you had bought the property with cash. Most banks, credit unions, and mortgage brokers offer home equity loans.
Land Loans – Land loans are those loans that hold the land itself as collateral. Whereas many times you can buy a home with 5-10% downpayment, most times you will need 15-30% of the purchase price as downpayment to get a land loan. Land Loans typically have a slightly higher interest rate than you can get on a home equity loan or regular home mortgage, however, many institutions that specialize in land lending are becoming more competitive with the conventional home loan market. Local banks (local to the property) are a good source for land loans, as well as lending cooperatives like the Federal Land Bank, and the Farm Credit System. My experience with land loans is that you want to work with a lender that understands land and land issues. Most, not all, mortgage brokers and loan officers are not as experienced in land lending as are those that work for companies that specialize in that segment of the industry.
Owner Financing – Many times buyers and sellers find advantages in owner or seller financed transactions. This typically occurs by the buyer making a down payment to a seller on a property. The seller then conveys the property to the buyer, with the seller holding a mortgage on the property until the buyer pays the remainder of the amount due. Terms and conditions of owner-financed sales can vary greatly. In my experience, sellers usually want 15-20% down payment from the buyer and an interest rate that is slightly above what rates are in the conventional markets. Repayment terms can range from monthly payments over 30 years down to a single payments soon after the initial transaction. This must be worked out between the buyer and seller. It is important to note that not all sellers are willing or able to offer this option on a property. The buyer should be sure to perform the same due diligence that a lending institution would require to protect themselves from potential pitfalls in owner financed transactions. Owner financed sales are advantageous to some sellers because they can differ some of the income from the property and get a steady stream of income over time. Buyers benefit since most owner financed sales do not typically involve credit checks, origination fees, and the hassle of dealing with a lender.
Lease Purchase – Some properties are contracted for in a Lease/Purchase Option contract. In this type of arrangement, the buyer leases the property from the seller for an agreed upon timetable at the end of which the buyer can elect to buy the property or forfeit their money paid to the seller until that time. Sometimes these arrangements do not leave the buyer with an option to buy, but rather an obligation to buy at the end of the lease period. Typically, monies paid as rent and for the option are deducted from the purchase price, but this is not a requirement. In this type of arrangement, title to the property does not pass to the buyer until the end of the lease period, when the buyer exercises their option to purchase the property. Usually there is interest charged by the seller on the principal amount due during the lease period. It might be helpful to think of this as “Rent to own”. Again, not all sellers are willing or able to offer this arrangement. Also, it is important that the buyer performs sufficient due diligence in checking out the property, as well as the seller of the property, since the seller will retain title to the property during the lease period.
There are many other options for funding land transactions and are limited only by the creativity and the acceptance of the parties to the contract. Sometimes transactions are negotiated in broad strokes, sometimes deals worth hundreds of thousands of dollars hinge on something as small as who pays for inspecting the title to the property. One creative manner of funding a land transaction is through the use of your 401K funds or IRA funds…and you can do it without incurring Federal taxes for transferring the investment. I will examine that further in a later post.