A shared equity finance agreement is an arrangement that permits two or more parties buy a property and share its ownership. It is typically used to help a relative or friend buy a home they couldn’t otherwise afford. If a lender is one of the parties getting a share in the equity, the arrangement is often called a shared equity mortgage or shared equity agreement. Find out how they work, when they make sense, and how they can help you buy your next property.
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You want to buy a home but can’t quite manage the financing. Maybe you don’t have enough money for a down payment on the property you want. Perhaps your income won’t let you cover the full mortgage payment. Maybe you face some other financial challenge. Equity sharing is one solution to consider. In such circumstances, a shared equity financing agreement could be just what you need to buy that piece of real estate you’ve had your eye on. Here’s who they work.
The definition of a shared equity financing agreement
Shared equity finance agreements are contracts between two or more people who want to buy real estate together. Typically, it is used because one of the parties could not purchase the property alone. This agreement is rare, so it’s a good idea to make sure you understand the terms and conditions before you consider entering into one. There are two parties in a shared equity finance agreement, the investing owner, which usually provides the lion’s share of the initial investment (i.e., downpayment). Then, the occupying owner, who lives in the home and typically makes monthly payments.
Rather than answer further questions in the abstract, let’s look at some examples of how shared equity financing agreements are used in the real world. Along the way, we’ll point out some of the complexities that can arise with these agreements. Finally, we’ll describe tax consequences and explain some perplexing terminology.
Home equity investors vs shared equity financing agreements
The term shared equity agreement is also used by firms that help extract equity out of your home. This article focuses on shared equity financing agreements used to buy a home where the investor is not a lender. If you are looking for an investor to buy equity in your home in exchange for cash, you need a home equity investor. These companies use a special type of shared equity financing agreement where the lender is also an investor.
Shared equity agreements, sometimes known as home equity investments, allow homeowners to cash out on their equity without getting into debt. It works like this. Investors give homeowners a lump sum in exchange for a share in the future value of their homes. When the homes are sold (or when the contract term ends), the investors receive their share from the sale. If the value of the house increases, so does the amount the investor receives. If the house drops in value, the investor also shares in the loss.
Home equity agreements are an attractive option for people who either don’t qualify for traditional home equity financing or want to tap into their home equity without getting into debt.
Here are our top choices.
Shared equity financing agreement: the most common use
How is this type of financing agreement most commonly used? One common use is to help younger adults buy their first homes. This usually means the adult children of parents who have done well and can afford to help out. But any relative might assist. In fact, anyone might choose to help out. Why? A shared-equity arrangement can be a profitable investment for the assisting party.
How a shared equity financing agreement works
This type of agreement goes by various names: “shared equity finance agreement,” “shared equity financing,” and “equity sharing” are three of them. Broadly speaking, equity sharing involves two parties. The first party is the “investor,” the “nonresident owner,” or the “investing owner.” The second party is the “occupier,” the “occupying owner,” or the “resident owner.” Like all legal and financial arrangements, equity sharing can get much more complex. More than two parties can get involved. Ownership stakes of the parties can vary. Standard terms can become inapplicable, and confusion can reign.
Shared equity financing agreements: a tour of some potential complexities
How much more complex can it get? You don’t even want to know. As one small example, consider the term “landlord.” You’d naturally assume that the nonresident or investing owner is the landlord. That makes the resident owner the tenant, right? Well, yes. But it’s not always clear-cut.
Both parties as residents
Most states do mandate that the investing owner charge the resident owner the “fair market rent.” This means the fair market value for rent. The monthly payments required for rent must be within the range of prices typical in the local rental marketplace. This doesn’t mean the fair market rent for the whole property, mind you. It means the rent that’s fair for just that portion of the property the resident occupies.
Children getting help from parents to buy homes probably will want to occupy the entire homes. But this won’t be the case with all equity sharing arrangements. For example, an investing owner might choose to occupy half the property and buy half its equity. This “assisting owner” might live on the second story while the “assisted owner” lives in and owns the lower story, for example.
In this case, both the equity sharing owners occupy the property, confounding the standard terminology. (Hence the new assisting/assisted wording.) The downstairs party pays rent on half the property. So we have a “tenant” downstairs and a “landlord” upstairs. But talk of “resident” and “non-resident” owners has become meaningless.
In the end, the downstairs party will buy out the upstairs party’s equity share. When that happens, the upstairs party will move out or start paying rent. On that great day, there will be no more need for confusing terminology. Landlords will just be landlords. Tenants will just be tenants. And all will be right with the world — at least until new parties sign the next equity sharing agreement.
Both parties as landlords
In the above case, before the buyout, the assisting owner is also an owner-occupant landlord. Strangely enough, the assisted owner might also be a landlord. Consider landlords who live in units of their apartment complexes. These landlords might enter into equity agreements with nonresident owners. (“Equity agreements” is yet another way equity sharing arrangements are often identified.) Such agreements may allow them to buy more expensive complexes.
In states with the “fair market rent” requirement, this will mean the landlords will be paying rent for the units they occupy. The resident landlords will have nonresident landlords.
Shared equity financing: back to basics
Fortunately, such complexities are the exception rather than the rule. Parents helping kids buy their first homes won’t usually occupy part of those homes. And kids getting this help won’t normally live in just part of the homes. Either or both of these things could happen, of course. But let’s keep things simple and assume the typical case.
In the typical arrangement, the assisting parents will be the investors, their child’s family the occupiers. Through shared equity financing, the parents will provide the cash for a down payment. For a period of time specified in the agreement (the “term”), the new family will live in the home and maintain it, paying all expenses. At the end of that time, the occupiers will pay the investing parents an amount based on the home’s increased value. Before that payment, the parents will be co-owners of the property. Both the parents and their child may receive tax benefits typical of homeownership. This will depend on the precise provisions of the financing arrangement. For instance, will the parents provide only a down payment? Or will they also cover some portion of the mortgage payments?
At the end of the agreement, the child’s family will meet its equity sharing obligation in one of two ways. Way one: sell the property and give the parents an agreed-to portion of the profits. Way two: get the property appraised and pay the parents a set percentage of the increase in value. Using way one, adult children end up with funds for a new home they would not have been able to afford otherwise. Using way two, adult children end up with a home they couldn’t afford on their own. Either way, parents make a profitable investment.
Shared equity financing arrangement: a more detailed example
Without some dollar amounts, this general case seems a bit vague. The Association of International Certified Professional Accountants (AICPA) offers a more specific example (Source). The following is a modified version of that 2018 example.
A and B helping C
Parents A and B agree to help their son, C, buy a home. The total home purchase price is $500,000: a $400,000 mortgage plus a $100,000 down payment. In an equity sharing arrangement with C, A and B agree to pay half of the down payment and make half the mortgage payment. This makes them 50% owners of the property and gives them a 50% equity share. In compliance with the same agreement, C pays the fair rate for rent on half the property. Based upon the rental market, that fair rate is specified in the agreement. C only pays rent on half the property because he only owns and occupies half the property during the term of the agreement.
Benefiting from shared-equity financing arrangements: tax benefits for A, B, and C
During this term, C gets to treat this piece of real estate as his residence for tax purposes. (For this financing arrangement to be legal, in fact, C must use the home as his principal residence. This is per U.S. Code Sec. 280A(d)(3).) Because this is his residence, C can deduct his 50% share of the mortgage interest and property taxes. The deduction is based on 50% rather than 100% of the property’s value. This means it won’t be as high as it would have been had C bought the property without parental assistance.
A and B must treat the property as a rental. They must report the rent they receive from C as income. But they can deduct 50% of the mortgage interest and property taxes. They can also deduct their maintenance expenses. They can only deduct property depreciation based on 50% of the property’s depreciation basis.
Because A and B do not occupy the property, it is not subject to the rules governing vacation homes. (For that to apply in any year, A and B would need to live in the home. Specifically, they would need to live there for 14 days or one-tenth the number of days the home was rented out at fair market value.) This means deductible losses are not limited to the rental income. (Rental income is “passive” income for tax purposes.
The normal limit on deductible losses for passive income in any tax year is an amount equal to the rental income.) As a result, the property could generate a tax loss. This, in turn, could reduce A and B’s obligation to the IRS. If some of these losses are not deductible in the current tax year, they may be “suspended.” A and B may still be able to deduct such losses when the property is sold. These losses are called “suspended passive losses.”
Tax-benefit caveats: points of caution for A and B
The AICPA points out a couple of caveats. One concerns the suspended passive losses just mentioned. As noted earlier, the resident owner (C) will usually buy the equity share held by the nonresident owner (A and B).
Normally, suspended passive losses cannot be deducted if you sell your interest in a property to a relative. This means A and B can’t recover those missed deductions. A possible way for A and B to compensate for this would be to arrange a higher monthly rent. (It still has to be within the range of fair values determined by the rental market.) Another would be to make a larger down payment. This would reduce the mortgage interest expense. These actions would reduce yearly losses, allowing A and B to deduct a larger percentage of their remaining losses each year. Fewer losses would then get suspended. So, at buyout, A and B would lose fewer deductions for suspended losses.
A second caveat concerns Sec. 121 of the U.S. Code. To people moving from one home to another, that section’s opening words are sweet music. Here are the lyrics: “Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer’s principal residence for periods aggregating 2 years or more.” This is discordant music written by attorneys, no doubt. But it’s sweet nonetheless.
Sadly, the nonresident owners in an equity sharing arrangement do not qualify for this exclusion. They still must pay the investment income tax of 3.8%. Actually, that isn’t true. The IRS only imposes the 3.8% tax on earners who reach certain “statutory threshold amounts.” The specific modified adjusted gross income (MAGI or AGI) values that subject someone to the tax are these:
- Married filing jointly: $250,000
- Married filing separately: $125,000
- Single or head of household: $200,000
- Qualifying widow or widower with a child: $250,000
(The percentage and income amount date to 2013 and were still shown as current by the IRS in July of 2021.)
If A and B expect to reach one of these income levels by the time C sells, they may wish to consider cosigning C’s mortgage instead. Setting up shared ownership through an equity sharing arrangement might cost them money. They could owe 3.8% in taxes on the increase in the value of their half of the property. Of course, if the whole point of equity sharing is for A and B to supply cash for the down payment, cosigning won’t cut it.
How does a shared equity mortgage work?
“Now that you mention it, I’ve heard of these shared equity agreements,” someone says. “They’re the same as shared equity mortgages, right? I’ve always wondered about that. How does a shared equity mortgage work, anyway?”
It would be nice if everything with “shared equity” at the beginning referred to shared equity financing agreements. It would also be logical. The terminology would make sense, and no one would ever get confused.
Sadly, that isn’t the case. As it happens, “shared equity mortgage” is another way to refer to a shared appreciation mortgage or SAM. However, shared appreciation mortgages and shared equity financing agreements are completely different products.
Sharing equity means sharing ownership. Sharing appreciation does not mean sharing ownership. Both shared appreciation mortgages and shared equity financing agreements are pretty rare nowadays. However, there is a third product, shared equity agreements, which are becoming much more popular because they offer a debt-free way to leverage the value of your home. Find out more about how shared equity agreements work here.
What is the difference between shared ownership and shared equity?
Equity is the present market value of your property minus however much you still owe on it. For example, if you own a home worth $1 million and you still owe $500,000 on your mortgage, you have $500,000 in equity.
Appreciation is the change in your home’s value since you bought it. If the same $1 million home cost $750,000 when you bought it, its appreciation is $250,000.
Imagine that you bought this home 10 years ago. Further, imagine that you agreed to share 50% of your home’s appreciation after 10 years with your bank. Maybe you did this because you loved your banker. More likely, it’s how you convinced your banker to loan you so much money. Whatever the case, you now owe that bank 50% of $250,000: $125,000. This bank’s share of your appreciation is called “contingent interest.” As mortgage interest, it’ll be deductible if you choose to itemize your deductions.
If instead, you signed an agreement giving your bank 50% ownership in that pricey piece of real estate, the bank is entitled to 50% of $500,000: $250,000. If you wrote up a sensible shared equity financing agreement, your bank picked up 50% of the costs that produced this equity. In that case, you were the adult child in our more detailed hypothetical, and the bank was your parents. The bank owns half the property because it paid for half the property. If you want to own the whole property now yourself, you have to buy out the bank. Doing so will cost you $250,000.
The money you spend buying out your equity-sharing co-owner isn’t mortgage interest. So you can forget that deduction. A tax professional might be able to help you find some other deductions to offset this big expense, though. So it couldn’t hurt to ask.
- One common use of shared equity financing is parents helping adult children buy first homes.
- An equity sharing agreement may allow you to qualify for a home you couldn’t buy otherwise.
- Equity sharing means shared ownership. Both parties may take advantage of the tax benefits of homeownership. These benefits will be proportional to each party’s share of ownership.
- In many states, resident owners will have to pay market rental rates during the agreement.
- In those states, non-resident owners will have to charge fair market rents. As landlords, they’ll be able to deduct such expenses as maintenance.
- This article covers fairly simple cases. Much more complex shared equity financing is possible. This sort of financing can be put to many uses.
- Shared appreciation mortgages (SAMs) are not a form of equity sharing. Even so, people often call them “shared equity mortgages.’ Try not to let the terminology confuse you.
There aren’t as many ways to finance a property purchase as there are properties to purchase. But sometimes, it can seem like there are. Equity sharing is another form of home-purchase financing some may wish to consider. This form of financing provides ownership interests to both the party in need of assistance and the party able to assist. When all goes well, both parties can profit from the arrangement. One profits as an investor who owns part of the property temporarily. The other profits by exchanging some of the benefits of ownership, temporarily, to finance a home.
Could this be the right financing for you? If you’re not sure, there’s no need to rush into anything. Instead, why not read our complete guide to home loans and compare the prices and rates you can get from regular mortgages. Here are some reviews to consider before deciding?
- 26 USC 121: Exclusion of gain from sale of principal residence — Office of Law Revision Counsel (OLRC) United States Code
- 26 U.S. Code § 280A – Disallowance of certain expenses in connection with business use of home, rental of vacation homes, etc. — Legal Information Institute, Cornell Law School
- About Publication 925, Passive Activity and At-Risk Rules — Internal Revenue Service (IRS)
- Benefiting from shared-equity financing arrangements — The Tax Adviser, Association of International Certified Professional Accountants (AICPA)
- Depreciation basis definition — AccountingTools
- Equity Sharing — SirkinLaw APC
- Find out if Net Investment Income Tax applies to you — IRS
- Publication 925 (2020), Passive Activity and At-Risk Rules — IRS
- What Happens to Suspended Passive Losses When You Sell (Or Lose) Your Rental Property? — Nolo
- What is a shared equity financing agreement? — Kass Legal Group, PLLC