A Case Study: The Discounted Notes with Participations
In this time of economic uncertainty, one of the excellent opportunities in real estate is purchasing discounted notes. This is particularly attractive when you use tax-deferred funds in your IRA or other retirement plan. The payment stream comes into your IRA and in the final analysis, on a first trust deed, the worst case is that you own the property.
A Case Study: The Discounted Notes with Participations
Buying notes at a discount is becoming more popular, as real estate professional discover additional ways to generate income as well as dealing with problem loans or properties. Recently one of our clients discovered problem loans that a collection agency had made her aware of on two properties she had originally sold. The original financing, in August of 1990, for $100,000 and $115,000 to each buyer had been consummated through a local bank. When the borrowers were about to go into foreclosure, a third party was able to arrange private financing and purchase the obligation from the bank prior to foreclosure. In both cases the private financing was provided by a group of three investors each of whom, owned varying percentage of each note. Terms were at 15 percent for 30 years on both notes.
In November, the borrowers had problems again, and the investors decided to assign the two loans to a local collection agency. The loans were being collected, and a 45 percent investor in the $100,000 note decided that he to sell out. The same investor wanted to also sell their 20 percent in the $115,000 also, but was willing to take a bigger discount on that note. (The $100,000 note was paying better than the $115,000 note at this time.) The Realtor who had sold the original properties knew the principals in the transactions, and also knew that the values were in the properties in the event of foreclosure. Although payments were slow, they were being made.
The Realtor has a SEP-IRA with $180,000 in uninvested funds, and other assets. Recognizing the opportunity, she decided to make an offer to all of the investors in this pool. The offer consisted of $50,000 for the $100,000 note and $40,000 for the $115,000 note from all of the investors. With the 45 percent investor being a large part of the $100,000 note, the other investors also sold. Our client thus bought the entire $100,000 note for $50,000. Principal balance outstanding at this time: $98,900.
The 20 percent investor of the $115,000 note sold his interest for $12,500, somewhat more than the buyer wanted, but nevertheless, with a remaining $22,968 balance (twenty percent) the discount was still worth it to the client. The other investors remained, and as a result the SEP-IRA became a vested participant in the loan. Comparable sales in the area for both notes continued to support values in excess of the face value of the mortgages, and the purchase of the notes at 50 percent or better of the face value were a good bet.
Six months later, the $115,000 was no longer paying, and the investors decided to foreclose. The owner of the property gave the investors a deed in lieu of foreclosure. The SEP-IRA client was able to find a buyer for the property for an immediate cash sale of $110,000. This represented a loss of $4, 844 from the note face amount. For our client, however, it represented a gain of $9,5500 net. Recognizing that all gains in SEP-IRAs are tax deferred, it turns out well for the client on all counts.
About the $100,000 note? It is paying relatively regularly, albeit slowly. Again the income received on that note is tax deferred. The SEP-IRA had an extra $38,000 with which to make investments. $10,000 went into 1st Trust Deeds, Interest only at net 15 percent for five years. The trust deeds are being serviced externally at a one- percent fee from the mortgage servicer. This fee is usually tax deductible as an accounting fee that the trust (IRAs and SEP-IRAs are trusts) pays. The amount of these fees and IRA administration fee as well as other accounting feeds must meet conditional tests as a percentage of income. The deductible amounts should be reviewed with the tax preparer.
The other part of the un-invested fund was invested in a managed account in which the client gave specific direction to a securities broker as to her goals and objectives for income and growth. Part of the objective was that the remaining $28,000 was to be liquid enough so that within a sixty-day period, the managed account portion could be liquidated to be placed into another real estate opportunity. Although this is a limiting instruction, good managers of funds are able to balance the needs of clients’ short and long term financial objectives, and still achieve reasonable results. A securities broker who also understands the real estate market and ability to achieve high yields, especially in self-directed tax-deferred accounts can be a valuable asset in the overall scheme of self-direction.
