How should my brother and I structure our real estate purchase?

Question

Currently, my wife and I are renting a home from my brother at a discounted (just over his mortgage) rate of $1000 per month. He wanted to buy the home across the street but didn't end up getting the financing on his credit because he has too many other rentals. He asked if we wanted to partner with him on the deal so we could have ownership in a home and he could still gain another (part-owned) property. We really like it and would rather live there and although we weren't planning on buying for a few years, we like the idea of paying (roughly) the same and owning instead, without putting up a down-payment (we would rather pay down student debt and other loans first).

He offered to pay the down-payment and we would get the financing. I got approved for an FHA loan with a 3.5% down-payment. We’re buying the home right over $200,000 so that means he will only need to put down (as a ‘gift’) roughly $7000. While he’s willing to pay more than that, I think the overall rate of return would diminish, so this seems most wise. We’ll get the financing and planned to pay the mortgage and all of the utilities and such since we’re living there, but he also offered to pay some of the mortgage if needed to make it fair.

At what percentage would you suggest splitting ownership and future expenses? Typically a cash/financing partnership would be 50/50, but since it’s only a 3.5% down-payment instead of 20% is that still fair? Also, we’re getting the benefit of living there so shouldn’t we have to pay more? Would a 75/25% split be better? Or, are there things we can do (have him pay some of the mortgage) to offset costs and still keep a 50/50% deal (which is what I would prefer)? I would love some unbiased opinions on how to structure the deal. We plan to talk to a CPA and maybe a real estate attorney first and put everything in writing, but I wanted to survey unbiased individuals (Solomon the wise) to help us decide how to split this baby. We both feel like we’re helping the other out (because we are), even though we could both probably find cheaper alternatives to do the deal on our own.

Answer 1

Because this question seems like it will stick around, I will flesh out my comments into an actual answer. I apologize if this does not answer your question as-asked, but I believe these are the real issues at stake. For the actual questions you have asked, I have paraphrased and bolded below:

• Firstly, don't do a real estate transaction without talking to a lawyer at some stage [note: a real estate broker is not a lawyer].

• Secondly, as with all transactions with family, get everything in writing. Feelings get hurt when someone mis-remembers a deal and wants the terms to change in the future. Being cold and calculated now, by detailing all money in and out, will save you from losing a brother in the future.

• "Should my brother give me money as a down payment, and I finance the remainder with the bank?"

If the bank is not aware that this is what is happening, this is fraud. Calling something a 'gift' when really it's a payment for part ownership of 'your' house is fraud. There does not seem to be any debate here (though I am not a lawyer).

If the bank is aware that this is what is happening, then you might be able to do this. However, it is unlikely that the bank will allow you to take out a mortgage on a house which you will not fully own. By given your brother a share in the future value in the house, the bank might not be able to foreclose on the whole house without fighting the brother on it. Therefore they would want him on the mortgage. The fact that he can't get another mortgage means (a) The banks may be unwilling to allow him to be involved at all, and (b) it becomes even more critical to not commit fraud! You are effectively tricking the bank into thinking that you have the money for a down payment, and also that your brother is not involved!

Now, to the actual question at hand - which I answer only for use on other transactions that do not meet the pitfalls listed above:

• "How much should my brother and I pay for this joint investment?"

This is an incredibly difficult question - What happens to your relationship with your brother when the value of the house goes down, and he wants to sell, but you want to stay living there? What about when the market changes and one of you feels that you're getting a raw deal?

You don't know where the housing market will go. As an investment that's maybe acceptable (because risk forms some of the basis of returns). But with you getting to live there and with him taking only the risk, that risk is maybe unfairly on him. He may not think so today while he's optimistic, but what about tomorrow if the market crashes?

Whatever the terms of the agreement are, get them in writing, and preferably get them looked at by a lawyer. Consider all scenarios, like what if one of you wants to sell, does the other have the right to delay, or buy you out. Or what if one if you wants to buy the other out? etc etc etc. There are too many clauses to enumerate here, which is why you need to get a lawyer.

Answer 2

While I agree with the existing bulk of comments and answers that you can't tell the lender the $7k is a gift, I do think you might have luck finding a mortgage broker who can help you get a loan as a group. (You might consider as an LLC or other form of corporation if no one will take you otherwise.) That is, each of you will be an owner of the house and appear on the mortgage. IIRC, as long as the downpayment only comes from the collective group, and the income-to-debt ratio of the group as a whole is acceptable, and the strongest credit rating of the group is good, you should be able to find a loan. (You may need a formal ownership agreement to get this accepted by the lender.) That said, I don't know if your income will trump your brother's situation (presumably high debt ratio or lower than 100% multiplier on his income dues to its source), but it will certainly help.

As to how to structure the deal for fairness, I think whatever the two of you agree to and put down in writing is fine. If you each think you're helping the other, than a 50/50 split on profits at the sale of the property seems reasonable to me. I'd recommend that you actually include in your write up a defined maximum period for ownership (e.g. 5yr, or 10yr, etc,) and explain how things will be resolved if one side doesn't want to sell at that point but the other side does.

Just remember that whatever percentages you agree to as ownership won't effect the lender's view of payment requirements. The lender will consider each member of the group fully and independently responsible for the loan. That is, if something happens to your brother, or he just flakes out on you, you will be on the hook for 100% of the loan. And vice-versa. Your write up ought to document what happens if one of you flakes out on paying agreed upon amounts, but still expects there ownership share at the time of sale.

That said, if you're trying to be mathematically fair about apportioning ownership, you could do something like the below to try and factor in the various issues into the money flow:

• Figure out the monthly outgoings (mortgage, interest, insurance, savings for maintenance, etc.) for the property
• Divide that in half so as to start with a 50/50 ownership and financial responsibility split
• Amortize your brother's down payment amount as if it was a loan (at the mortgage interest rate, or whatever rate you guys agree to) over the projected ownership period of the house in order to get a monthly equivalent to his down payment
• Subtract that from his half of the outgoings and add it to yours (the sum of his and your parts should still be 100% of the value of monthly outgoings you calculated in the first step above)
• Figure out what a reasonable rate of return on the house would be at current market rent. Multiply that percentage times 50% times the total monthly outgoings you calculated above. This is effectively the profit his half of house would have earned him every month.
• Subtract that amount from his side and again add it to yours.
• You now have an amount for each of you to pay every month that factors in the 50/50 ownership starting point, the split in down-payment amounts, and the fact that you're paying "rent" to him for living there.
• Given you're already splitting those factors equitably, any unforeseen, unpredicted, special expenses should be split 50/50 between you. Or used to adjust future payments in an agreeable manner.

The above has the benefit that you can start with a different ownership split (34/66, 25/75, etc.) if one of you wants to own more of the property.

Answer 3

We’re buying the home right over $200,000 so that means he will only need to put down (as a ‘gift’) roughly $7000.

I'm with the others, don't call this a gift unless it is a gift.

I'd have him check with the bank that previously refused him a mortgage if putting both of you on a mortgage would allay their concerns. Your cash flow would be paying the mortgage payment and if you failed to do so, then they could fall back on his. That may make more sense to them, even if they would deny each of you a loan on your own. This works for them because either of you is responsible for the whole loan. It works for him because he was already willing to be responsible for the whole loan. And your alternative plan makes you responsible for the whole loan, so this is just as good for you.

At what percentage would you suggest splitting ownership and future expenses? Typically a cash/financing partnership would be 50/50, but since it’s only a 3.5% down-payment instead of 20% is that still fair?

Surprisingly enough, a 3.5% down-payment that accumulates is about half the equity of a 20% down-payment. So your suggestion of a 25%-75% split makes sense if 20% would give a 50%-50% split.

I expected it to be considerably lower. The way that I calculated it was to have his share increase by his equity share of the "rent" which I set to the principal plus interest payment for a thirty year loan. With a 20% down-payment, this would give him 84% equity. With 3.5%, about 40% equity. I'm not sure why 84% equity should be the equivalent of a 50% share, but it may be a side effect of other expenses. Perhaps taking property taxes out would reduce the equity share.

Note that if you increase the down-payment to 20%, your mortgage payment will drop substantially. The difference in interest between 3.5% and 20% equity is a couple hundred dollars. Also, you'll be able to eliminate any PMI payment at 20%.

It could be argued that if he pays a third of the monthly mortgage payment, that that would give him the same 50% equity stake on a 3.5% down-payment as he would get with a 20% down-payment. The problem there is that then he is effectively subsidizing your monthly payment. If he were to stop doing that for some reason, you'd have what is effectively a 50% increase in your rent. It would be safer for you to handle the monthly payment while he handles the down-payment.

If you couldn't pay the mortgage, it sounds like he is in a position to buy out your equity, rent the property, and take over the mortgage payment. If he stopped being able to pay his third of the mortgage, it's not evident that you'd be able to pick up the slack from him much less buy him out. And it's unlikely that you'd find someone else willing to replace him under those terms. But your brother could construct things such that in the face of tragedy, you'd inherit his equity in the house. If you're making the entire mortgage payment, that's a stable situation.

He's not at risk because he could take over the mortgage if necessary. You're not at risk because you inherit his equity share and can afford the monthly payment. So even in the face of tragedy, things can go on. And that's important, as otherwise you could lose your equity in the house.