Your Mortgage : Tax Glitch Hurts Many First-Time Buyers

WASHINGTON —  Here’s the deal: Zero dollars down payment on a brand new three- or four-bedroom house. All you pay up front are the closing costs on the loan, transfer taxes, title insurance and inspection fees.

To qualify, you’ve got to be a bona fide first-time home buyer. You’ve got to have a monthly household income sufficient to handle mortgage payments equal to 100% of the home price--at least for the first five years.

One other requirement: The home you’re buying can’t be expensive. Its price should be no more than 75% of the cost of the average newly constructed single-family homes in your area.

Sound inviting? Sound like the sort of financing that can help solve the toughest problem confronting many would-be first-time home buyers: How to accumulate the 10% or 20% down payment needed to qualify for a mortgage?

Tax and homebuilding experts say such a concept could indeed put thousands of renters into homes they can economically afford nationwide if Congress would simply correct a little-noticed glitch in federal tax law.

The glitch, focus of a bill soon to be introduced by Rep. Bill Goodling (R-Pa.), crept into the federal tax code through legislation passed in the late 1980s. Inadvertently, Goodling said, the change had the side effect of killing fledgling, private efforts under way to bridge the affordability gap for first-time buyers.

York, Pa., homebuilder Barry R. Rauhauser’s zero down payment program caught Goodling’s attention. Rauhauser’s Eagle Building Inc., has developed, constructed and sold 150 moderately priced, single-family homes to first timers--all using no or low-equity conventional, non-governmental financing to enable the purchasers to swing the deal. In one 18-month period, Rauhauser sold 100 new homes in the $70,000-$80,000 range with zero or minimal down payments.

The financing was the key: If buyers could demonstrate that they had almost everything needed to qualify for homeownership--good credit, stable jobs, steady incomes--Rauhauser would supply the sole missing piece to the puzzle: all or most of the down payment dollars.

Through an agreement with a local savings bank, Rauhauser’s firm provided qualified first-time purchasers a conventional 30-year first mortgage of 80% at prevailing market interest rates. On an $80,000 house, that would mean a mortgage of $64,000. The 20% balance due--the buyer’s equity--took the form of a second mortgage note held by Rauhauser. The note carried the same market rate as the first mortgage, a 30-year amortization schedule, with a lump sum balloon payment due at the end of the fifth year. Only purchasers with incomes adequate to handle the combined first and second payments were permitted to participate. The cash requirement for closing and escrow expenses averaged $2,500 per house.

The concept had obvious attractions for consumers. But it also worked for the local lender and for Rauhauser. The lending institution was willing to participate because it knew the mortgaged houses and land represented solid collateral, well beyond its 80% risk exposure on the first mortgages.

Rauhauser liked the arrangement: It produced a huge jump in sales volume and the second mortgage notes also created a steady cash flow. The loans have proved to be “extremely high quality,” says Rauhauser, with just “three or four” of the 150 houses experiencing serious payment delinquencies or other problems.

So why is this innovative, privately funded and run program for first-time buyers now dead? Because it was blind-sided by tax law changes aimed at targets far different from Rauhauser--primarily firms and individuals seeking tax shelters. In their wake, the second mortgage notes paid by Rauhauser’s young buyers now constitute installment contracts, to a “dealer” in real property.

As a result, the dealer--Eagle Building--must pay taxes immediately on the full price of each home sold, even though it never collected 20% of that amount (the deferred down payment), and is receiving it in monthly dribs and drabs.

“I don’t mind paying taxes on income when I receive it,” Rauhauser said, “but I can’t pay taxes on income I haven’t even gotten in my pocket yet.” The tax code glitch has already cost Eagle about $300,000 to cover taxes due on 100 of the 150 homes. The others were sold prior to the effective date of the code changes.

Which is where Goodling’s forthcoming tax bill enters the picture. Though it wouldn’t get Rauhauser his $300,000 back, it would amend the Internal Revenue Code to allow builders like Eagle to use traditional installment sale treatment--paying taxes only on the profits as they’re received pro-rata--on second mortgage notes provided to finance qualified first-time home buyers acquiring newly built, modest-cost dwellings.

The proposal already has attracted the backing of trade groups like the National Assn. of Home Builders and the Pennsylvania Builders Assn. Analysts at the Treasury Department are “studying it,” according to a spokesman, but have no definitive comment on it yet.

The bottom line, according to Rauhauser: “When the private market comes up with an intelligent, effective way to put people into houses--with no government bureaucracy involved--why should federal tax policy stand in the way?”