Shared-appreciation mortgage and tax implications

A shared-appreciation mortgage is one in which the lender offers the borrower an interest rate that is lower than the “applicable prevailing rate” in exchange for a percentage of the appreciated value of the mortgaged property at the time when the loan is due or when the property is sold.

But how much can or should the rate be reduced below the applicable prevailing rate? The IRS sets minimum rates that lenders much charge; these are known as applicable federal rates (AFR) and broadly classified as short-, medium-, and long-term. If a lender charges a rate that is below the applicable rate, he is considered (1) to have received “imputed interest” that is the difference between applicable rate and the lender’s rate and (2) to have gifted the borrower that difference. From a bookkeeping point of view, going below the applicable federal rate is a nightmare, and I would recommend that private lenders just use the published AFR.

Now, with shared-appreciation mortgage, setting the rate is not trivial. On the one hand, California civil code 1917.133(d) stipulates a minimum percentage (as a function as the shared percentage) by which the fixed rate must be reduced. On the other hand, this document (view as html) (paragraph 10 on page 8, or search for “imputed”) seems to indicate (without quantifying how much) that if the rate is set too low, the transaction may run afoul of IRS’s imputed-interest rule. So what is reasonable? I am not trained in real-estate or tax law, but I think the following scheme seems to be reasonable: split the interest rate into two parts, the first part being the fixed-rate that requires regular payments, and the second part providing a “floor” on the appreciation. That is, if the appreciation does not exceed the accrued interest according to the floor rate, then the borrower must pay that minimum amount.