ASC 470-30 defines the accounting treatment for participating mortgage loans. These loans involve a sharing arrangement between the lender and the borrower usually.
Both parties agree on the sharing proportion, interest rate, and other loan terms.
Let us discuss what is a participating mortgage loan and what is the accounting guidance for it.
What is a Participating Mortgage Loan?
The arrangement refers to a type of mortgage loan where two or more parties join hands to share the interest income through rentals and sale proceeds.
Usually, a lender and a borrower arrange these loans where the borrower agrees to pay a portion of rental income to the lender. In return, the lender offers a lower interest rate on the participating mortgage loans as compared to other mortgages with similar risk profiles.
How Does Participating Mortgage Loan Work?
A participating mortgage loan occurs when two or more parties agree on sharing the profits from a mortgaged property. The profit can be in the form of rental income or gain on the sale of the property.
A usual agreement involves the lender and the borrower sharing the proceeds in a 55/45 arrangement. The arrangement can be made between two lenders, two borrowers, or more than two parties.
Both parties in the agreement share profits minus operating expenses. The lender gets a portion in the resale of the property as well.
The loan repayment terms work similarly to a conventional mortgage loan with a few exceptions. These loans may come with an interest-only payment structure, while the principal repayment occurs at loan maturity.
Both sides receive some advantages and disadvantages with these mortgages. For lenders, they receive higher profits and an equity stake in the project they are financing. However, they need to closely monitor the account books of the borrower to ensure transparency.
For borrowers, the advantages may be access to lower interest rate loans. Also, they can get access to capital financing when other options do not work. They also have to sacrifice a significant proportion of equity and profits in the project in return.
Accounting for Participating Mortgage Loan – ASC 470-30
ASC 470-30-50-1 guides on the accounting treatment of participating mortgages for the borrowers.
It requires disclosures to the following points:
- The total amount of participating mortgage obligations
- The total amount of participating liabilities and debt discounts
- The lender’s participation terms related to:
- The operations of the mortgaged real estate
- The appreciation in the fair value of the mortgaged real estate
Most arrangements offer lenders to receive a share of rental income or capital gains through appreciation in the fair value of the mortgaged real estate.
The borrower must disclose certain points regarding the arrangement in the financial statements through disclosures. Broadly, the borrower is required to consider the following points:
- At inception, when the lender is entitled to participate in the mortgage loan, the borrower should estimate the fair value of the project.
- The borrower would recognize a participation liability of that amount immediately.
- A correspondent debit entry is recorded for the debt-discount account.
- The debit account is then amortized using the interest amortization method. The borrower should use the effective interest rate in the calculations.
- The aim is to include the net effect of the additional expected cost of the participating feature in the periodic cost of the loan.
- At the end of each accounting period, the borrower should adjust for the fair value of the mortgage so that the liability amount properly reflects the participating feature value.
- The corresponding debit or credit amount to reflect the new fair value is adjusted to the debt-discount account.
The revised discount value is then amortized using the new effective interest rate as done previously.
Accounting for the Interest Cost in Participating Mortgage Loans
The interest expense in a participating mortgage loan consists of different components.
Amounts designated in the mortgage agreement as interest
The borrower would record the designated interest costs for the same accounting period in which the interest expense incurs. For floating rate mortgage loans, the interest cost will change with a change in the base rate.
When a change in the interest rate results in a change in the market value of the project, the borrower would record the interest cost based on the change factor. However, if the change factor does not affect the market value of the project, the borrower should not include new costs.
Amounts related to the lender’s participation in operations
The participating mortgage loan agreement may define the participation activities of the lender. A lender’s participation in the project’s operations should be recorded as an interest expense by the borrower in the corresponding financial reporting period.
Amounts related to the lender’s participation in the appreciation
Lenders may participate in the price appreciation of the project as well as in the interest earnings. The borrower should value the project (property) to include the fair value in the balance sheet at the end of each accounting period.
If the arrangement allows an early payment when the property is sold or refinanced, the borrower should recognize the participating liability at the financial statement date equal to the fair value of the estimated payment.
Important Considerations
The real estate property may change its fair value during the loan term several times. Usually, the value of the property diminishes over time and the rental income from the property may deteriorate as well.
However, interest costs tend to increase over time generally. Thus, the borrower should adjust for the changes in the fair value of the property and the interest costs.
For example, if there is a change in the estimated value of the property, the carrying value of the loan is adjusted at the reporting as if the new yield would have been applied since the inception of the loan.
The amortization calculations would record new values using the new yield and the differences are recorded for the prior years as well.
If the participating mortgage loan specifies that the lender is a participant in the market price appreciation only, the borrower would not recognize a change in the liability if the market value of the property declines. It means the borrower cannot recognize a corresponding participating asset in this case.
The borrower may record a reduction in the participating liability in a depreciating real estate market. However, the value of the participating liability cannot be reduced to zero.
Example
Suppose a company ABC purchased a property worth $ 10 million. ABC paid a cash advance of $1 million while $9 million was arranged as a participating mortgage loan with a lender XYZ.
The arrangement has the following terms:
- Mortgage loan tenure of 15 years
- Only interest payments during the tenure while repayment of the principal at maturity
- Interest rate 5%
- XYZ’s participation proportion is 40% above price appreciation of $10 million
- The participation rights remain effective if the property is sold prior to maturity or refinanced
We assume the price changes in the property for the first five years as below:
- Year 1 = $ 11 million
- Year 2 = $ 12 million
- Year 3 = $ 11.5 million
- Year 4 = $ 10.5 million
- Year 5 = $ 11 million
Based on these assumptions, we can calculate the accounting entries for the first five years for ABC company as given below.
| Details | Year1 | Year2 | Year3 | Year4 | Year5 |
| Participation in Appreciation | $400,000 | $800,000 | $600,000 | $200,000 | $400,000 |
| Fixed Interest Cost | $450,000 | $450,000 | $450,000 | $450,000 | $450,000 |
| Interest Cost as Participation Value Appreciation | $468,000 | $505,944 | – | – | – |
The figures are calculated as below:
Participation in Appreciation = (Property value at year-end – acquisition cost of $10 m) × 40%
Fixed Interest Cost = Loan Amount $ 9 m × 5%
Interest cost as part. Value appreciation = value of effective interest cost – fixed interest cost
Suppose the effective interest rate is 5.2%. then,
| Year | Effective Interest Cost | Fixed Interest Cost | Loan Balance |
| 0 | $9,000,000 | ||
| 1 | $468,000 | $450,000 | $9,018,000 |
| 2 | $468,936 | $450,000 | $9,036,936 |
| 3 | $469,920 | $450,000 | $9,056,856 |
| 4 | $470,956 | $450,000 | $9,077,812 |
| 5 | $472,046 | $450,000 | $9,099,858 |
Suppose the effective changes to 5.4% in the year2, then:
| Year | Interest App. Cost | Interest Fixed | Difference | Loan Ending Balance |
| 0 | $9,000,000 | |||
| 1 | $486,000 | $450,000 | $36,000 | $9,036,000 |
| 2 | $487,944 | $450,000 | $37,944 | $9,073,944 |
| 3 | $489,993 | $450,000 | $39,993 | $9,113,937 |
| 4 | $492,153 | $450,000 | $42,153 | $9,156,090 |
| 5 | $494,429 | $450,000 | $44,429 | $9,200,518 |
ABC will record the accounting entries if the effective interest rate is 5.2% as below:
At the beginning when the loan term starts:
| Account | Debit | Credit |
| Property – Land/Building | $ 10,000,000 | |
| Cash | $ 1,000,000 | |
| Mortgage Loan | $ 9,000,000 |
At the end of the year1 with an effective interest rate of 5.2%:
| Account | Debit | Credit |
| Loan discount- Participation liability | $ 400,000 | |
| Interest Expense | $ 468,000 | |
| Loan Discount Participating Liability | $ 18,000 | |
| Participating liability appreciation | $ 400,000 | |
| Interest Payable – Fixed | $ 450,000 |
At the end of the year1 with an effective interest rate of 5.4%:
| Account | Debit | Credit |
| Loan discount- Participation liability | $ 400,000 | |
| Interest Expense | $ 505,944* | |
| Loan Discount Participating Liability | $ 55,944 | |
| Participating liability appreciation | $ 400,000 | |
| Interest Payable – Fixed | $ 450,000 |
- *If the interest amount changes from 5.2% to 5.4% in year2, the loan balance becomes $ 9,073,944 instead of $9,018,000. The difference of $55,973 is recorded as a change in the interest cost liability for the year2.
- ABC company can record a change in the interest cost and loan liability in a similar way until the loan maturity.
