Mortgage Financing for Muslim Americans Muhammed-Shahid Ebrahim and Zafar A. Hasan Islamic economics is a rapidly growing discipline seeking to redirect econmomic behavior under the umbrella of Islam. This field combines malleable modem economic concepts with immutable moral principles in its attempt to address the economic climate of a given society. The most significant differences between Islmaic economics and the world’s more prevalent economic systems are the Islamic ban on r i h l (usury) and the Islamic institution of zakah. The ban on usury is based on the verse: 0 you who believe, fear Allah and give up what remains due to you of usury if you are indeed Believe=. And if you do not, then be warned of war (against you) by Allah and his messenger, while if you repent you shall have your capital. Do not wmng and you shall not be wronged (wan 2:278-9). This paper addresses mortgage firiancing problems on real property that Muslims face as a result of Islam’s ban on interest. The United States has a unique tax system designed to enmurage investment in real prop- erty. Congtess allows property owners to deduct all mortgage interest, along with operating expenses and depreciation writeoffs, from income taxes. This is an indirect form of government subsidy.’ Muhammed-Shahid Ebrahjm is associated with the Department of Economics and Busi- ness, Rosary College, River Forest, Illiiois. a f a r A. Hasan is associated with the Depar- tment of Economics, Northwestern University, Evanston, Illinois. Both wish to acknowl- edge suggestions made by AJISS referees and to dedicate this study to the Salaf $dim. ‘El-Ashker (1987) defines riW as an increase in money or kind that the debtor might be asked to y over the principal to com pmte for the payment. In modem economic terms, it muE be defied as a positive ris -free return from an investment vehicle or an investment strategy. Ebrahim (199%) e lains that one may “go long”: buy an index on a basket of stocks such BS the Standard% Poors 500 and sunultanmusly sell short a fu- tures contract against it. This results in a risk-& return and therefore CoostitUtes riM. 2Home owners cau deduct only the intemt expenses from their income taxes. Ebrahim and Hasan: Mortgage Financing 73 One modem form of Islamic mortgage financing that does not con- tradict Islamic values in Called an equity participating mortgage? This type of mortgage has been studied as an alternative form of financing in the American real estate market. In addition, it should be noted that the benefits of an equity participating mortgage, as will be modelled in this tesearch paper below, are applicable to both Muslim and non-Muslim societies. A participating mortgage is an equity form of financing in which the lender and the borrower undertake a joint investment and agtee to a fu- ture division of the profits (or losses) according to pmpecified sham. Thus the lender participates in the income, the residuals, or both. The mechanism is simple: the lender loans money to the borrower in ex- change for a predetermined share of the profits (or lasses) earned in the enterprise plus a portion of the tax benefits for which the enterprise is eligible. Such a form of mortgage financing is unique in the field of real estate investment. This study refers to the works of such scholars as Keeley (1987) and Levy et al. (1989), which discuss several advantages accruing to a bor- rower involved in a participating mortgage: a) The borrower holds the title and the ownership, and thereby retains control of the real estate; b) As both the borrower and the lender share in the profits and the losses, the borrower does not have to finance the enterprise alone and, in addi- tion, he/she receives a cushion against bankruptcy; c) During bad eco- nomic times, one feature of which is lower debt setvice costs, the enter- prise’s poor rate of return is borne by both parties; d) The holder of the title, in this case the borrower, receives most of the applicable tax bene- fits, e) Higher financing proceeds, as the loan-to-value ratio is higher with equity; and 9 Some of the risk is shifted to the lender. There are also several advantages for a lender involved in such a deal: a) He/She benefits from the cash flow stream received from the en- terprise and the capital gains made upon the sale of the real estate; b) Participating mortgages allow the nontaxable lender to invest in real estate and thereby add greater diversity to his/her investment portfolio: c) Real estate protects the lender’s rate of return by providing a hedge against inflation (i.e., periods of inflation would be offset by an increase in the property’s nominal value); and d) The lender receives some of the tax benefits associated with the enterprise. The main purpose of this paper is to present an optimal mortgage contract that will allow nontaxable entities (i.e., pension funds) to benefit from income and appreciation opportunities in the real estate market. Such investors may be priced out of the market, since real estate invest- ment is imbued with tax advantages and writeoffs through depreciation 30ther seller financing techniques also avoid usury: the Installment-Sale method and the Lease-with-an-OptioteBuy method, both of which are described in Ebrahjm (1991). However, these techni es are not institutionalized and depend on individual negotiation between buyer and se& 74 The American Journal of Islamic Social Sciences 101 and deductible interest payments, whereas other forms of investment (i.e., financial securities) are not. Ennis and Burik (1991b) assert that taxes constitute an additional non-risk factor. If pension fund in- vestment decisions take taxes into account it becomes more diffi- cult to justify real estate investment by pension funds, regardless of fund size or plan type. As a d t , they (1991a) disagree with many scholars, among them Fogler (1984), Brueggemann et al. (1984), Zerbst and Cambon (1984), Webb and Rubens (1987), Irwin and Landa (1987), and Fimtenberg et al. (1988), who advocate placing 20 percent of a pension fund's portfolio into real estate in order to provide it with diverse holdings and to enhance its return-to-risk ratio: Ennis and Burik (1991a, b) opine that pension funds have invested only 3.5 percent of their portfolio in real estate, be- cause the Employee Retirement Income Security Act (ERISA) of 1974 admonishes pension fund investors to diversify their portfolios in different asset classes. Eb&m (1992b) also points out that all nontaxable entities hold only 4.63 percent of American real estate for investment purposes. Thus equity participating mortgages allow nontaxable investom to circum- vent entry constraints and invest in the real estate market.5 An optimal security design, which encompasses the allocation of cash flows and control rights, has been discussed extensively by Hams and Raviv (1991). However, their theories exclude tax considerations. Basheer (1990) has an excellent paper on profit sharing (muddrubah) as an opti- mal contract under asymmetric information according to the Shari'ah, but it does not include the intricacies of real estate investment under the American tax code. This paper uses the two-period general equilibrium theory to model equity participating mortgages, as this tool is widely accepted by aca- demics and policymakers. Risk neutrality is also used, because it readily allows the derivation of a closed-form solution. A framework akin to that of DeAngelo and Masulis (1980) is used. In addition, this study also in- corporates the recapture of depteciation as capital gains. The modelling is structured accotding to the present tax code.6 'These scholars' results are controversial, for they have used ex- returns based on smootfm the returns' variance. Most of these studies, moreover, have ignordtaxes. Thus the objection of Ennis and Burik (1991% b) deserves attention. 'Real estate has been temed a tax shelter by such practitioners as Bruss (1 990) and academics as Cords and Calper (1985). Since there are tax benefits to investing in real prop* (even in the new tax law), taxable investors may outbid nontaxable investors. an ap aised value of real estate. It is a well-known fact that t E"' e appraisal mess me Tax Reform Act of 1986 (TRA '86) reversed the incentives of the Economic Re- covery Tax Act of 1981 (ERTA'81). This was due to the fact that tax depreciation was made less genemus than that under ERTA '81 and capital gains tax rates were raised above pre- 1978 levels. For individuals and closeIy held corporations, the act limited pas- Ebrahim and Hasan: Mortgage Financing I5 Section two provides a mathematical model for an equity participating mortgage, the solution of which shows that this mortgage expands the pool of real estate investors to include those with nontaxable income. Section three concludes the paper by placing equity participating mort- gages within the framework of an Islamic socioeconomic sttuctm. Modeling Investment in Depreciable Real Estate under an Equity Participating Mortgage (TRA '86) Consider the following two-period general equilibrium model. At time t = 0, there are N agents in the economy, who are young in period t = 0, old/retired in period t = 1, and dead in period t = 2 and beyond. Half of the agents/investors are in the marginal T tax bracket, and the other half are in the zero tax bracket. This is the only form of heterogeneity in the model. All investors have endowments of wo in period zero. There is no en- dowment at the age of retirement (time t = 1). The endowment wo can be consumed, loaned, or used to buy teal estate, and is not taxed. There are only two kinds of assets in the economy. One is a "depreciable teal estate" investment that yields a stream of net operating income { d, ) and a liquidating dividend {P,), where d, and PI are positive random first-order Markov processes. The second asset is a risky asset (i.e., a mortgage) in zero net supply as explained in the Market Clearing Condition in the following pages. It is assumed that all investors are consumers of the endowment, of the real estate investment (in the form of net rent plus future price after tax), or of interest income. Investors retire in period 1 and consume what- ever is left of the portfolio. The government allows a one-time tax depre- ciation Do, which is proportional to the price Po of the asset. There are (N/2) real estate assets in the economy, which are assumed to outlive the investors. The investors have a choice of buying real estate with a combination of endowment wo and a loan (the loan assumed to be between two types of investors). The interest rate i charged by a lender is the return on the loan demanded by the lender. The analysis is done by modeling the returns to both types of inves- 01s. It then determines if the solution is an interior or a comet solution. Modeling Objective Function of a Zero Tmable Risk Neutral Investor. The first step is to optimize the expected utility of a zero tax investor: Max. E,,{c'o+yc'l) Q o , co, CI, s' sive activity losses to the amount of passive income. It also limited tax-deductible losses to the amount the investor had "at risk," rather than to the amount of the investor's basii in the pro rty. Despite these restrictions, most real estate investments continue to offer some tax Enefits. 76 The American Journal of Islamic Social Sciences 101 Subject to: (a) c ' ~ +Q'o + s'Po = wo (b) c', = Q o (1 + i) + s' (d, + PI), where: E,, ( ) = expectation operator at time 0. cfo = cotwmption of nontaxable investor at time 0. c', = consumption of nontaxable investor at time 1. y = discountfate. s' Q o = amount of funds Ient/bomwed.' Po = price of teal estate at time 0. w, = endowment at time 0. i = intenstrate. d, = net operating rental income of the property received at time 1. P, = value of the property at time 1. = ftactional investment in teal estate by nontaxable investor. The lagrangian L' can be written as follows: L,' = &([c'~+yc',I + ~ O [ ~ O - ~ f P o - Q ' O - ~ ' O ] + h',y[Q'o(l+i) + s'(d,+P,) -c',]} The Fitst Order Necessary Conditions (F.0.N.C.s) are given by: = E, (y(1) + A, y e l ) } = 0 - h', = 1 Using (1') and (27, we get: 6L' = E,, (-1 + y (1 + i)) 6Qo (3') 'A positive level of Qa indicates the amount of funds lent, whereas a negative level indicates the amount borrowed. Ebrahim and Hasan: Mortgage Financing 77 2 0, V Q o ) 0 with equality in an interior solution and inequality in the comer solution, - < 0, V Q o ( 0 with equality in an interior solution and inequality in the comer solution. Investors will continue to buy fractional s h a m in real estate until the net benefit equals zem at the margin. Similarly, investors will avoid real pmperty if the net benefit is less than zem at the margin. This can be rep- resented by the partial derivative of the lagmngian with reference to the fractional sham owned as given below: - = E,(X',[-PJ + T1 y [d, + PI]] 6s' = 0 for an interior solution where s' # 0 ( 0 for a comer solution where s' = 0. Modeling Objective Function of a T Tax Bracket Risk Neutral Investor. Consider the T tax bracket investor. The goal of this investor is: (a) co + sPo + Qo = wo, where: E, ( } = expectation operator at time 0. co = consumption of taxable investor at time 0. c, = consumption of taxable investor at time 1. = discountrate s = fractional investment in real estate by taxable investor. Qo = amount of funds lent/bomwed.8 Po = price of real estate at time 0. wo = endowment at time 0. i = interest rateon Q,,. *A positive level of Qo indicates the amount of funds lent, whereas a negative level indicates the amount borrowed. 78 The American Journal of Islamic Social Sciences 1O: l d, = net operating rental income (NOI) of the property received P, = value of the property at time 1. T = the marginal tax rate on interest/dividend/rental income. gT = effective capital gains tax levied on the appreciation of Property. at time 1. T Do = tax depreciation allowed in the law. k = depreciation constant (rate of depreciation allowed) i.e., k = 3 PO The after-tax cash flow from the operation and the sale of the prop- erty is explained in footnote 9.’ The lagmgian L can be written as: The F.0.N.C.s a=: 6L - 6c0 6L = Eoi-ho i(1-TI} 2 0 Substituting the value of A,, and h, from (1) and (2), we get: 6L m e book value of the pmperty at time t = 1 is (Po - Do) = (Po - W,,) The capital gains tax is therefore levied on PI - (Po - D,,) = PI - (Po- kPo) The after-tax cash flow from the sale of the pmpexty = PI - gT [PI - (Po - kPJ1 The after-tax cash flow from operation = d, (1-T) + T D ~ = d, (1-T) + &Po :. Total after-tax cash flow from operation and sale of propem = = [d, ( I-T) + T ~ P J + [PI - gT [PI - (Po - kPJ]] = [d, (1-T) + P, (1-gT) + T (Do(l-g) + gPJ] Eb- and Hasan: Mortgage Financing 79 2 0, V Qo ) 0 with equality in an interior solution and inequality in the comer solution, < 0, V Q ( 0 with equality in an interior solution and inequality in the comer solution. Investors will continue to buy fractional shares of real estate until the net benefit equals zero at the margin. Similarly, investors will avoid real proprty in the net benefit is less than zero at the margin. This can be represented by the partial derivative of the lagrangan with reference to the fractional shares owned as given below: = %{-Po + Y[d,(l-T) + PI (I-&) + TP0&(l-g) + go), after sub- stituting the value of h, and h, from (1) and (2). = 0 for an interior solution, where s # 0, ( 0 for a comer solution, where s = 0 (4) The Market Clearing Condition. The following conditions are needed for equilibrium: (a) For the money market to be in equilibrium, it is necessary that ( Q o ) B m O W d = - (Q,Jht, i.e. Q o = -Qo * Q', + Qo = 0 (5) (b) For the goods market to be in equilibrium, it is necessary that s = fractional shares owned by the taxable investor = 1 - s' = 1 - fractional shares owned by the nontaxable investor, i.e., sf + s = 1. Furthermore, we need both s' 2 0, and s 2 0. (6) (c) At time t = 0, it is required that: cfO+QfO +stPo = w, c, + Q + SP, = w, :. c', + c, + Po = 2w0 (d) At time t = 1, it is required that: (7) cfl= Qo(l+i)+ s' (d,+P,) 80 The Amenam Journal of I s W c Social Sciences 101 The SOlUtiO?ls to the Model. Subcuse 1. First Corner Solution s = 1, i.e., taxable investors own all real estate. Price Po is given by equation (4) as: = Y&,{dl[l-T]+Pl[ l-gT]+TIPo(k(l-g)+g)} since Do=kPo Po = Po)taubb = Basic Condition for a Comer Solution: i.e., The tax benefit (net tax writeoff from depreciation) is greater than the tax liability of the net orperating rental income plus the tax liability of the capital gain. The Interest Rate: The interest rate i is within an interval [ i-, iMJ i.e., ie [L, i,] The interest rate falls in this inteval, because the lender (the non- taxable investor), prefers to lend at a rate above i,. On the other hand, the borrower (the taxable investor) seeks loans at any rate below i,. iMm is evaluated as follows: Equation (3) gives us: 1= y$[1 + iM(1-7)] Ebrahim and Hasan: Mortgage Financing 81 -r) +P,(1 -gr) +rPo(k(l -g) +g) -Po PO - - &,,is evaluated as follows: Equation (3') gives us: 1 = yh(1 + i,,,) - Po = POy&(l+iJ :. &,, The optimal loan-to-value ratio is given as (Qo)M,: (Q6) = Min. wo; Mh.[dl[ 1 -21 +P1[ 1 -g~]] +r[Po[ 1 -g] +gP J as long as: [l +i(l -r)] (i) there is no initial capital constmint, and 82 The American Journal of klamic Social Sciences 1O: l (ii) the taxable investor is able to pay off the loan with intetest even in the worst case. The consumption levels a: c'O = wO - (Q'0)Mm ; co c', = (QO)M&+i 1 ; = wo +(Q'o)Mm - Po cl = [d,(l-.r + pl(l-gT) + (DO(l-g)+ gpO)l - (Q'o)Ma~(l+~(l-~ 1) Subcuse 2. Interior Solution: Both Investors Own Real Property. There is no interior solution, because Equation (Y), i.e., yE,,(l+i) = 1, and Equa- tion (3), i.e., yEo(l+i(l-.r)) = l are not simultaneously true. Subcuse 3. Second Comer Solution: s' = 1 (i.e., the nontaxable investor owns all real estate). Equation (4') gives us: Po = yEo[d,+P,] The interest rate i is again within an interval [i-, iMJ i.e., e [ i, i,] iMm is evaluated as follows: From equation (3'), we have 1 = YEo( 1 + iM) - Po = PoyEo(l + iM) Now since Po = yEo(d,+P,) '0 = 'OYh(' + :. Po = yE,,(d,+P,) = PoyEo(l+iM) is evaluated as follows: Equation (3) gives us 1 = yE,,[l+i-(l-~)] - Po = PoyEo[1+i~(l-.r)] Ebrahim and Hasan: Mortgage Financing 83 Since Po = yE,,(d,+P,) Po = Poy&[l+id(l-T)] =* k(1-T) i, Now the lender seeks to loan funds at a rate above i,. On the other hand, the borrower seeks funds at a rate below i,. Since i,, ) i,, - this equilibrium does not exist. :. We cannot have a second comer solution. Thus the participating mortgage presented in this paper provides a quasi-equity alternative mechanism for nontaxable investors to enter the real estate market, for the solution (Subcase 1) illustrates that the lender receives the principal plus interest, which is a proportion of the Net Oper- ating Income (NOI) and the capital appreciation of the property. Conclusion Equity participating mortgages are allowed by the Shari'ah, for both the borrower and the lender assume the risk, there is no predermined rate of retum, and for several other reasons, as noted by Al-Qaradawi (1984). Muslims in the United States can get a participating loan on their owner-occupied homes through Muslim Savings and Investments Inc. (MSI). This company will loan approximately 80 percent of a home's price. In lieu of interest payments, the borrower pays MSI a proportionate rent that takes into consideration the property's appreciation. The bor- rower can elect to buy out MSI in a scheduled period of fifteen years or less, again according to the appraised value of the property. Unfortu- nately, the rents paid to MSI are not tax deductible, as MSI fears that the IRS may regard equity participation as a joint venture and challenge any tax deductions by the owner. But there have been cases in which the 84 The American Journal of Islamic Social Sciences 101 court has granted tax-deductible status to these mortgages: i.e., in Hard- man vs. U.S. (1987), as reported by Levin ( 1990)." MSI has a small portfolio (approximately $4 - $5 million). Its assets have not grown for several reasons: a) MSI does not sell mortgages on the secondary market as do most financial institutions; b) most Muslims are ignorant of alternatives to fixed interest investments; and c) declining real estate values have d t e d in losses in MSI's real estate portfolio. Other entities in the United States, such as Real Estate Investment Trusts (REITS), Real Estate Limited Partnerships (RELPS), and pension funds, invest in the type of participating mortgages described in this paper as well as in those based on some combination of fixed interest and equity participation. The ones with fixed interest (ribti), as already discussed, should be avoided. Pension and Investment Age (1 6 September 1991) repolted that as of 30 June 1991, the fifty largest managers of tax- exempt assets had $101.17 billion in real estate equity and $14.86 billion in hybrid mortgages, which include participating and convertible mort- gages." Thus hybrid mortgages comprise approximately 14.7 percent of the equity real estate held by these institutions. Participating mortgages are a recent innovation in real estate finance. However, the data above illustrates the demand for equity real estate investment and, as society becomes more aware of the opportunities in equity/profit sharing investment opportunities, equity participating mort- gages of the kind discussed in this article will gain in popularity. '%win (1990) states that "In Hardman versus the U.S. (19879, the Ninth Circuit Court found that a shareholder was a creditor when vacant land was sold to a family corporation for uisition cost and the corporation's promise to pa 1/3 of any net profit it derived h ? % e property. The district court, focusing on the a L n c e of an obhgation to pay a principal sum with interest on a fiied maturity date held that the taxpayer was not a cre- ditor but rather had received equity in the nature of a joint venture interest. However, the Court of Appeals for the Ninth Cucuit reversed this decision. It considered 11 factom to be relevant m determining whether there was debt as a result of a genuine sale. A fixed maturity date was the only factor absent, and this was mitigated because repayment was tied to a fairly certain event-the sale of the propeIty. All other factors supported debt stab. Tax lawyers would be well advised to remember this case when structurhg pattici- pating mortgages." "Convertible mortgages also involve fied interest and are therefore not allowed by Islamic law. Ebrahjm and Hasan: Mortgage Financing c', 85 Consumption on nontaxable investor at T=O Appendix A: Notational Glossary c, c', Consumption of taxable investor at t=l Consumption on nontaxable investor at ~ = l Endogenous Endogenous Variable Tvbe 11 co lconsumption of taxable investor at t=O I Endogenous Endogenous Net rents after opting expenses at p e i d 1 Exogenous I Depreciation allowance I Exogenous I 1 Y Capital gains rate i.e., 40% in old tax law Discount rate Exogenous Exogenous i Endogenous Interest rate on money lent between T=O and Depreciation constant i.e., rate of depreciation allowed i.e.. k = D,/ P, T=l k Exogenous Endogenous Lagtange multipliers in the optimization problem for investors Price of real esetate at beginning i.e.,T=O Price of real estate at period 1 Amount lenybomwed at T=O by taxable investor Amount lenybomwed at T=O by nontaxable investor Ftactional ownership of real estate by taxable investor Fractional ownership of real estate by non- taxable investor Highest marginal tax rate A'S Po P, Qo Endogenous Exogenous Endogenous Q'o Endogenous S Endogenous Endogenous S' Exogenous T wo IEndowment at T=O I Endogenous 86 The American Journal of Islamic Social Sciences 1 0 1 References El-Ashker, A. 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