No downpayment carryback sales

This article comments on the reasons for accepting an offer with little to no down payment, the presentation of the offer and brokerage fee aspects, and alternative structuring to generate cash.

Minimizing the carryback risks

A couple decides to purchase income property to begin a real estate investment program.

Each has an excellent income, with a combined discretionary disposable income in excess of $20,000 annually which they will commit to real estate investments.

Over the years, the couple spends most of their disposable income on the cost of high living. Consequently, they have accumulated insufficient cash savings for a down payment on a purchase.

Despite the lack of savings, the couple’s high income enables them to make a “deferred down payment” through significant additional monthly or quarterly principal payments on carryback financing. Thus, the couple creates a self-enforcing savings program.

A deferred down payment investment program builds up an equity in the property purchased through additional, periodic principal payments. The principal reduction is in addition to regular amortized payments and is treated as a deferred cash down payment.

Additional principal payments will be made during the first few years following the purchase of property. With the couple’s $20,000 excess annual income, they have the capacity to pay a seller an additional $60,000 in principal over a three-year period.

At their broker’s suggestion, the couple signs an offer to purchase income property on the following terms:

• a purchase price of $600,000;

• no cash down payment;

• a seller carryback note and trust deed for the entire purchase price;

• a current market interest rate;

• monthly payments on a 30-year amortization;

• additional monthly payments of principal only for three years totalling $60,000; and

• a 10-year due date.

The couple’s broker reviews the offer for presentation to the seller and delivers the offer to the seller’s broker.

Editor’s note – Had the property been encumbered by an existing trust deed note, the carryback could be structured as a regular second or an all-inclusive trust deed (AITD).

Risk review

The carryback aspect of the offer presents additional legal and financial risks to the seller. The seller’s broker, on submitting the offer, will point out:

• the seller will not be cashed out since his net proceeds will be in the form of a note – thus the seller should receive either a higher-than-market interest rate or a higher-than-market price for his property than he would receive on an all-cash sale [Timmsen v. Forest E. Olson, Inc. (1970) 6 CA3d 860];

• the carryback note is purchase money paper – a nonrecourse note – so the seller’s only remedy on the couple’s default is to foreclose on the property sold since a money judgment is not allowed on a nonrecourse note [Calif. Code of Civil Procedure §580b]; and

• without a down payment, no cash proceeds from the sale or buyer equity exist to absorb the out-of-pocket costs to foreclose should the couple default on the carryback note.

For example, if the carryback seller forecloses, he is likely to lose several months’ interest (rental value), plus the brokerage fee paid or remaining due on the carryback sale. In addition to the costs of the trustee’s sale and of carrying any underlying trust deed notes, the seller will incur costs and fees to resell the property.

To demonstrate the possible financial burdens faced by the seller, the seller’s broker prepares a Carryback Foreclosure Cost Sheet and reviews it with the seller. On the sheet, the broker estimates the costs incurred for foreclosure and resale of the property.

Before presenting the offer, the seller’s broker concludes the offer is unsuitable for his client as it stands.

Should the broker present the no-down offer to the seller?

Yes! A broker acting as an agent is legally and ethically bound to present all legitimate offers he receives, even though he may consider the offers to be unsound and unacceptable.

Presenting the offer

On presenting an offer, the seller’s broker owes an agency duty to his client to disclose all aspects of the proposed transaction which are known to him and which might affect his seller’s decision to accept the offer, such as:

• the legal aspects of carrying paper, since the seller takes on the rights and obligations of a mortgage lender [Calif. Civil Code §2956];

• the tax aspects of the profit and income reportable in an installment sale [Internal Revenue Code §453]; and

• the financial suitability to the seller of the risks of loss involved in carrying paper. [Timmsen, supra]

Instead of accepting the offer or returning the offer as rejected, the listing broker suggests a counteroffer to re-structure the transaction so it will be feasible for the seller.

Motivated sellers

One hundred percent carryback financing on a “little or no” down payment transaction has benefits for the seller. A seller is motivated to accept a no-down offer by the desire to sell the property at the price sought, obtain interest income and defer profit tax reporting on the sale until the principal is paid.

Also, the seller who is able to provide carryback financing can more readily sell his property since buyers often do not have or want to use all their cash funds for a down payment. Also, buyers are more interested in acquiring the property if the seller provides the purchase money financing needed to buy the property – the two parties can handle all the aspects of the sale.

Taxwise, the seller faces the following considerations:

• he will receive no down payment and thus no profit to be reported on a down payment in the year of sale;

• no debt relief will occur and thus no profit tax will be due in the year of sale – the seller will wrap any underlying debt with an AITD; and

• no profit will be reported in the carryback until principal is paid or the note is sold or assigned as collateral.

Default and beyond

In a no-down carryback sale, the major legal and financial risk the carryback seller faces is a default by the buyer on the carryback note. A default will force the seller to consider foreclosure on the property.

The combined amounts of the carryback note, any underlying financing and the costs of foreclosure and resale are supported solely by the value of the property.

Thus, when the seller commencing a foreclosure has not received sufficient downpayment funds, the seller will have to use his own funds to pay the costs of foreclosure. Unless the property value rises, funds expended by the seller after a little-or-no down payment will not be recovered on foreclosure and resale of the property.

Even if the carryback seller immediately initiates foreclosure on default, completing a typical problem-free second trust deed foreclosure and resale of the property can easily consume cash funds equal to 15% of the property’s value, paid approximately 50:50 from the seller’s cash reserves and cash proceeds from a resale.

Again, any cash loss on the carryback can only be recovered from the property’s resale price.

On a 100% carryback sale, unless the property value increases by a minimum of 15% between the date of the original sale and the date of the resale after foreclosure, a loss of principal and foreclosure costs will most likely occur.

Minimizing the seller’s risk of loss

All sales involve some degree of risk of loss, as do all loans and carryback notes. A seller should not avoid a sale or a carryback note simply because a foreseeable risk of loss exists.

The correct approach is to analyze the extent of the risk and take steps to offset and cover the risk by:

• making a down payment large enough to cover a foreclosure and resale;

• increasing the price, interest rate, or principal reductions; or

• acquiring additional security, guarantees, letter of credit, etc.

A seller need not rely solely on the real estate sold to secure his carryback note in a no-down transaction. Through a counteroffer, the seller can negotiate with the buyer to deliver up additional security acceptable to the seller. The additional security can be real estate owned by the buyer or others.

Also, a carryback note becomes recourse paper when it is secured by property other than or in addition to the property sold. With recourse paper, the seller may pursue a deficiency judgment against the buyer by judicial foreclosure if the fair market value of the properties securing the carryback notes becomes less than the amount of the underlying loans and carryback note.

Through a counteroffer, the carryback seller negotiates to include provisions such as:

• a continuing guarantee for the carryback note – guarantors are not protected by anti-deficiency laws, only the buyer;

• a security interest in personal property or other real estate, called cross-collateral; and

• the carryback of an unsecured note for part of the price.

The seller can negotiate to cross-collateralize the carryback note by securing it by the property purchased together with other property owned by the buyer or other persons. In cross-collateralization, one trust deed describes all the real estate securing payment of the carryback note – called a blanket trust deed.

Under a blanket trust deed, the seller is able to obtain a personal judgment against the buyer if the market value at the time of a judicial foreclosure sale does not cover the balance due on the cross-collateralized carryback note. [CCP §580a]

Generating cash

Consider a buyer who makes an offer to purchase real estate on terms which include a low cash down payment, an assumption of the first trust deed loan and a carryback note for the remainder of the purchase price.

The seller has substantial equity in the property and is aware of the financial risks of carrying paper and how the risks can be covered. The seller agrees to obtain an equity loan secured by a second trust deed on the real estate which generates cash for the seller and increases the loan-to-value (LTV) ratio to 80%.

A purchase agreement is entered into calling for the buyer to assume the first and second trust deed on the property with the seller carrying back the remainder of the purchase price secured by a third trust deed (or unsecured and thus recourse paper).

Escrow will process the buyer’s assumption of both the first and second trust deed loans. The carryback note, trust deed and grant deed will then be prepared and escrow closed when the assumptions are approved.

With the assumptions, the lenders waive their right to call the loans on the close of the sales escrow.

If an assumption is refused by the lender, the buyer can still take title subject to the loans of record. Alternatively, the seller can carry an AITD and negotiate a waiver of the due-on clause with the lender by remaining responsible for the loan payments.

The brokerage fee in a no-down deal

Payment of the brokerage fee is an additional concern for brokers and sellers involved in minimal or no down payment transactions.

The problem is not the amount of the fee, but how and when the broker will collect the fee he has negotiated in a cash-less transaction, such as a no-down sale or an exchange of equities.

In cash sales, the fee is paid in cash by the seller on close of escrow. When the sale includes little to no cash down payment and no new financing to generate cash funds, the broker, like the seller, must wait to be paid.

Typically, the fee will be paid by the seller out of payments made by the buyer on the carryback note. Alternatively, the buyer can create a separate note (reducing the amount of the carryback note by an equal amount), payable to the broker for the fee and secured by a junior trust deed. The purchase price for the real estate remains the same.

Thus, if the buyer defaults and an underlying trust deed holder (i.e., the seller) forecloses, wiping out the broker’s trust deed, the broker cannot obtain a personal money judgment against the buyer. The broker simply loses his fee.

Editor’s note – This anti-deficiency rule applies only if the buyer purchases and occupies a one-to-four unit residential property. If the buyer does not occupy, or the property is other than one-to-four residential units, the broker can recover a money judgment. [Kistler v. Vasi (1969) 71 C2d 261]

To prevent being wiped out by the foreclosure of a senior trust deed, the broker may wish to avoid holding nonrecourse paper. Several options are available.

For example:

• the seller can guarantee the buyer’s junior trust deed note on the real estate, making the seller personally liable to the broker if foreclosure wipes out the broker’s security;

• the buyer or seller can provide property other than the real estate being sold as additional security;

• the broker can become a co-owner/beneficiary of a pro rata share of the carryback note or an assignee of the note for payment of his fees;

• the broker can carry an unsecured recourse note payable by either the seller or the buyer – as part of the price; or

• the brokerage fee can be a recourse note signed by the seller and secured by a collateral assignment of the seller’s carryback trust deed note. A security agreement would provide for all or part of the carryback payments to be received by the broker until the brokerage fee is paid in full. When the fee is fully paid, the broker will reassign the trust deed to the seller.

However, the seller takes on an additional risk of loss under any arrangement the seller makes to pay the deferred fee. The risk arises when the buyer defaults on the payments which require the foreclosure of the carryback.

If the broker owns a percentage of the carryback, the seller and the broker become partners in any foreclosure process. To avoid anarchy, they should enter into a partnership agreement naming the partnership as the beneficiary of the trust deed before the closing of the original sales escrow. Otherwise, on foreclosure they will have to find a way to cooperate without the benefit of a written agreement.

If the broker holds a note for the fee signed by the seller, collateralized or not by the carryback note, the note for the fee is recourse/deficiency paper. The seller can be forced to pay – even when the carryback sale sours and the seller is faced with a loss – unless the fee note provides for relief in the event the buyer defaults on the carryback note.