Carryback arrangements facilitate a sale, Part I

This article series analyzes the use of an installment sale as a flexible financing arrangement to encourage prospective buyers to purchase a seller’s property in a recessionary market.

Part I of this series introduces the concept of seller carryback financing and discusses the tax benefits of carrying paper for the seller, and the flexible sale terms available to the buyer.

Seller financing supports the price

During economic periods of plentiful and inexpensive mortgage money, such as occurred during the Millennium Boom, lenders are eager to make loans to nearly every buyer, no matter the type of property sought, its location or the buyer’s creditworthiness.

However, when economic conditions tighten, the availability of real estate loans constricts, narrowing the definition of what were previously considered “qualified” buyers. As is now the case as California continues its washboard trek across the long plateau of the Great Recession, lenders on both single family residences (SFRs) and commercial properties have greatly reduced the loan-to-value (LTV) ratio they are willing to lend at, if they are willing to make a loan at all.

Thus, a seller hoping to sell his property – and maintain his asking price – must consider financing the sale himself if his agent is to locate a buyer willing (and able) to purchase the property.

Seller financing, also called an installment sale, credit sale or owner-will-carry arrangement, involves carrying back a note executed by the buyer as payment for that portion of the price remaining unpaid after deducting:

• the down payment; and
• the amount of any existing mortgage financing the buyer assumes or new financing the buyer obtains.

Thus, the carryback seller takes a secured creditor’s position in the property for the amount of the price remaining to be paid – the note. The carryback seller’s role is comparable to that of a mortgage lender. On closing, the rights and obligations of real estate ownership held by the seller carrying back a note and trust deed are shifted to the buyer, while the seller takes on the rights and obligations of a secured creditor.

Seller financing is documented in a variety of ways, including:

• land sales contracts;
• lease-option sales;
• sale-leasebacks; and
• trust deed notes.

Legally, the note and trust deed is the most certain, as well as the most universally understood, of the various documents for structuring seller financing. In this arrangement, carryback documentation consists of:

• a promissory note executed by the buyer in favor of the seller as evidence of the portion of the price remaining to be paid for the real estate before the seller is cashed-out; and
• a trust deed lien on the property sold to secure the debt owed by the buyer as evidenced by the note.

The note and trust deed are combined to evidence the debt owed to the seller and provide security for repayment in the event of default under either document.

The seller who offers a convenient and flexible financing package to prospective buyers makes his property more marketable and defers the tax bite on his profits. Qualified buyers who are rational are always willing to pay a higher price for real estate when attractive financing is available, regardless of whether it is provided by the seller or a mortgage lender. For most buyers, the primary factors when considering their purchase of a property is the size of the down payment required and the monthly carrying cost of the mortgage payments.

Even the most qualified buyer will agree to a higher price when he can defer payment through financing provided by the seller – a fact used by listing agents to inform their sellers about pricing arrangements in any hyper-competitive buyer’s market. Buyer willingness is especially apparent when the rate of interest on the carryback financing is competitive with or below the rates lenders are charging on their purchase-assist loans.

A carryback note is also advantageous for buyers when market prices (and rents) are or will be trending upward, the economic equivalent of reducing the fixed rate of interest and principal paid to the seller from year to year – a function of price inflation and, with it, the dollar’s annual loss of purchasing power. A 2% rate of consumer inflation functions to offset 2% of the interest paid as the inflation produces more personal income and rents.  In turn, the property’s value increases, the hedge against inflation for the capital invested.

Tax benefits for the seller

Listing agents who are aware that many buyers in their market require more flexible financing than offered by institutional mortgage lenders inform their sellers that a properly structured carryback financing arrangement will help attract potential buyers. Carrying paper also offers considerable financial and tax advantages for sellers.

Taxwise, it is preferable for higher-income sellers to carry back a portion of the sales price, rather than be cashed out, when the sale will produce a significant taxable profit. The seller taking a reportable profit on a sale is able to defer payment of a substantial portion of his profit taxes, spreading payment of profit taxes over the life of the carryback note. Thus, he avoids a premature tax bite in the year of the sale on profits that are not exempt (§1031 reinvestments) or excluded (§121 principal residence).

The tax reporting of the interest the seller will receive from year to year on his carryback financing is reflected as portfolio category income. The reporting of interest income is not concerned with the fact the untaxed profit in the principal amount of the carryback note is reported from year to year in another income category (passive or trade/business). Unless the seller converts his real estate equity into a note payable in other than the year of sale to defer taxes, he will be cashed out and pay profit taxes in the year of the sale (unless exempt or excluded) and is left to reinvest what remains of his diminished after-tax sales proceeds.

Risk-wise in a rising market, a carryback note typically provides for a higher interest yield than generated on other investments containing a similar level of risk which are available to the cashed-out seller. However, the converse is true in a recessionary market.

Flexible sales terms for the buyer

For buyers, seller carryback financing generally offers:

• a moderate down payment;
• competitive interest rates;
• less stringent terms for qualification than those imposed by lenders; and
• no origination (hassle) costs.

Mortgage lenders mechanically require a minimum down payment of around 20% for the buyer to avoid the additional burden of qualifying for private mortgage insurance (PMI). In a carryback sale, the amount of the down payment is negotiable between the buyer and seller without outside influences a traditional mortgage loan broker and borrower must contend with (such as the requirements of secondary mortgage market pools and PMI underwriters).

Additionally, a price-to-interest rate trade-off often takes place in the carryback environment.  The buyer is usually able to negotiate a lower-than-market interest rate in exchange for agreeing to the seller’s higher-than-market asking price. The seller can have one or the other, but not both, if the buyer (or the buyer’s broker) is knowledgeable and everyone involved is at least somewhat rational.