Brush up on installment sale basics to make deals in a tightening mortgage market.
Part I of this article series introduces the concept of seller carryback financing. We’ll go over the tax benefits of carrying paper for the seller, the flexible sale terms available to the buyer and the potential risks for the seller.
For insight into the carryback seller’s and their agent’s need to investigate and analyze a buyer’s creditworthiness and capacity to pay, see Part II of this article series. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.
Seller financing supports the price
When mortgage money is plentiful and accessible, 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 the availability of real estate loans tightens, the definition of a “qualified” buyer becomes more restrictive. As Californians trek through our current washboard recovery, lenders have greatly tightened their lending guidelines. Reduced loan-to-value ratios (LTVs) are the order of the day, if lenders are willing to lend at all.
In these economic conditions, a seller hoping to locate a buyer amenable to the seller’s asking price needs to consider seller financing.
Seller financing is also known as:
- an installment sale;
- a credit sale;
- carryback financing; or
- an owner-will-carry sale.
Seller financing occurs when a seller carries back a note executed by the buyer to evidence a debt owed for purchase of the seller’s property. The amount of the debt is the remainder of the price due after deducting:
- the down payment; and
- the amount of any existing or new mortgage financing which funds part of the price.
On closing, the rights and obligations of real estate ownership held by the seller are shifted to the buyer. Concurrently, the seller carries back a note and trust deed taking on the rights and obligations of a secured creditor, becoming one of the rentier class.
Editor’s note —California brokers and agents who make, offer or negotiate residential mortgage loans for compensation are required to obtain a Mortgage Loan Originator (MLO) license endorsement on their Bureau of Real Estate license. A residential mortgage loan is a consumer purpose loan secured by a one-to-four unit residential property.
Thus, offering or negotiating carryback financing triggers the MLO license endorsement if the broker or agent receives additional compensation for the act of offering or negotiating the carryback, beyond the fees collected for their role as seller’s agent or buyer’s agent. [See the Bureau of Real Estate’s FAQ, “Do the New MLO License Endorsement Requirements Apply to Me?”]
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 and documentation than imposed by lenders; and
- no origination (hassle) costs.
Mortgage lenders mechanically require a minimum down payment of around 20% if the buyer is to avoid 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 narrow requirements of secondary mortgage market pools, PMI underwriters and regulatory agency guidelines).
Additionally, a price-to-interest rate tradeoff 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 their broker is knowledgeable and everyone involved is at least somewhat rational. In today’s interest rate environment, imputed interest reporting is not an issue.
The closing documents needed for the carryback
On closing the sale, the seller financing may be documented in a variety of ways. Common arrangements include:
- land sales contracts;
- lease-option sales;
- sale-leasebacks; and
- trust deed notes, standard and all-inclusive.
Legally, the note and trust deed provides the most certainty, as well as being the most universally understood of the various documents used to structure 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 [See first tuesday Form 421]; and
- a trust deed lien on the property sold to secure the debt owed by the buyer as evidenced by the note. [see first tuesday Form 450]
The note and trust deed are legally coupled, inseparable and function in tandem. The note provides evidence of the debt owed which is not filed with the County Recorder. The trust deed creates a lien on property as the source for repayment of the debt in the event of a recorded default.
In addition, when the seller carries back a note executed by the buyer as part of the sales price for property containing four-or-fewer residential units, a financial disclosure statement is to be prepared. This statement is prepared by the broker who represents the person who first offers or counteroffers on terms which include a carryback note. [Calif. Civil Code §2956; see first tuesday Form 300]
Marketing property: the seller will carry
The seller who offers a convenient and flexible financing package to prospective buyers makes their property more marketable and defers the tax bite on their 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 mortgage payments.
Seller’s agents use these circumstances to inform their sellers about pricing arrangements in hyper-competitive buyer’s markets (the next is expected after 2014, as speculator acquisitions drop). Buyer willingness is especially apparent when the rate of interest on the carryback financing is in line with or below the rates lenders are charging on their purchase-assist loans. The lower the interest rate, the higher the price may be.
Many qualified buyers need more flexible financing than offered by institutional mortgage lenders. Agents need to inform their sellers that a properly structured carryback financing arrangement will attract these potential buyers.
Tax benefits for the seller
Taxwise, it is preferable for sellers to carry back a portion of the sales price, rather than be cashed out when taking a significant taxable profit. The seller, with a reportable profit on a sale (beyond any §1031 investment property exemptions or §121 homeowner exclusions available), is able to defer payment of a substantial portion of their profit taxes until the years in which principal is received. When the seller avoids the entire profit tax bite in the year of the sale, the seller earns interest on the amount of the note principal that represents taxes not yet due and payable.
If the seller does not carry a note payable in future years, they will be cashed out and pay profit taxes in the year of the sale (unless exempt or excluded). What funds they have left after taxes are reinvested in some manner. These after-tax sales proceeds are smaller in amount than the principal on the carryback note. Thus, the seller earns interest on the net proceeds of the carryback sale before they pay taxes on the profit allocated to that principal.
Riskwise, 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. However, the converse is true regarding interest rates during a recovery.
Carryback risks for the seller
A carryback seller assumes the role of a lender at the close of the sales escrow. This includes all the risks and obligations of a lender holding a secured position in real estate – a mortgage. Being a secured creditor is a fundamental real estate concept the seller’s agent needs to understand in order to advise their seller on its nature and consequences. Most sellers of homes are wage earners aware of debt obligations but unaware of the management required of one whose income is derived from assets (the note), rather than employment.
Above all, the seller’s agent needs to confirm the seller appreciates why they are receiving a trust deed as a lien on the property sold. The secured property described in the trust deed serves as collateral, the seller’s sole source of recovery to cover the risk of loss due to a default by the buyer on the note or trust deed.
Another implicit risk of loss carried by secured creditors arises when the property’s value declines due to negative forward market conditions or the buyer committing waste. The risk of waste, also called impairment of the security, is often overlooked during boom times. However, a decline in property value during recessionary periods due to the buyer’s lack of funds – the vicious part of the cycle – poses serious consequences for the seller when the buyer defaults on the payment of taxes, assessments, insurance premiums or maintenance of the property.
Thus, costs incurred to foreclose and resell property can quickly turn a sale from a low-down payment, high-interest-rate note into a cash drain for the seller. This is a potential condition any seller’s agent is to advise their seller on, prior to the seller agreeing to carry back a note.
Concerns about the buyer’s default
On a default by the buyer, the carryback seller may suddenly find themselves returned to their original position — owning property they do not want to own. Worse, they will own it subject to a senior trust deed. In the end, the seller will incur out-of-pocket costs for:
- carrying the property (taxes, insurance, maintenance and senior mortgage payments);
- any reduction in property value;
- reassessment to current value triggered by both the sale and foreclosure;
- a modified (higher) interest rate on the old loan (foreclosure also triggers the due-on clause); and
- profit taxes on any previously untaxed principal received from the down payment and in amortized monthly payments. [See first tuesday Form 303]
Also, the seller needs to understand a carryback note secured solely by a trust deed lien on the property sold is nonrecourse paper. Thus, the seller will be barred from obtaining a money judgment against the buyer for any part of the carryback debt not satisfied by the value of the property at the time of foreclosure – the unpaid and uncollectible deficiency. [Calif. Code of Civil Procedure §580b]
However, as with any mortgage lender, if the risk premium built into the price, down payment, interest rate and due date on the carryback note is sufficient, the benefits of carryback financing level out or outweigh the risks of loss.
Part II of this article series discusses the seller’s need to investigate and analyze a buyer’s creditworthiness and the proper structure for a carryback transaction purchase agreement. For comments on the yield limitations which contrast loans from credit sales, and the requirements a carryback seller is to meet to be eligible for exemption from mortgage loan originator licensing, see Part III of this article series.