Money has a funny way of burning a hole in everyone’s pockets, and mortgage lenders are no exception. When cash is plentiful and accessible, lenders are eager to originate mortgages no matter the buyer’s qualifications.
But when the availability of real estate mortgages tightens, the definition of a “qualified” buyer becomes more restrictive. 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 (OWC) 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 deducing:
- the down payment; and
- the amount of any existing or new mortgage financing used by the buyer to pay 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.
Editor’s Note – California brokers and agents who make, offer or negotiate residential mortgages for compensation are required to obtain a Mortgage Loan Originator (MLO) license endorsement on their Department of Real Estate (DRE) license. A residential mortgage 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 only if the broker or agent receives additional compensation for the act of offering or negotiating the carryback, beyond the fee collected for their role as a seller’s or buyer’s agent.
Marketing the 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 will often pay a higher price for real estate when attractive financing is available. This holds regardless of whether financing is provided by the seller or a mortgage lender. For most buyers, the primary factors when considering their purchase of a property are the amount of the down payment and the monthly mortgage payments.
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 mortgages. The lower the interest rate, the higher the price may be.
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.
In a carryback sale, the amount of the down payment is negotiable between the buyer and seller. There is no need to contend with outside influences that a traditional mortgage broker and borrower bring.
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.
Tax benefits and flexible sales terms
Taxwise, it is preferable for a seller 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, is able to defer payment of a substantial portion of their profit taxes until the year 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 will be 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.
The capital gains taken on the sale of a principal residence remaining after exclusions and the interest received on the carryback note are reported as portfolio category income. However, when the property is a rental, the capital gains is reported a passive category income but the interest received on the carryback is reported as portfolio category income.
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. Further, they are 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 RPI 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 RPI Form 450]
The note and trust deed are legally coupled, inseparable and function in tandem. The note provides evidence of the debt owed but 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 default and is recorded.
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 calling for a carryback note. [Calif. Civil Code §2956; See RPI Form 300]
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. The secured property described in the trust deed serves as collateral, the seller’s sole source of recovery to mitigate the risk of loss on a default by the buyer on the note or trust deed.
Another implicit risk of loss for secured creditors arises when the property’s value declines due to deflationary future 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 poses serious consequences for the seller when the buyer defaults on the payment of taxes, assessments or insurance premiums.
Also, the seller needs to understand that 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.
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. [See RPI Form 303]
Carryback financing comes in clutch when traditional financing arrangements become unreachable. While agents need to take extra precautions when arranging carryback financing, this service is a productive lifeline for underrepresented homebuyers.
This article was originally published in December 2013 and has been updated.
