Carryback risks for the seller

A carryback seller takes on the role of a lender at the close of the sales escrow, with all the risks and obligations of a lender holding a secured position in real estate (read: a mortgage). Being a secured creditor is a fundamental real estate concept the listing agent needs to understand and, in turn, advise his seller on its consequences.

Above all, the seller’s agent needs to confirm the seller appreciates why he is receiving a trust deed secured by the property he is selling. The secured trust deed is collateral to cover him for the risk of loss due to a default on the note or trust deed by the buyer.

Another implicit risk of loss carried by secured creditors arises when the property’s value declines due to negative market conditions or the buyer committing waste. Though the risk of waste, also called impairment of the security, is often overlooked during boom times, a decline in property value during recessionary periods – the vicious part of the cycle – poses serious consequences for the seller when the buyer defaults on the trust deed provisions for 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, a condition any listing agent must advise on if not properly understood by the seller.

The seller is barred from obtaining a money judgment from the buyer for the carryback debt not satisfied by the value of the property on foreclosure.

Also, the seller must 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 from the buyer for any part of the carryback debt not satisfied by the value of the property on foreclosure under the trust deed – the deficiency. [Calif. Code of Civil Procedure §580b]

On a default by the buyer, the carryback seller may suddenly find himself returned to his original position — owning property he does not want to own, much less own it subject to a senior trust deed. In conclusion, the seller will incur out-of-pocket costs for:

  • foreclosure;
  • carrying the property (taxes, insurance, maintenance and senior mortgage payments);
  • any reduction in property value;
  • reassessment 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 monthly payments.

However, as with any mortgage lender, if the risk premium built into the price, down payment and interest rate on the carryback note is sufficient, the benefits of carryback financing level out or outweigh the risks of loss.

Secured or unsecured, nonrecourse or recourse

Consider an offer submitted by a buyer to purchase real estate with a provision calling for the seller to carry back an unsecured note for a portion of the sales price. The balance of the price will be paid as a cash down payment and the assumption of an existing loan on the property. The seller is given ten days after acceptance of the offer to further approve of the buyer’s creditworthiness and net worth, or cancel the transaction. [See first tuesday Form 207-1]

The buyer wants to acquire the property clear of any carryback encumbrances so the property’s equity can be used by the buyer to finance the acquisition of other property, information known to the listing agent and told to the seller.

On presentation of the offer, the seller receives the buyer’s fully itemized financial statements indicating the buyer’s net worth includes the ownership of numerous properties known to the listing agent’s broker.

Relying on his agent’s review of the buyer’s net worth, the seller accepts the offer. Prompted by the listing agent, the seller approves the buyer’s credit, thus waiving the further-approval contingency. [See first tuesday Form 182]

Cash back disclosure

Prior to the close of escrow, the buyer informs the listing agent he will not have enough cash to close unless the agent accepts a promissory note for the cash fee the seller has agreed to pay with funds received from the buyer’s down payment.

To close the transaction without causing confusion by bringing the buyer’s lack of funds to the seller’s attention, the listing agent enters into a “cash back” arrangement with the buyer. This arrangement will “lend” the buyer funds for the down payment, which in turn will fund the seller’s payment of the brokerage fee.

Under the arrangement, the buyer and the listing agent agree to exchange a check from the agent payable to the buyer for a note from the buyer payable to the agent, both for the amount of the brokerage fee. On closing, the listing agent will deposit in his account the fee he receives from the seller, and the buyer will negotiate the agent’s check issued on that account. In turn, the buyer will hand his promissory note to the agent.

The brokerage fee paid by the seller on closing will cover the check issued by the agent to the buyer. These arrangements are made outside of escrow and do not appear on the settlement statement the escrow officer prepares on closing. [See first tuesday Form 402]

Further, the buyer finances the remaining portion of the down payment through a new loan arranged by the listing agent with a private lender, which is not a part of the escrow documentation. Thus, the buyer has restructured the entire down payment to avoid the investment of any of his personal funds, and thus has no “skin” in the transaction as restructured.

The seller is not informed of the purchase-assist loan or the cash-back arrangement for funding the down payment. Also, the listing agent is aware the representations of the buyer’s other properties and the financing listed on the buyer’s financial statement approved by the seller significantly overstate the buyer’s true net worth.

The transaction closes. Soon afterward, the buyer defaults on the unsecured carryback note, which is recourse paper collectible by a money judgment.

The seller is only able to recover a portion of the outstanding balance on the carryback note from the buyer.

The seller seeks to recover his loss on the carryback note from the listing agent’s broker, claiming the broker and his listing agent misled him to accept the unsecured carryback note – deceitful conduct for a fiduciary of the seller.

Is the broker or his listing agent liable for the seller’s losses due to the buyer’s default?

Yes! The broker and his listing agent are both liable for the seller’s losses. The agent intentionally misrepresented the buyer’s ability to make the down payment and perform on the carryback note in order to induce the seller to enter into the installment sale with the buyer. [Alhino v. Starr (1980) 112 CA3d 158]

For a discussion on the listing agent’s and carryback seller’s need to investigate and analyze a buyer’s creditworthiness and capacity to pay, see Part II of this article series.