This article is a general review of the types of notes used in real estate secured transactions.
Evidence of the debt
Almost all real estate sales hinge on the financing of some portion of the purchase price. The buyer promises to pay a sum of money, in installments or a single payment at a future time, either to the seller of the real estate or a lender who funds the sales transaction.
Given in exchange for property or a loan of money, the promise to pay creates a debt owed by the borrower in favor of the seller or lender to whom the promise is made.
Usually, the promise to pay is set out in a written document called a promissory note, signed by the buyer/borrower. A promissory note merely represents an underlying debt owed by one person to another. The signed promissory note is not the debt itself, but evidence of the existence of the debt.
The borrower, called the debtor or payor, signs the note and delivers it to the lender or carryback seller, also called the creditor.
The note can be either unsecured or secured. If the note is secured by real estate, the security device which should always be used is a trust deed. When secured, the debt becomes a voluntary lien on the borrower’s real estate or the property purchased described in the trust deed.
The promissory note
Notes are categorized by the method for repayment of the debt as:
- installment notes; and
- straight notes.
The installment note is used for debt obligations with constant periodic repayments in any amount and frequency negotiated.
Variations of the installment note include:
- interest-included; and
Finally, notes are further distinguished based on interest rate calculations as:
- fixed interest rate notes; and
- variable interest rate notes, commonly called adjustable rate mortgages (ARMs).
Installment note, interest included
An interest-included installment note with constant periodic payments produces payments containing diametrically varying amounts of principal and interest. Principal reduction on the loan increases and interest paid decreases with each payment.
Each payment is applied first to the interest accrued and owing on the remaining principal balance through the end of the payment period, typically monthly. The remainder of the payment is then applied to reduce the principal balance of the debt.
Interest-included installment notes may either:
- be fully amortized through constant periodic payments until paid; or
- include a final/balloon payment after a period of installment payments, called a due date.
Installment note, interest extra
Interest-extra installment notes call for a constant periodic payment of principal on the debt. In addition to the payment of principal, accrued interest is paid concurrently with the principal installment.
The principal payments typically remain constant, from payment to payment, until the principal amount is fully paid or a due date occurs. Accordingly, the interest payment decreases with each payment of principal since the interest is paid on the remaining balance. [See Form 422 accompanying this article]
Thus, unlike an interest-included note, the amount of each scheduled payment of principal and interest on an interest-extra note is not constant from payment to payment.
For example, the amount of the first payment of interest is based on the entire original, unpaid balance of the interest-extra note. The second interest payment will be on the principal amount remaining after the principal reduction resulting from the first payment of principal. Thus, the amount of interest paid decreases from payment to payment. However, in contrast to an interest-included note, the principal paid with each payment is not increased by the same amount as the interest decreases since the principal portion of the payment is constant.
To set the amount of each periodic payment, recalculation is made of the accrued interest due on the note balance and is added to the constant principal payment until the principal is fully paid.
A straight note calls for the entire amount of its principal to be paid in a single lump sum due at the end of a period of time, such as five years after close of escrow or on a fixed future date. No periodic payments of principal are scheduled, as in the installment note. [See Form 423 accompanying this article]
Interest usually accrues unpaid and is due with the lump sum principal installment, financing sometimes referred to as a “sleeper” trust deed. Occasionally, the interest accruing is paid periodically during the term of the straight note, such as monthly payments of interest only with the principal all due in seven years.
The straight note is typically used by bankers for short-term loans, called a signature loan, since a banker’s short-term note is not usually secured by real estate.
A carryback seller may agree to a straight note all due in a specified number of months or years.
Variations on the interest rate and repayment schedules contained in the installment and straight notes are available to meet the specific needs of the lender and borrower. The variations include the:
- adjustable rate note (ARM);
- graduated payment note (GPM);
- all-inclusive note (AITD); and
- shared appreciation mortgage (SAM).
The adjustable rate note (ARM), as opposed to a fixed-rate note, calls for periodic adjustments to both the interest rate and the amount of scheduled payments. The interest rate will vary according to a particular index, such as adjustments every six months based on the Cost-of-Funds Index for the 11th District Federal Home Loan Bank.
The ARM note provides the lender with periodic increases in his yield on the principal balance during periods of rising short-term interest rates.
When an upward interest adjustment occurs, the note’s repayment schedule will call for an increase in the monthly payment to maintain the original amortization period. If the amount of the monthly payment remains constant without an increase when an adjustment increases the interest rate, a longer or negative amortization results.
Graduated payment notes (GPM) are in greater demand when interest rates or home prices rise too quickly. Fewer buyers are then able to currently meet the increased cost of financing home ownership.
A graduated payment schedule allows buyers time to adjust their income and expenses in the future to begin the eventual amortization of the loan. Often a GPM note has a variable interest rate, called a GPARM loan.
For example, the GPM note provision allows low monthly payments on origination. The payments are gradually increased over the first three-to-five year period of the loan until the payment amortizes the loan over the desired number of remaining years.
However, any accrued monthly interest remaining unpaid each month is added to the principal balance on the carryback note, called negative amortization. The negative amortization causes the unpaid interest to bear interest as though it were principal, called compounding.
The all-inclusive trust deed (AITD) variation is used more often in carryback transactions than money lending. Lease-options, land sales contracts and AITDs become popular in times of recession, increased long-term rates and tight credit.
The lease-option and land sales contract are security devices which do not use a note to evidence the debt. Instead, they are themselves evidence of the debt owed to the seller on the price. However, the lease-option and the land sales contract contain greater legal risks than the AITD due to their recharacterization as mortgages, while producing the same financial function and tax result as the AITD.
The AITD “wraparound” note typically calls for the buyer to pay the carryback seller constant monthly installments of principal and interest. The carryback seller then pays installments due on the underlying (senior) trust deed note from the payments received on the AITD.
Instead of allowing negative amortization, a carryback seller can offer the buyer a 3-2-1 “buy-down” of the note’s interest rate.
Under a buy-down, also called an escalating interest note, the seller agrees to a reduced interest rate on the note during the first three to five years. Each year, the interest rate graduates upward on an agreed-to rate increase until the rate negotiated for the remaining life of the carryback note is reached.
For example, a seller wants an interest rate of 10% on a carryback note in the amount of $100,000. To maintain a high sales price, the seller agrees to monthly interest rate payments in the first year of 7% with payments based on a 30-year amortization.
The buyer will make payments of $699.21 for the first year on the $100,000 carryback note. In the second year, the interest rate increases to 8% on the remaining balance of $99,078.22, amortized over 29 years with payments of $767.63 monthly.
The note is reamortized each year the interest rate rises.
Another variation, the shared appreciation mortgage (SAM), is designed to help sellers attract buyers during times of tightening mortgage money, prior to a general decline in real estate sales, when no lack of buyers exists. The SAM is an example of a split-rate note. [See first tuesday Form 430]
Under a SAM note, the buyer pays a fixed interest rate, called a “floor” or “minimum” rate. The floor rate charged is typically two thirds to three fourths of the prevailing market rate but equal to or greater than the Applicable Federal Rate (AFR) for reporting any imputed interest on the carryback note.
In return, the carryback seller will receive part of the property’s appreciated value as contingent interest when the property is sold or the carryback SAM is due.
One-to-four residential units
If the property being sold is one-to-four residential units and a final balloon payment is called for, the note is required to contain a provision for a 90-day prior notice of the balloon payment’s due date. [See first tuesday Form 419]
The statutory 90-day prior notice provision is entered on the note when it is prepared by escrow. [Calif. Civil Code §2966]
A note documents the terms for repayment of a loan or payment of a portion of the sales price carried back after a down payment, including:
- the amount of the debt;
- the interest rate;
- the monthly payment schedule; and
- any due date.
The amount of the note carried back on an installment sale is directly influenced by whether the carryback is:
- an AITD note; or
- a regular note.
An AITD note carried back by a seller will always be of a greater amount than a regular note in any given sales transaction. The AITD note includes the amount of the wrapped loans while a regular note is only for the amount of the seller’s equity remaining after deductions of the down payment.
Interest rate limitations on loans
A carryback note is exempt from interest rate limitations on loans under usury law. [Calif. Constitution Article XV]
California’s usury law limits the interest rate on non-exempt real estate loans to the greater of:
- 10%; or
- the discount rate charged by the Federal Reserve Bank of San Francisco, plus 5%. [Calif. Const. Art. XV]
A non-exempt loan is usurious if the promissory note provides for an interest rate exceeding the ceiling rate on the day the note is agreed to.
All real estate loans made or arranged by a real estate broker, however, are exempt from the usury restriction. [Calif. Const. Art. XV §1]
However, seller carryback notes are not money loans. Rather they are extensions of credit on a sale, and are not covered by the usury laws even if the trust deed note is sold to an investor prior to closing. [Boerner v. Colwell Company (1978) 21 C3d 37]
In addition, a carryback note does not later become usurious on the modification of the note, such as the extension of a due date or a change in the interest rate on a forebearance to foreclose. [DCM Partners v. Smith (1991) 228 CA3d 729]
The trust deed
In most carryback transactions, the buyer gives the seller a trust deed lien on the real estate sold to provide security for payment of the portion of the price left to be paid.
The trust deed attaches the debt to the property as a lien on the property. The trust deed is recorded to give notice and establish the priority of the seller’s security interest in the property. [Monterey S.P. Partnership v. W.L. Bangham, Inc. (1989) 49 C3d 454]
A trust deed alone, without an unpaid monetary obligation, is a worthless trust deed. Although the note and trust deed executed by a buyer in favor of the seller are separate documents, a trust deed can only exist when it secures an existing and unsatisfied promise to pay or perform a lawful act. [Domarad v. Fisher & Burke, Inc. (1969) 270 CA2d 543]
Even though separate documents, the note and trust deed are for the same transaction and are considered one contract to be read together. [CC §1642]
Satisfaction of the debt
The promissory note, once signed by the borrower and delivered to the lender or its agent, represents the existence of a debt. [Calif. Code of Civil Procedure §1933]
When a secured debt has been fully paid, the trust deed securing the debt must be removed from title to the secured property. [CC §2941]
The trustee under the trust deed will require the original note and a request for reconveyance from the lender before the trustee will release the lender’s trust deed lien from the real estate.
If the original note has been lost or the noteholder cannot be located, the trustee will require that a bond be posted in its place before reconveyance.
If the lender or the trustee fails to reconvey the security interest after full payment, both may be subject to a civil fine of $300, a criminal fine of $400 and/or six months imprisonment. [CC §§2941; 2941.5]
Legal aspects of the carryback note
Provisions of the carryback note must be in writing and include:
- a promise to pay;
- identification of the lender; and
- the debt.
Consideration for a carryback note is the conveyance or agreement to convey real estate, such as a land sales contract or lease-option, in exchange for the carryback note and trust deed. A promissory note is unenforceable unless consideration is given for it. [CC §1550(4)]
A carryback note must contain an unconditional written promise signed by the buyer, to pay as scheduled an agreed-to amount of principal and any interest due the holder of the carryback note. The buyer’s promise to pay the seller according to the terms outlined in the note is necessary for a carryback note to be negotiable in a sale or collateral assignment. [Calif. Commercial Code §3104]
Also, for a carryback note to be negotiable, it must contain a promise to pay made payable to a definite person or persons. [Schweitzer v. Bank of America N. T. & S. A. (1941) 42 CA2d 536]
If the carryback note does not specify the amount of the debt, the note is unenforceable due to uncertainty. A note which does not contain an agreed-to amount to be paid to the seller is nonnegotiable. [Com C §3104]
Tax aspects of a carryback sale
A carryback sale usually creates reportable profit for the seller, called recognized gain by the Internal Revenue Service (IRS). If the net sales price exceeds the cost basis remaining in the property, a profit exists. (Price minus basis equals profit.)
The reporting of the carryback seller’s profit in the carryback note is automatically deferred until the year’s payment is received on the principal, through installments and the final/balloon payoff.
The minimum interest reported to the IRS on carryback notes should be contracted at or above a minimum average interest rate over the life of carryback note of 9% or the AFR, whichever is less.
Risk of loss
When a carryback note is secured by the real estate sold, the carryback note is classified as purchase money paper, and the debt is nonrecourse.
Thus, the carryback seller’s only source of recovery in the event of the buyer’s default on the carryback note is the real estate sold and encumbered as security for the note.
Buyers are shielded by California’s anti-deficiency laws. The seller cannot hold the buyer personally liable for the amount of the carryback note secured only by the property sold – even if the foreclosure sale, judicial or nonjudicial, fails to satisfy the debt. [CCP §580b]
Conversely, should a default occur on a carryback note which is subordinated to a construction loan, the carryback seller may collect any deficiency in property value from the buyer. [Spangler v. Memel (1972) 7 C3d 603]
However, the existence of an agreement to subordinate in the future does not trigger the construction loan recourse exception. Until the carryback trust deed is actually subordinated to a construction loan, the seller’s security interest in the property does not face a greater risk-of-loss than the value of the property sold.
After the carryback trust deed has been subordinated to a construction loan, the purchase money carryback becomes recourse paper. [Budget Realty, Inc. v. Hunter (1984) 157 CA3d 511]