This article sets forth the maximum prepayment penalties available to carryback sellers and suggests the enforceable prepayment penalty as a substitute for contentious loan lock-in provisions.
A 30% bonus for the seller
A seller of real estate, other than a buyer-occupied, one-to-four unit residential property, informs his broker he will carry back paper for a substantial portion of the property’s sales price after a 20% down payment.
The seller is aware the profit in the carryback note will not be taxed until principal is paid or the note is collaterally assigned, called hypothecation, or sold.
The seller’s broker determines the seller’s remaining cost basis for the property is less than the balance of the trust deed lien on the property. Thus, the entire amount of the carryback note as an installment sale will be profit, subject to taxes as principal is paid, because of the seller’s mortgage-over-basis situation.
If the seller were to receive cash, and thus be taxed on all of his profit in the year of the sale, he would pay a combined federal and California state income tax of approximately 30% of his profit. Here, his profit consists of unrecaptured gain (25% federal tax rate) and long-term capital gain (15% federal tax rate). If the seller were to cash out at the time of sale, he would deposit the balance of his net proceeds remaining after the payment of taxes in an interest-bearing account. Thus, he would receive interest earnings on only 70% of his equity – the other 30% being disbursed (in cash) to pay state and federal profit taxes.
However, with taxes deferred until later years on an installment sale, the seller will earn interest (at the carryback note rate) on the full amount of his equity remaining unpaid after the down payment, which includes profit, without the devastating 30% decrease in wealth due to taxation.
The seller’s motivation is to defer taxes on his profit until the carryback note is due, in five years for example. Meanwhile, the seller will earn interest on the deferred profit tax retained as principal in the carryback note.
To accomplish the goal of avoiding the loss of interest income for a five-year period on that portion of the sales price representing the deferred profit taxes, the broker presents two alternatives available to the carryback seller:
lock in the buyer to payment of no more than the scheduled installments by eliminating the “or more” provision in the note, in order to prevent early payoff of additional principal; or
include provisions in the note for a prepayment penalty to be due on any payoff of principal in addition to scheduled installments.
The seller selects the prepayment penalty alternative after the broker voices concern over the enforceability of a lock-in clause. Deletion of the or-more clause prohibits principal reduction except under regular monthly payments and the final/balloon payment.
The seller and his broker agree to include a prepayment penalty in all negotiations. A 30% penalty on the payoff of any principal not included in regular monthly payments is estimated to be sufficient to cover the income taxes due on an early payoff of the note.
Can a carryback seller enforce a prepayment penalty in the amount of his estimated profit tax should the buyer pay off any additional principal within five years?
Yes! A prepayment penalty is enforceable if the penalty is reasonably related to the carryback seller’s anticipated money losses for the premature payment of profit taxes likely to be incurred due to a prepayment of part or all of the carryback note.
Since the anticipated amount of profit taxes to be paid on an unscheduled principal reduction is the amount of the penalty, a 30% penalty on the prepayment of unamortized principal is reasonable. [Williams v. Fassler (1980) 110 CA3d 7]
A prepayment penalty in notes secured by property other than buyer-occupied, one-to-four unit residential property is enforceable if the penalty is reasonably related to the note holder’s loss.
In the above example, if the seller instead carries back an all-inclusive trust deed (AITD) and note, he will avoid any debt relief since the buyer does not take over payments on the existing loan. Thus, the carryback seller defers reporting of a far greater percentage of his profit than under a note carried back for the remainder of his equity with the buyer taking over payment on the existing loan.
What is a prepayment penalty?
A prepayment penalty is an extra or additional charge incurred by a borrower for paying principal on a note before the principal is due as scheduled by the terms of the note. Since the penalty relates to the payment of the debt, not to the real estate, the provision is properly included in the promissory note, not the trust deed.
The prepayment of a loan is viewed as a privilege. A prepayment of principal does not conform to the schedule of payments agreed to. Thus, the carryback seller can demand an extra payment, bonus or penalty for the buyer’s exercise of a loan reduction privilege if a provision in the note so states.
From the point of view of a carryback seller, the prepayment penalty is designed to reimburse him for the consequences of incurring profit taxes during a fixed period of years after the sale of the property.
Also, a carryback seller can limit the amount of profit taxed in the year of sale by agreeing to receive constant principal payments which include only a portion of the sales price each year. [Internal Revenue Code §453]
If the buyer elects to prepay principal on the note, he must pay the agreed prepayment penalty on the amount of principal prepaid. Thus, the seller is compensated for the taxes it was estimated he would incur on an early payoff of principal.
Amount of the prepayment penalty
The reasonableness of the penalty amount is tested at the time the note and trust deed are entered into, not years later on payoff when interest and tax rates may have gone through major fluctuations, up or down. [Williams, supra]
Although a prepayment penalty inhibits conveyancing and reconveyancing, it is considered a reasonable restraint on the owner’s use of his title, a use called alienation. [Sacramento Savings and Loan Association v. Superior Court County of Sacramento (1982) 137 CA3d 142]
An exorbitant or “unconscionable” penalty is unreasonable and cannot be enforced. The courts police the amount of prepayment penalties to ensure it is reasonable.
Owner-occupied, one-to-four residential units
The amount of the prepayment penalty the carryback seller can charge the buyer also depends on the type of property and its use.
For a carryback on the sale of one-to-four residential units which will be occupied by the buyer, the buyer-occupant can prepay principal at any time during any 12-month period in an amount equal to 20% of the original principal amount of the note without being penalized for the prepayment. [Calif. Civil Code §2954.9(b)]
The amount of the penalty on the prepayment of principal amounts exceeding 20% of the original loan amount is limited to six months’ unearned interest on the excess amount. [CC §2954.9(b)]
Also, enforcement of the prepayment penalty by the carryback seller on buyer-occupied, one-to-four residential units is limited to five years after the close of the sales escrow. After five years, the carryback note can be paid off without a prepayment penalty. [CC §2954.9(b)]
Enforcement of a prepayment penalty provision is also prohibited on buyer-occupied, one-to-four residential units when a carryback seller:
calls the note due under a due-on-sale clause;
starts foreclosure to enforce a due-on-sale clause; or
fails to approve, within 30 days, the completed credit application of a qualified buyer to assume the carryback note. [12 Code of Federal Regulations §591.5(b)(2),(3)]
However, a seller carrying back a note secured by one-to-four residential units can bar prepayment in the calendar year of sale, if he has not already carried back more than three notes in the same year. [CC §2954.9(a)(3)]
The five-year prepayment penalty rule which applies to buyer-occupants of one-to-four residential units does not apply to investors who buy one-to-four unit residential properties.
After the calendar year lock-in period expires, the one-to-four unit investor can pay off the carryback note at any time, subject to any reasonable, agreed-to prepayment penalty.
The prepayment penalty included in any note secured by one-to-four residential units and executed by an investor can be set at 30% of any principal prepaid to cover the seller’s potential state and federal profit tax liability on early payoff. Thus, the carryback seller’s potential profit tax liability on an early payoff of principal on a note executed by an investor who bought the property can be fully recovered since the investor is not a buyer-occupant of the property. [CC §2954.9(a)(2),(3)]
Enforcement by foreclosure
Consider a prepayment penalty clause in a seller carryback note which allows the seller to collect a penalty on voluntary or involuntary prepayment of the debt.
The buyer defaults on the trust deed and the seller calls the note due, demanding a prepayment penalty for full satisfaction and reconveyance.
The buyer tenders full payment of the debt excluding the prepayment penalty, which the carryback seller refuses.
The buyer claims the prepayment penalty clause is unenforceable since the penalty can only be applied when the buyer voluntarily prepays the debt.
The seller claims the prepayment penalty clause is enforceable since the penalty provision allows the seller to demand a prepayment penalty whenever the note is called.
Is the prepayment penalty clause enforceable when the note is called?
Yes! The prepayment penalty clause is enforceable on the note holder’s acceleration of the debt. The clause permits the seller to demand a prepayment penalty on an involuntary prepayment resulting from the seller’s acceleration of the balance due on the note, unless the call resulted from the seller’s exercise of the due-on clause. [Biancalana v. Fleming (1996) 45 CA4th 698]