When mortgage money is plentiful and readily accessible, lenders are eager to make loans to nearly every buyer. But when the availability of mortgages tightens, as is happening with 2022’s rising interest rates, loan approvals become more elusive.

Further, the definition of a “qualified buyer” becomes more restrictive in tight credit markets. A seller hoping to locate a buyer amenable to the seller’s asking price during a tight mortgage market needs to consider seller financing.

Seller financing supports the price

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 and trust deed 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 to the seller after deducting:

  • the down payment; and
  • the amount of any existing or new mortgage used by the buyer to pay part of the price.

Rights and obligations of seller financing

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 mortgage, taking on the rights and obligations akin to that of a mortgage holder.

Editor’s note — Before making, offering or negotiating consumer mortgages for compensation, California brokers and agents need to first obtain a mortgage loan originator (MLO) license endorsement on their California Department of Real Estate (DRE) license. A consumer mortgage is a consumer purpose loan secured by a one-to-four unit residential property.

A broker offering or negotiating a carryback consumer mortgage as part of a home sale transaction triggers the MLO license endorsement only if the broker or agent receives separate additional compensation for arranging the carryback, a fee beyond the fee collected for their role as seller’s agent or buyer’s agent in the real estate transaction.

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 are willing to pay a higher price for real estate when attractive financing is available. This holds true regardless of whether financing is provided by the seller or a lender. For most buyers, the primary factors when considering their purchase of a property is:

  • the amount of the down payment; and
  • the monthly mortgage payments.

Seller’s agents use these circumstances to inform their sellers about pricing arrangements in hyper-competitive buyer’s markets.

Buyer willingness is especially apparent when the interest rate on the carryback mortgage is equal to or below the rates competitive lenders are charging on their purchase-assist loans. The lower the interest rate, the higher the price may be.

Flexible sales terms for the buyers

Seller financing also provides tangible benefits for buyers. For buyers, seller

carryback financing generally offers:

  • a moderate down payment;
  • competitive interest rates;
  • less stringent terms for qualification and documentation than imposed by traditional lenders; and
  • no origination costs or lender processing hassle.

Lenders automatically require a minimum down payment of 20% if the buyer is to avoid private mortgage insurance (PMI), which adds over one percent to annual mortgage costs and reduces the maximum amount a homebuyer can borrow. Further, Federal Housing Administration (FHA)-insured mortgages include a mortgage insurance premium (MIP) regardless of the loan-to-value (LTV).

In a carryback sale, the amount of the down payment is negotiable between the buyer and seller without the outside influences a traditional mortgage broker and buyer have to contend with.

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 earnings for the seller

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 years in which principal is received from the buyer. When the seller avoids the entire profit tax bite in the year of the sale, the seller earns interest on the portion of the note principal that represents the tax not yet due and payable.

If the seller does not carry a note payable in future years, they will be cashed out and pay significant profit taxes in the year of the sale (unless the profit is exempt or excluded from taxation, such as occurs in a §1031 transaction).

What funds the seller has 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 tax impact the seller receives on their carryback mortgage is classified as portfolio category income. This is the case regardless of the fact the property sold was in another income category (passive/business/personal).

Proper documentation for carryback financing

On closing the sale, the seller financing may be documented in a variety of ways. Common mortgage arrangements include:

  • land sales contracts;
  • lease-option sales;
  • sale-leasebacks; and
  • trust deed notes, standard and all-inclusive.

Legally, the note and trust deed provide 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 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. They are inseparable and function in tandem. The note provides evidence of the existence 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 by the buyer. Together, they are referred to as a mortgage.

In addition, when the seller carries back a note executed by the buyer as part of the sales price for property containing one-to-four residential units, a financial disclosure statement needs to be prepared and handed to the buyer and seller. This statement is prepared by the broker who represents the person who first offers or counteroffers on terms calling for carryback financing. [See RPI Form 300]

Regular and all-inclusive notes and trust deeds

The carryback note and trust deed may be structured in regular or all-inclusive terms to meet the financial needs of the buyer and seller.

For instance, if the real estate is encumbered by a mortgage which a qualified buyer may assume with the mortgage holder, the seller may carry back a regular note secured by a second trust deed. The note will be for the balance of the seller’s equity which remains unpaid after deducting the buyer’s down payment.

However, if the mortgage holder for the existing mortgage will not allow the mortgage to be assumed, the buyer may arrange a new mortgage to pay off the existing mortgage. Here, the lender of the new mortgage will need to approve of the seller carrying back a second mortgage.

Often, the seller’s borrowing power is greater than the buyer’s. Here, the seller may choose to refinance the existing mortgage on the property themselves and withdraw a portion of their equity by taking out a new mortgage on the property.

With the property properly financed, the buyer assumes the new mortgage and the seller carries back a regular note and second trust deed for the remainder of their unpaid equity in the property.

Regulation Z carryback exemptions

When a mortgage on a one-to-four unit residential property funds a consumer purpose, such as the acquisition of a buyer’s family home or vacation home, it is classified as a consumer mortgage and comes within the purview of federal Truth-in-Lending Act (TILA) and Regulation Z (Reg Z) rules. [12 Code of Federal Regulations §§1026 et seq.]

Carryback sellers (and lenders) are not controlled by the federal Reg Z disclosure and ability-to-repay rules when:

  • they make five or less carryback consumer mortgages per calendar year;
  • the terms of the carryback financing do not include a prepayment penalty; and
  • the seller is not paid a fee for providing the carryback mortgage. [12 CFR §1026.43(c)(1); 12 CFR §1026.2(a)(17)(v)]

Thus, until the seller’s quantity (more than five) and terms (inclusion of a prepayment penalty) of carryback consumer mortgages subjects them to Reg Z, they may carryback a consumer mortgage without regard to federal requirements.

Further, a critical licensing and endorsement distinction exists between carryback sellers and mortgage loan originators (MLOs).

An MLO is any person who charges a fee to make or arrange a consumer mortgage. For example, this includes a lender or broker who receives a fee, separate from a transaction agent’s fee on a sale, for arranging a purchase-assist mortgage (a loan or a carryback) for a buyer-occupant of a one-to-four unit residential property. These fee-based consumer mortgage arranging activities are controlled by state law regarding the need to be licensed by the California DRE and MLO-endorsed. [Official Staff Commentary to 12 CFR §1026.36(f)-3]

However, California rules only compel persons who arrange loans for a fee to hold a DRE license, and if the loan arranged is a consumer mortgage, to also hold an MLO endorsement.

Seller carryback consumer mortgages are not loans. Thus, carryback sellers are exempt from California’s Secure and Fair Enforcement for Mortgage Licensing Act (SAFE Act) licensing and MLO endorsement requirements for consumer mortgages — even when the quantity and terms of a seller’s carryback activity are considered a consumer mortgage under federal law. [Calif. Business and Professions Code §10166.01(d)]