This article discusses the advantages of a carryback all-inclusive note and trust deed (AITD), the forms to be used and the terms to be negotiated.
Flexible carryback financing
As a debt instrument and security device for the credit sale of encumbered real estate, the all-inclusive note and trust deed (AITD) provides brokers and buyers with the flexibility needed to finance the balance of the sales price remaining unpaid after a down payment.
For a buyer, the AITD is all the financing needed to acquire encumbered real estate with a down payment. The principal amount of the AITD includes both the seller’s unpaid equity in the property and the unpaid balance on the existing loan which will remain of record, called the wrapped loan or underlying loan. The buyer makes monthly AITD payments to the seller. The seller, in turn, makes payments to the underlying lender.
The advantages of an AITD over a standard second trust deed are mainly for the seller. However, the buyer, seller and lender all benefit since the buyer does not assume the wrapped loan.
For the seller, the benefits of an AITD include:
- a greater yield than could be negotiated on a standard second trust deed note, a financial advantage due to the AITD note’s overriding interest rate feature;
- a reduced risk of loss due to a default on the underlying loan since the seller remains responsible for payments on the underlying loan;
- the deferral of profit tax liability for a greater percentage of the transaction’s profit taxes since the seller remains responsible for payments on the underlying loan, thus avoiding debt relief;
- support of the price sought by providing financing; and
- a trustee’s foreclosure on the buyer’s default, unlike other wraparound security devices, such as land sales contracts and purchase/lease-option agreements, which require a judicial foreclosure unless they also contain a power-of-sale provision.
For the buyer, the AITD provides more simplicity and flexibility than conventional or government-insured loans, since:
- the interest rate and payment schedules are fully negotiable and not tied to secondary money market standards;
- the carryback seller is less concerned than standardized institutional lenders with creditworthiness and income ratios;
- the buyer makes payments on only one debt, the AITD note; and
- no third-party lender fees are required, such as points, “garbage fees,” private mortgage insurance (PMI) or a separate lender’s ALTA title insurance policy.
The AITD is always a junior trust deed, usually a second behind a pre-existing, underlying first trust deed. Legally, the AITD has the same function as a standard trust deed, as it is the same trust deed form, except for the AITD addendum covering the disclosures and accounting for the all-inclusive “wraparound” aspect.
Land sales contracts and lease-option sales also are all-inclusive security devices. They exhibit the same wraparound debtor/creditor features as an AITD. In using an AITD, a land sales contract or lease-option sale, the seller has sold the property and remains responsible for payments on the underlying loan while receiving installments from the buyer. Tax results are the same for each security device.
The terms negotiated for payment of the sales price when the seller carries back an AITD include five variables:
- The down payment.
- The amount of the AITD note.
- The interest rate.
- The periodic (monthly) payments.
- A due date.
The down payment on an AITD carryback transaction is handled no differently than on any other method of carryback financing, such as a standard first or second trust deed, land sales contract or lease-option sale. The amount of the down payment is fully negotiable between the buyer and the seller, and can range from zero to the seller’s entire equity in the property.
A prudent carryback seller will require a down payment of no less than 10% to 20% of the sales price depending on whether the property sold is, respectively, income property or a buyer-occupied, single-family residence (SFR). The smaller the down payment, the greater the risk of loss for the seller should the buyer default and the property be repossessed and resold. The risk is covered by an increase in the price or interest rate, or both.
Amount of the note
The most distinctive characteristic of the AITD note is its face amount. The AITD note amount includes the unpaid balance on any underlying encumbrances which remain the seller’s responsibility to pay, plus the seller’s equity remaining after a down payment. Viewed another way, the AITD note is the balance of the sales price remaining after the down payment. [See first tuesday Form 421]
At first glance, the debts secured by the underlying trust deed and the all-inclusive carryback trust deed appear to over-encumber the property.
However, the amount of the AITD note wraps around and is inclusive of the underlying loan balance. Thus, the separate trust deed balances cannot be added together to determine the total amount of encumbrances on the property. The AITD amount is the total amount of encumbrances.
For example, property encumbered by a $60,000 first trust deed is sold for $100,000 with a $30,000 down payment. An AITD note is carried back for $70,000, the amount remaining unpaid on the purchase price. The buyer does not agree to pay off the first trust deed. Collectively, the amounts secured by the two trust deeds total $130,000, yet the amount required to clear title of both trust deeds is only $70,000, the amount of the AITD note.
Conversely, a standard second trust deed note carried back for the balance of the seller’s equity (after a down payment) would have been for $10,000, with the buyer assuming the $60,000 first trust deed – an aggregate debt of $70,000.
The minimum dollar amount the seller can carry back on an AITD is the total amount of underlying loans for which the seller remains responsible. The AITD note must be mathematically structured so it has a remaining principal balance equal to or greater than the wrapped loans at all times.
However, an AITD need not include all pre-existing trust deeds (or other loans) recorded against the property sold. The AITD may be a third trust deed which wraps only the second and not the first, or vice versa. The buyer will take over payments on the existing trust deed loan that is not included in the AITD amount, and the seller will remain responsible for the second lien (which may be a judgment or a loan with an interest rate unacceptable to the buyer).
When only one of two existing loans is wrapped, the AITD note is for the balance of the purchase price remaining after deducting both the down payment and the balance of the one loan taken over by the buyer.
The AITD seller can make his carryback financing more attractive for the buyer during periods of high interest rates by offering a below-market rate, whether or not the underlying note rate is below market.
The interest rate on the AITD note will preferably, but not necessarily, equal or exceed the rate on the underlying note.
In this respect, the AITD rate is said to override the rate on the underlying trust deed note. The override is the difference between the interest rate on the underlying trust deed note and the rate negotiated for the AITD note.
For example, an AITD note with a 10% rate, which wraps a first trust deed note at 7%, gives the seller a 3% interest override on the underlying loan balance.
The override is the financial advantage available to the carryback seller when using an AITD, as it can greatly increase his yield on his equity in the AITD note.
If the interest rate on the underlying loan exceeds the interest rate on the AITD, the seller’s equity in the AITD is said to “burn off” bit by bit, shrinking daily as interest accrues in varying amounts on each trust deed note.
This principal burn-off reduces the seller’s equity in the AITD. More important, the AITD note balance will reduce faster than the balance on the underlying loan, converting principal payments received on the AITD note into interest paid on the wrapped loan. A due date on the AITD must be set before the “crossover” in principal balances occurs.
Wrapping a variable interest rate loan
The seller wrapping a variable rate loan (ARM) with an AITD should make sure the interest rate provisions in the AITD note conform to the rate adjustment provisions in the underlying ARM. The same index, adjustment periods, floor and ceiling rates, and payment schedules should be included in the AITD note to make the AITD an ARM.
For example, an owner decides to sell real estate encumbered with an ARM. The ARM has a note rate comprised of the 11th District cost-of-funds and a margin of 2.5%. By using the same index and a margin equal or greater than on the underlying loan, the seller will receive sufficient interest to service the first trust deed without reducing the seller’s return on the all-inclusive ARM – there will be no principal “burn-off.”
When the seller uses the same index on the AITD note as the index used on the underlying loan but negotiates a greater margin, the seller receives additional overriding interest on the portion of the AITD note equal to the balance on the underlying loan.
A carryback seller should not use a different index on the all-inclusive ARM than the index used on the underlying loan. If a different index is used, the index for the carryback could fall while the index on the underlying loan rises, with the seller paying the difference.
Also, a seller can wrap a fixed-rate loan by carrying back an all-inclusive ARM. The adjustable rate provision in the AITD note would set the life-of-loan floor rate at no less than the fixed rate on the underlying loan. Thus, the seller prevents the interest rate on the all-inclusive ARM from falling below the rate on the underlying fixed-rate loan.
In the typical AITD transaction, the buyer makes installment payments on the AITD note directly to the seller. The seller then makes the scheduled payment due to the underlying senior lender. The seller retains the difference as his net cash flow on the AITD note.
A contract collection account can be entered into by the seller to receive payments and make disbursements. Under contract collection, a bank, thrift, escrow or broker will collect and disburse the monthly payments called for in the AITD note.
Contract collection is convenient. However, if the seller and the buyer mutually agree that the seller will place the AITD note on contract collection, the agreement will severely reduce the deferral of profit tax on the installment sale. The collection agent, when required by an agreement between the buyer and the seller, is deemed to be the agent of the buyer. When payments are made by the buyer’s agent, the responsibility for payments on the underlying loan is attributed to the buyer.
Due to the shift in responsibility, the seller has debt relief – increasing the profit-to-equity ratio on the installment sale and increasing the percentage of down payment and principal payments reported annually as profit. [Goodman v. Commissioner of Internal Revenue (1980) 74 TC 684]
The buyer’s monthly payments on the AITD note may be in any amount. However, prudence suggests the payments will be no less than the amount the seller must pay on the underlying note, even if a good reason exists for a lesser payment.
Also, the AITD allows for a flexible payment schedule, which is attractive to buyers.
For example, young buyers, whose rising incomes will allow them to make larger payments in the future, might be able to purchase the seller’s property through a graduated payment program.
Graduated monthly payments allow buyers to make monthly payments which start out low, but gradually increase from year to year. For instance, a buyer who cannot now afford what should be a monthly AITD payment of $2,000 could offer to pay $1,400 monthly the first year. The monthly payments could by agreement be increased annually by $200, until reaching the full $2,000 amount needed to amortize the AITD.
Of course, the low monthly payments may be insufficient to cover the accrual of a fixed rate of interest on the AITD note. A provision can be included in the note calling for any accrual and unpaid interest to be added to the principal, called compounding.
Thus, until the buyer’s monthly payments increase enough to cover the accruing interest, the principal amount of the note will increase, a situation called negative amortization.
Rather than adding interest to the principal, a provision for an additional installment could be negotiated and added into the note calling for payment of all accrued interest which remains unpaid on a future date.
For an alternative to negative amortization under the fixed rate, a graduated rate of interest could be charged that is consistent with the graduated payment schedule.
Another tax consideration is to use a prepayment penalty provision to induce the buyer to pay no more than the amount of the scheduled monthly payments for an agreed-to period of years. Any early payoff of additional principal during the period of the provision will include a penalty. Prepayment penalties are limited on one-to-four unit residential properties.
A prepayment penalty should be of sufficient amount to provide funds for the seller of other than one-to-four unit property to cover the tax liability incurred on the premature termination of the installment sale due to an early payoff.
There are two types of AITDs:
- An equity payoff AITD [See first tuesday Form 442 accompanying this article]. and
- A full payoff AITD. [See first tuesday Form 443 accompanying this article]
With an equity payoff AITD, reconveyance occurs when the seller’s equity in the AITD, the principal amount of the AITD note remaining after deducting the underlying loan balance, is fully paid.
Once the seller receives the payoff amount for his AITD equity and reconveys, the buyer becomes responsible for installment payments on the underlying trust deed note. The underlying trust deed is not paid off and remains of record, the buyer having previously taken title subject to the loan.
Full payoff AITDs require payment of the entire balance of the AITD note, which includes amounts owed on the underlying loan, before reconveyance occurs. Thus, both the AITD and the underlying trust deed are fully satisfied and reconveyed on payoff of the AITD. The full payoff AITD is less flexible for the buyer when arranging for a payoff.
Taxwise, for the seller, the full payoff AITD is preferable. The full payoff AITD note, without a contract collection provision, does not provide for debt relief at any time. The buyer can never take over the responsibility for the underlying loan, even on final payoff and reconveyance of the AITD. Thus, the full payoff AITD allows the seller to use the installment sales method of income tax reporting without the issue of debt relief ever arising.
The due date for an AITD note can be set at any length of time – ranging from the first of the next calendar year up to 15 years or more.
However, the due date of the AITD note should fall on or before any due date on the underlying loan.
For example, if an underlying loan is due in three years and the AITD in five, the seller will be required to pay off the underlying lender before he is paid off on the AITD.
The seller could pass the payoff burden on to the buyer by including a special additional installment in the AITD note. The payment would be sufficient in time and amount to meet the final/balloon payment on the underlying loan. The alternative is to set the due date on the AITD no later than the date of the final/balloon payment on the underlying loan.
Also, an amortization schedule which reduces the AITD note balance to an amount equal to the wrapped loan requires a due date on or before the date when both notes will have the same balance so the seller can avoid liability for a pay down of the wrapped loan.
The AITD also contains pass-through provisions to cover charges demanded by the underlying lender. [See first tuesday Forms 442 §5 and 443 §6]
For instance, the buyer may wish to refinance and pay off the AITD note and the underlying loan before they come due. With a pass-through provision in the AITD addendum, the buyer will fund any prepayment penalties demanded by the underlying lender for early payoff, not the carryback seller, even though the seller is primarily responsible for paying the underlying debt.
Also, if the underlying lender demands payment of any late charges, future advances or the entire loan balance brought about by the buyer’s conduct, the payment of the demands is passed through to the buyer.
A lender holding a trust deed that contains a due-on clause can call the loan balance due on the transfer of almost any interest in the property. The due-on clause is called an alienation clause, and the call is referred to as an acceleration of the note balance.
The due-on clause is triggered by:
- any conveyance of ownership, including land sales contracts;
- origination (except home equity loans) or foreclosure of junior trust deeds on the property; or
- the creation of a lease for more than three years, or any lease with an option to buy. [12 Code of Federal Regulations §591.2(b)]
The carryback AITD transaction, of course, involves both a sale (the grant deed) and a further encumbrance (the trust deed).
Thus, an AITD transaction triggers the due-on clause in any underlying trust deed, allowing the lender to:
- call or recast the loan unless written consent to the sale has been given; or
- fail to act on the right to call after notice of the transaction, called a waiver.
Thus, when current market interest rates are high and the AITD is most beneficial to both the buyer and the seller, a senior trust deed lender is likely to call the underlying loan due on the sale. Alternatively, the lender might demand the loan be recast at current market rates, including modified payments to retain the same amortization period and fees for doing so, or the lender may do nothing at all.
Now consider an AITD buyer who (obviously) takes title subject to the underlying loan. The buyer does not assume the seller’s obligation to pay the loan at the time of sale. No lender consent to the carryback sale is sought or obtained by the seller.
Under the terms of the AITD, the seller agrees to hold the buyer harmless from all obligations which exist on the underlying loan. [See first tuesday Forms 442 and 443]
Thus, the buyer is held harmless (by the seller) against any activities of the underlying lender, unless:
- the buyer interferes by triggering the due-on clause through further encumbrance, long-term lease, resale, waste, etc; or
- a pass-through provision shifts the due-on-sale burden to the buyer, as with late charges, prepayment penalties or future advances.
The seller’s primary duty is to make all the payments due on the underlying loan, as long as the AITD remains of record and the buyer is not in default.
If the buyer fails to make payments on the AITD note, the seller is under no legal obligation to forward his own funds to the underlying lender, or to protect the property from a foreclosure by the first trust deed lender.
Even without the obligation to keep the first trust deed current, the AITD seller may feel compelled by the buyer’s default to advance funds to keep the underlying trust deed current, or else risk the alternative and allow his trust deed to be wiped out by the underlying lender’s foreclosure.
Should the underlying lender call the loan based on the AITD transaction, the seller may be forced to use his own funds or borrow against other assets (or collateralize the AITD) to pay off the lender. Thus, the buyer must agree in advance to cooperate with the seller should the first trust deed be called due and it becomes necessary to refinance the real estate to fund a payoff of the first trust deed.
If possible, prior arrangements should be made with senior lenders to prevent due-on enforcement during the term of the AITD, sometimes called a reverse assumption.
The AITD transaction should be documented:
- between the buyer and the seller with a purchase agreement, grant deed, trust deed and note;
- between the seller and the lender with a due-on waiver and any modification of the underlying note demanded by the lender for consent; and
- with escrow, the buyer depositing the downpayment funds and the AITD, and the seller depositing his grant deed.
Brokers must make full disclosure to the buyer and the seller about the terms of the carryback and the underlying financing. Disclosure is accomplished by use of the AITD addendum. A carryback financing disclosure form with statutorily mandated content is to be used on carryback sales of one-to-four unit residential property.
The buyer and the buyer’s broker must be sure the terms of the AITD are consistent with the underlying senior trust deeds it wraps – is it truly a wraparound trust deed?
To assure consistency, escrow should be instructed to order a beneficiary statement from the existing trust deed lender. A lender’s beneficiary statement confirms the terms of the underlying encumbrance are as represented by the seller. The statement enables the buyer to confirm the consistency of the terms in the underlying loan and the AITD. [See first tuesday Form 429]
The buyer should also consider having the seller agree to record and serve the underlying lender with a Request for Notice of Default and Notice of Delinquency (NODq) on the underlying trust deeds. [See first tuesday Form 412]
The request for an NODq assures the buyer he will promptly learn of the carryback seller’s failure to make payments to senior lienholders. [Calif. Civil Code §§2924b; 2924e]
Editor’s note – A carryback seller who fails to pass AITD payments on to the wrapped lender will be open to criminal sanctions.
Finally, the buyer or his broker should check the preliminary title report to find out if the underlying trust deed is a blanket encumbrance that also affects property other than the property in question.
All-inclusive trust deeds are sometimes used by undercapitalized developers and land sales promoters. With the AITD, they can finance the sale of lots which have been cut out of a larger parcel when the larger parcel is encumbered by a blanket trust deed that lacks a partial release clause.
For their purpose, these developers and promoters use an AITD which only discloses that “underlying loans may or may not exist.”
Typically, in these cases of blanket encumbrances, no disclosure is made of the amount or terms of the underlying loan, nor of the existence of the blanket trust deed on the “parcel in question with other parcels (PIQWOP).”
Should the seller default on a blanket trust deed that lacks a partial release clause, the buyer of a lot on an AITD would have to pay off or refinance the entire blanket trust deed to protect himself – an economically unlikely possibility when, as typical, the underlying loan balance exceeds the AITD balance (and the price paid for the individual lot). [Drake v. Martin (1994) 30 CA4th 984]