Rising rates bring seller financing back
When mortgage money is plentiful and readily available, lenders are eager to lend to almost any buyer. But when mortgage availability tightens, as is the case with rising interest rates in 2022, loan approvals become more elusive.
Additionally, the definition of a “qualified buyer” becomes more restrictive in tight credit markets. A seller hoping to find a receptive buyer at the seller’s asking price during a tight mortgage market should consider vendor financing.
Seller financing supports the price
Vendor financing is also known as:
- an installment sale;
- a sale on credit;
- carry-over funding; or
- an owner-carrier sale (OWC).
Seller financing occurs when a seller brings back a note and deed of trust signed by the buyer to evidence a debt owed for the purchase of the seller’s property. The amount of the claim is the remainder of the price due to the seller after deduction:
- the down payment; and
- the amount of any existing or new mortgage used by the buyer to pay part of the price.
Seller Financing Rights and Obligations
At closing, the rights and obligations of the real estate property held by the seller are transferred to the buyer. At the same time, the seller defers a mortgage, assuming rights and obligations similar to those of a mortgagee.
Editor’s Note – Before granting, offering, or negotiating consumer mortgages for compensation, California brokers and agents must first obtain Mortgage Originator License (MLO) approval on their license from the California Department of Real Estate (DRE). A consumer mortgage is a loan for consumption purposes secured by a residential property of one to four units.
A broker offering or negotiating a deferral consumer mortgage as part of a sale of home transaction only triggers MLO license approval if the broker or agent receives separate additional compensation for arranging the deferral back, a fee in addition to the fees charged for their role as seller’s or buyer’s agent. agent in the real estate transaction.
Marketing of the property: the seller will carry
The seller who offers a practical and flexible financial package to potential buyers makes their property more marketable and postpone the tax bite on their profits.
Qualified buyers are willing to pay a higher price for real estate when attractive financing is available. This is true whether the financing is provided by the seller or by a lender. For most buyers, the main factors when considering the purchase of a property are:
- the amount of the deposit; and
- monthly mortgage payments.
Seller’s agents use these circumstances to inform their sellers of price agreements in hyper-competitive buyer’s markets.
The buyer’s will is particularly evident when the interest rate on the deferral mortgage is equal to or lower than the rates that competing lenders charge on their purchase assistance loans. The lower the interest rate, the higher the price can be.
Flexible terms of sale for buyers
Seller financing also offers tangible benefits to buyers. For buyers, seller
Carry-over funding typically provides:
- a moderate down payment;
- competitive interest rates;
- qualification and documentation requirements that are less stringent than those imposed by traditional lenders; and
- no set-up fees or lender processing hassles.
Lenders automatically require a minimum down payment of 20% if the buyer wants to avoid private mortgage insurance (PMI), which adds more than one percent to annual mortgage costs and reduces the maximum amount a buyer can borrow. In addition, mortgages insured by the Federal Housing Administration (FHA) include a mortgage insurance premium (MIP) regardless of the loan-to-value (LTV) ratio.
In a sale with deferral, the down payment amount is negotiable between buyer and seller without the outside influences that a traditional mortgage broker and the buyer must deal with.
Moreover, a price/interest rate trade-off often takes place in the deferral environment. The buyer is usually able to negotiate a lower than market interest rate in exchange for accepting the seller’s asking price, which is higher than the market price.
Tax advantages and gains for the seller
From a tax point of view, it is preferable for a seller to defer part of the sale price, rather than to be cashed out when he makes a significant taxable profit.
The seller, with a profit to declare on a sale, is able to defer payment of a substantial portion of his income taxes until the years in which the principal is received from the buyer. Where the seller avoids all income tax in the year of the sale, the seller earns interest on the portion of the principal of the note which represents the tax not yet due and payable.
If the seller does not bear a promissory note in future years, he will be cashed in and pay significant profit taxes in the year of the sale (unless the profit is exempt or excluded from tax, such as this happens in a §1031 transaction).
The funds left behind by the seller after taxes are reinvested in some way. This after-tax sale proceeds will be less than the principal amount on the deferral note. Thus, the seller earns interest on the net proceeds of the deferred sale before paying taxes on the profit attributed to that principal.
The tax impact the seller receives on their deferral mortgage is classified as portfolio class income. This is the case regardless of whether the property sold belonged to another category of income (passive/professional/personal).
Appropriate documentation for carry-back financing
At the closing of the sale, seller financing can be documented in a variety of ways. Common mortgage arrangements include:
- land sale contracts;
- sales with rental option;
- sale-leaseback; and
- trust deeds, standard and all-inclusive.
Legally, the note and deed of trust provide the most certainty. Additionally, they are the most universally understood of the various documents used to structure seller financing. In this arrangement, the deferral documentation includes:
- a Remark executed by the buyer in favor of the seller as proof of the part of the price remaining to be paid for the immovable before the seller is Cashed [See RPI Form 421]; and
- a trust deed lien on the sold property to secure the debt owed by the
- the buyer as evidenced by the note. [See RPI Form 450]
The note and the trust deed are legally coupled. They are inseparable and work in tandem. The note provides proof of the existence of the debt owed but is not filed with the County Recorder. The deed of trust creates a lien on the property as a source of debt repayment in the event the buyer defaults. Together they are called a mortgage.
In addition, when the seller brings back a note signed by the buyer as part of the sale price of a property containing from one to four residential units, a financial disclosure statement must be prepared and delivered to both buyer and seller. This statement is prepared by the broker representing the person who first offers or counter-offers on terms that provide for carry-back financing. [See RPI Form 300]
Regular and Lump Sum Notes and Trust Deeds
The deferral note and deed of trust can be structured in regular or lump sum terms to meet the financial needs of both buyer and seller.
For example, if the building is subject to a mortgage that a qualified buyer can assume with the mortgagee, the seller can postpone a regular note secured by a second deed of trust. Note will be for the balance of Seller’s equity that remains unpaid after deduction of Buyer’s deposit.
However, if the holder of the existing mortgage does not allow the assumption of the mortgage, the buyer can take out a new mortgage to pay off the existing mortgage. Here, the new mortgage lender will need to approve the seller’s deferral of a second mortgage.
Often, the borrowing power of the seller is greater than that of the buyer. Here, the seller can choose to refinance the existing mortgage on the property themselves and take out some 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 defers a regular note and second deed of trust for the remainder of his unpaid equity in the property.
Regulation Z carryback exemptions
When a mortgage on a residential property of one to four units finances a consumption purpose, such as acquiring a buyer’s family home or vacation home, it is classified as a consumer mortgage and falls under federal jurisdiction Truth in Lending Act (TILA) and Regulation Z (Reg Z) rules. [12 Code of Federal Regulations §§1026 et seq.]
Deferral sellers (and lenders) are not controlled by federal Reg Z disclosure and repayment capacity rules when:
- they take out five or fewer consumer mortgages per calendar year;
- the terms of the carry-back financing do not include a prepayment penalty; and
- the seller does not receive a fee for providing the deferral mortgage. [12 CFR §1026.43(c)(1); 12 CFR §1026.2(a)(17)(v)]
So until the quantity (more than five) and terms (including a prepayment penalty) of the seller’s consumer mortgages make them subject to Reg Z, they can defer a consumer mortgage regardless of federal requirements.
Additionally, there is a key distinction between licenses and endorsements between carry-over sellers and mortgage loan originators (MLO).
An MLO is anyone who charges a fee to make or arrange a consumer mortgage. For example, this includes a lender or broker who receives a commission, separate from a transaction agent’s commission on a sale, for arranging a purchase assistance mortgage (a loan or deferral) for a buyer -occupant of a one to four unit residential property apartment. These paying consumer mortgage arranging activities are controlled by state law regarding the requirement to be licensed by the California DRE and approved by the MLO. [Official Staff Commentary to 12 CFR §1026.36(f)-3]
However, California rules only require people who arrange loans for a fee to hold a DRE license, and if the arranged loan is a consumer mortgage, to also hold an MLO endorsement.
Consumer mortgages with seller’s carry-back are not loans. Thus, carry-over sellers are exempt from California Secure and Fair Enforcement of the Mortgage Licensing Act (SAFE Act) licensing and MLO approval requirements for consumer mortgages – even where the amount and terms of a seller’s carryback activity qualify as a consumer mortgage under the federal law. [Calif. Business and Professions Code §10166.01(d)]