Seller’s Risks with Owner Financing
1. The buyers may not pay. This is the only risk novice buyers
and sellers really think about. Participants in a owner financed
transaction need to realize they are going into the banking business
in a small way. Everyone knows banks have large buildings
and make a lot of money. They sort of forget banks also take some
heavy losses. However, banks get to play the odds. They
try to make more loans on which they profit than loans on which they
take a loss. For the seller trying to unload his house the news
on the day the monthly payment is due is either all good or all bad. Sellers
frequently insist on terms that actually increase the chances the loan
will get into trouble.
2. The sellers may need their cash faster than the contract pays. This
can be a subtle trap.The sale is done and some time later something happens
in the sellers life which causes them to need a chunk of cash. The obvious source of funds would seem to be selling the contract for cash. After all, the buyer has been paying every month and the interest rate on the
note is well over what banks are paying on CD’s.
A few calls to the note brokers advertising in the paper will spoil
that illusion. In the United States home ownership is reguarded
as a sacred right and governmental systems are in place to make sure
cheap money for home buyers is always available. The government
backs the bonds that get issued to provide the money so loans can be
made at the lowest possible rates. When you try to sell a privately
held note the buyers of the note will expect much higher rates. The
way they do this is to discount the value of the note.
Note discount calculations are complicated and depend on a lot of factors. However,
even a short term note, with market interest rate, and a good payment
history may be discounted by 25% or more. One of the difficult
parts of being a note broker is educating consumers about the true value
of their note on the open market. Successful note brokers typically
do that by proposing terms which help the note seller feel like they
are getting more for their note than they really are. This works
because few people really understand the mathematics of notes.
3. There may be unintended tax consequences. As
long as the seller continues to hold the note and reports the interest
as income the tax situation remains simple. For the buyer the interest
is deductible and the tax results are obvious. The tax situation
is more complex if the note gets sold to a third party at a discount. It
will also be more complicated if seller financing was used in the sale
of an income property. In that case the sellers “basis” in
the property comes into play and the allocation of the money from the
payments is more complex.
4. There may be title/ownership issues. Title
issues are rare in the residential home market. Subdivisions have
to on the books for years so there are few boundary issues. Title
insurance is a almost always used so potential problems are found and
corrected early. With land and income property title related problems are more likely. Owners
get sued, make bad business decisions, fail to pay their taxes, get divorced
and do other things that result in clouds on the title. Even with
residential property, sellers may “forget” to mention they
deeded an interest in their home to their kids who then will have to
sign the deed as part of the sale. Even though it is expensive,
I would strongly suggest title insurance.
5. Poorly drawn paperwork puts sellers at risk
of not being able to enforce the contract. Serious problems
will require a trip to court to resolve. THis is expensive and
takes a long time. In the
meantime the buyer may live the the property for months without making
payments. The seller is stuck making payments on the underlying
loan(s) to protect his equity without any income. I have known
sellers who would drive buy “their” property and watch it being
destroyed without being able to do anything about it. In court
the only thing which will really matter is the paperwork. Things
that were said or promised are not considered. This is the time
when the seller may realize the generic document they got at the stationary
store really doesn’t protect their interests well. In other words,
the parties to a seller financed sale should do everything with the idea
that they may eventually be in court and the documents they are signing
will determine what happens.
{ 28 comments… read them below or add one }
← Previous Comments
I have a lake house that I inherited about 10 years ago. I want to sell it for 50k. I have an offer of 50k. The purchase wants to pay 10% down payment and make monthly payments for 15 years.
What are the tax consequences for me? Do I count the monthly interest as income when reporting my taxes? At the end of the 15 year contract, will I owe capital gains tax?
In owner-finances sales, does the buyer pay the annual real estate taxes yearly over the 15 year contract period?
Thank you in advance for your answer.
Your basis in the property for tax purposes is it’s value when you inherited and it’s value when sold. Lets say for example, it was worth $25,000 when you inherited. That means you have a $25,000 capital gain. As I recall the rules ( I am not a tax guy) you can choose to recognize that gain in the year of sale or claim it as an installment sale.
If you have, or can create, capital losses you could net them against the gain from this sale. For example, if you own stocks that have lost value you could sell them and net the gains and losses. Absent such a situation I don’t see why you would want to come out of pocket for taxes on a gain you haven’t received yet.
In an installment sale each payment you receive includes interest, on which you pay taxes in the year of receipt as interest income. Each payment also includes a principle portion. In this example 50% of the principle portion of each payment is taxed as a capital gain and the other 50% is considered a return of capital. Keep in mind the amount of principle will change with each payment as the loan is paid down. Because of the way loans amortize this has the effect of shifting your capital gains taxes well into the future.
An owner financed sale is no different from a sale using a commercial lender in that taxes, insurance, etc. become the responsibility of the buyer at closing. Make sure the attorney who drafts your contract includes language that lets you make such payments if the buyer fails to. You will also want to make sure you are named as a loss payee on the insurance.
I hope this was helpful and good luck with the sale.
I am considering owner financing a lot that I bought 2 years ago. The current price is 110000 and I paid 128000. Therefore there is a loss. How or when do I claim the capital loss against other capital gains that I will realize during this year?
The last time I looked that up, which has been a while, I believe you report it on the same forms as any capital transaction. You used to have the choice of electing an installment sale or taking all the gain/loos in the year of sale. It sounds like you will be able to generate enough gains to offset this loss so claiming it all in the year of sale makes sense.
As of August 1, 2009 my niece is Owner Financing a house that I own. The house taxes and insurance could not added to the monthly payment– according to my lawyer. I have just found out that my niece has not paid the $750 house tax bill that was due 3 months ago. I have talked to her about this twice and she tells me that she will pay it in 2 weeks. What should I do?
In two weeks there isn’t really anything you can do besides wait and make plans for how you can handle the problem if she doesn’t perform. Typically it takes three or four years for the county to take action on unpaid property taxes so there isn’t any immediate problem from that direction. If you are really concerned, you could make the payment yourself and have her pay you back.
Is the insurance still in place? If she isn’t paying the taxes she may have let the insurance lapse. Are you named as a loss payee on the insurance? In other words, if the place burned down tomorrow, would your signature be required to cash the insurance check?
I am not a lawyer and don’t know the law in your state/county. However no real estate investor would ever owner finance without language in the agreement that allowed them to step in and make payments on taxes, insurance, water and sewer assessments, etc. That same agreement would make such payments a reason for default so they could start foreclosure. If your attorney didn’t include language that protects you in this situation I would strongly suggest you find one with more real estate experience to handle future issues with this property.
Good luck.
I have a client who recetly passed away and held a seller finance mortgage. Prior to his death the proberty was transfered to his significant other. I am going to claim 8 months of interest and payments on his tax return, and tell his significant other to claim the other 4 months, my question is since the proberty was transfered before my clients death does the seller financed mortage transfer with the proberty? Can the significant other continue to just collect the payments with same financing terms that the orginal owner had with the buyer?
I can see from several of the comments which have been made there is some confusion about what seller financing is and what it means. I get the feeling many people think it isn’t “real” in the same sense as a note and mortgage from a commercial lender.
As I understand your case, your client sold the property and took back a note and mortgage. Prior to his death his interest in the note and mortgage was transferred to his significant other. The key point is once the property was sold, your client was no longer the owner. He no longer had an ownership interest to transfer. What he did have was a contract, with terms and conditions as defined by the note and mortgage.
I assume the transfer to his significant other was recorded with the county clerk and is a matter of public record. None of this has any effect on the terms of the note and mortgage. Note brokers buy contracts like this all the time. Nothing changes except the party receiving the payments.
← Previous Comments