ThreeRiversREI
01-15-2007, 07:29 AM
Okay, part of tonight's chat got derailed due to misunderstandings in terminology. My hope with this thread is to describe various "seller financing" techniques that can be used. I'm not trying to be incredibly specific, but I do want to list as many different techniques as I can and differentiate between them as to tax consequences and how to deal with a "buyer" who defaults on their payments.
If I overlook an option, PLEASE point it out and I'll come back and edit this first post so it can continue to provide a "complete" list. If I overlook or misstate the pros and/or cons of a technique, again point it out so I can come back and keep this initial post as accurate as it is complete. Note: Some options like Subject-2 & Wrap mortgages work well when we're buying, but would open us up to unacceptable financial liability as non-motivated sellers and will NOT be included in this post.
Okay, here is the scenario. You have a cute little 3 bedroom, 2 bath, 2 car garage single family home that you want to sell for $100k. Bob & Betty Buyer come along and want to buy it. GREAT! Except, they don't happen to have $100k in cash. What options are there?
Conventional Financing
Seller Financing
Lease Option
Contract for Deed/Land Contract
Downpayment/Closing Assistance
Refer to broker for access to Private/Hard Money Lenders
Refer to FHA and similar First Time Homebuyer programs
???
Conventional Financing
Most obvious, most boring, but certainly a good choice. Buyer goes to the bank, mortgage broker, etc. of their choice, gets a loan, kicks in their cash down payment during escrow, and the seller walks away with full cash in pocket and no further responsibility for dealing with the property. As payment is received in full, taxes are also due immediately (barring things like a Section 131 exclusion or 1031 exchange).
Seller Financing
This one can be done on it's own, or in conjunction with conventional financing. Seller takes back a note for all or part of the purchase price and collects payments from the buyer. Title passes to the buyer at close of escrow so if they default on payments, the seller would have to foreclose. This is further complicated by the possibility of a senior lien being on the property if the seller only provided a second to cover all or part of the buyer's down payment. However, the seller DOES stand to collect more total (due to interest) and only has to pay taxes as the payments are collected. Seller also has the option to sell the Note to a 3rd party to terminate their interest in the property.
Lease Option
This technique is actually a combination of 2 techniques. The first is a lease to provide cash flow to help pay seller's carrying costs. Default on the lease would necessitate an eviction to regain control of the premises. The second part is the option to purchase the property at a future date for an agreed upon price.
Since no sale takes place until the option is exercised (if it is at all) the lease payments are ordinary rental income and taxed accordingly. Once the option IS exercised, the seller would only THEN realize the Capital Gain (or loss) for tax purposes.
Contract for Deed/Land Contract
Using this technique, payments are made but title is only transferred at the end of the contract. In this respect it is much like a Lease Option. It is different, though, in that while in both cases the seller maintains legal title until the conclusion of the agreement, under a Land Contract the buyer acquires "equitable title" immediately.
Equitable title gives the buyer the right to live in the property, improve it, rent it and otherwise enjoy all of the benefits of ownership. The IRS generally treats a contract for deed as a sale, which means the buyer has the tax benefits of ownership. Thus, the payments of interest that are made by the buyer in possession are deductible as “mortgage interest,” even though the buyer does not have legal title to the property.
A contract for deed seller must report the transaction as an installment sale on form IRS Form 6252. Once sold, the seller cannot claim depreciation or any other tax benefits of the property. If the buyer defaults on the contract and the seller exercises his legal option to reclaim the property, the tax code treats the transaction as a foreclosure.
The legal process for repossession of the property is not entirely clear in every state. Some state statutes (e.g., IL, TX & PA) clearly spell out the process, which is somewhat more involved than an eviction, but clearly less burdensome than a full–blown foreclosure. In most states, the process is not clearly defined, so courts deal with a buyer’s default on a case–by–case basis.
Also, a property sold with a land contract is already sold for tax purposes when the contract is entered into; thus, you cannot use a 1031 tax–deferred exchange on a property sold by contract for deed when the buyer pays off the debt balance. The entire balance paid on the contract will be due as a capital gain
Down Payment/Closing Assistance
There are a number of sub-options here, but they all boil down to the seller paying money in escrow to reduce the amount the buyer has to come up with to get into the home. This generally works best with conventional financing and can even be negotiated so as to maintain the same "net" to the seller. For example, the buyer may ask the seller to pay closing costs of up to $5,000. In exchange, the seller might agree only if the purchase price is raised to $105,000.
Similarly, rather than sell 5% below FMV to ensure a quick sale, the seller might agree to sell at full FMV and make a 5% donation to a qualified non-profit such as Neighborhood Gold who will in turn "gift" the 5% to the buyer allowing them to qualify for a 95% ltv FHA loan with no out of pocket down payment.
These techniques can even be combined, if necessary. Capital Gains are recognized on the net proceeds, so would not be due on any seller paid closing costs. However, gifts to non-profit down payment assistance companies are not tax deductible so Capital Gains would be due on that portion even though the seller would not actually receive the money.
Refer to broker for access to Private/Hard Money Lenders
Not necessarily "creative financing" per se, but can help close a deal. If your network includes a mortgage broker who works with owner occupants, they may be able to provide assistance for a sub-prime buyer, or one with limited income, etc. Tax consequences would be similar to conventional financing.
Refer to FHA and similar First Time Home Buyer programs
Similar to referrals to a broker. If you become aware of any such programs and can provide the information to your buyer, you may be able to help them obtain financing they might not find on their own. Depending on the program, tax consequences would be similar to conventional financing.
???
Did I miss your favorite technique? Reply and let me know. Remember, these are techniques to help SELL a home, not to purchase one. So techniques that open the seller up to excessive financial liability won't be included. But feel free to make your case as to why an investor might want to sell to a buyer with a wrap mortgage that leaves the investor liable on the underlaying note.
If I overlook an option, PLEASE point it out and I'll come back and edit this first post so it can continue to provide a "complete" list. If I overlook or misstate the pros and/or cons of a technique, again point it out so I can come back and keep this initial post as accurate as it is complete. Note: Some options like Subject-2 & Wrap mortgages work well when we're buying, but would open us up to unacceptable financial liability as non-motivated sellers and will NOT be included in this post.
Okay, here is the scenario. You have a cute little 3 bedroom, 2 bath, 2 car garage single family home that you want to sell for $100k. Bob & Betty Buyer come along and want to buy it. GREAT! Except, they don't happen to have $100k in cash. What options are there?
Conventional Financing
Seller Financing
Lease Option
Contract for Deed/Land Contract
Downpayment/Closing Assistance
Refer to broker for access to Private/Hard Money Lenders
Refer to FHA and similar First Time Homebuyer programs
???
Conventional Financing
Most obvious, most boring, but certainly a good choice. Buyer goes to the bank, mortgage broker, etc. of their choice, gets a loan, kicks in their cash down payment during escrow, and the seller walks away with full cash in pocket and no further responsibility for dealing with the property. As payment is received in full, taxes are also due immediately (barring things like a Section 131 exclusion or 1031 exchange).
Seller Financing
This one can be done on it's own, or in conjunction with conventional financing. Seller takes back a note for all or part of the purchase price and collects payments from the buyer. Title passes to the buyer at close of escrow so if they default on payments, the seller would have to foreclose. This is further complicated by the possibility of a senior lien being on the property if the seller only provided a second to cover all or part of the buyer's down payment. However, the seller DOES stand to collect more total (due to interest) and only has to pay taxes as the payments are collected. Seller also has the option to sell the Note to a 3rd party to terminate their interest in the property.
Lease Option
This technique is actually a combination of 2 techniques. The first is a lease to provide cash flow to help pay seller's carrying costs. Default on the lease would necessitate an eviction to regain control of the premises. The second part is the option to purchase the property at a future date for an agreed upon price.
Since no sale takes place until the option is exercised (if it is at all) the lease payments are ordinary rental income and taxed accordingly. Once the option IS exercised, the seller would only THEN realize the Capital Gain (or loss) for tax purposes.
Contract for Deed/Land Contract
Using this technique, payments are made but title is only transferred at the end of the contract. In this respect it is much like a Lease Option. It is different, though, in that while in both cases the seller maintains legal title until the conclusion of the agreement, under a Land Contract the buyer acquires "equitable title" immediately.
Equitable title gives the buyer the right to live in the property, improve it, rent it and otherwise enjoy all of the benefits of ownership. The IRS generally treats a contract for deed as a sale, which means the buyer has the tax benefits of ownership. Thus, the payments of interest that are made by the buyer in possession are deductible as “mortgage interest,” even though the buyer does not have legal title to the property.
A contract for deed seller must report the transaction as an installment sale on form IRS Form 6252. Once sold, the seller cannot claim depreciation or any other tax benefits of the property. If the buyer defaults on the contract and the seller exercises his legal option to reclaim the property, the tax code treats the transaction as a foreclosure.
The legal process for repossession of the property is not entirely clear in every state. Some state statutes (e.g., IL, TX & PA) clearly spell out the process, which is somewhat more involved than an eviction, but clearly less burdensome than a full–blown foreclosure. In most states, the process is not clearly defined, so courts deal with a buyer’s default on a case–by–case basis.
Also, a property sold with a land contract is already sold for tax purposes when the contract is entered into; thus, you cannot use a 1031 tax–deferred exchange on a property sold by contract for deed when the buyer pays off the debt balance. The entire balance paid on the contract will be due as a capital gain
Down Payment/Closing Assistance
There are a number of sub-options here, but they all boil down to the seller paying money in escrow to reduce the amount the buyer has to come up with to get into the home. This generally works best with conventional financing and can even be negotiated so as to maintain the same "net" to the seller. For example, the buyer may ask the seller to pay closing costs of up to $5,000. In exchange, the seller might agree only if the purchase price is raised to $105,000.
Similarly, rather than sell 5% below FMV to ensure a quick sale, the seller might agree to sell at full FMV and make a 5% donation to a qualified non-profit such as Neighborhood Gold who will in turn "gift" the 5% to the buyer allowing them to qualify for a 95% ltv FHA loan with no out of pocket down payment.
These techniques can even be combined, if necessary. Capital Gains are recognized on the net proceeds, so would not be due on any seller paid closing costs. However, gifts to non-profit down payment assistance companies are not tax deductible so Capital Gains would be due on that portion even though the seller would not actually receive the money.
Refer to broker for access to Private/Hard Money Lenders
Not necessarily "creative financing" per se, but can help close a deal. If your network includes a mortgage broker who works with owner occupants, they may be able to provide assistance for a sub-prime buyer, or one with limited income, etc. Tax consequences would be similar to conventional financing.
Refer to FHA and similar First Time Home Buyer programs
Similar to referrals to a broker. If you become aware of any such programs and can provide the information to your buyer, you may be able to help them obtain financing they might not find on their own. Depending on the program, tax consequences would be similar to conventional financing.
???
Did I miss your favorite technique? Reply and let me know. Remember, these are techniques to help SELL a home, not to purchase one. So techniques that open the seller up to excessive financial liability won't be included. But feel free to make your case as to why an investor might want to sell to a buyer with a wrap mortgage that leaves the investor liable on the underlaying note.