Seller financing, once used to attract buyers forced out of the market by high interest rates on conventional loans, may be making a comeback thanks to California’s handsomely appreciated market and the ceiling on tax-free home-sale profits.
“Owner-carry loans” or “take-back loans” -- in which the seller holds the mortgage for an agreed-upon interest rate and period of time -- gained popularity in the late 1970s and early 1980s when rates were in the double digits.
In 1981, when the average national 30-year fixed-rate mortgage reached a historical high of 18.63%, about 40% of all home sales utilized seller financing, according to the National Assn. of Realtors.
Nowadays, less than 4% of the nation’s residential sales rely on the seller to finance the deal, according to the Realtors group. Low interest rates allow most buyers to qualify for institutional loans. But there is renewed appeal, brought on by soaring real estate appreciation and an Internal Revenue Service rule that limits tax-free home-sale profits to $250,000 for an individual or $500,000 per couple filing joint returns. Anything beyond that is subject to up to 15% in federal taxes.
As prices in Southern California have run up in the last few years, many people who want to sell homes -- even modest ones -- are discovering that if they do, they will exceed the tax-free capital-gains ceiling. One way to avoid a large capital-gains tax bill is to hold the mortgage for the person buying the house. In a seller-financed mortgage, consumers who sell a rental property or a home that is owned free and clear do not have to report their gain all in one year, says Jeffrey O. Goodfriend, a CPA at Fullerton Business Service.
With seller financing, the seller can spread out the capital-gains tax over the number of years agreed upon in the contract. By spreading it out, the seller can avoid being placed in a higher tax bracket. For sellers who don’t own their homes outright or won’t be able to pay off their existing loans in such a transaction, carrying a second mortgage is a less attractive option. They run the risk of losing their investment if the borrower defaults.
With seller financing, the principal that a seller receives each year is considered capital-gain income and is taxed at a lower rate, Goodfriend said. The rest is considered interest income and taxed at ordinary rates.
John Ratzlaff, of Coldwell Banker Ambassador Realty, views seller financing as an excellent way to shelter profits while putting the seller’s money to smart use.
“Any time you do a carry back, you’re sheltering that principal amount from taxes until the year it’s paid,” Ratzlaff said. “You avoid some capital-gains tax by spreading it out.”
It’s an option most likely to appeal to retirees or people who have paid off their mortgages and want to receive steady income. If the current mortgage rate is 6.5%, the sellers could carry back at 6% -- better than what they could earn at a bank. According to Ratzlaff, if the buyer defaults, the seller can foreclose and keep the down payment if he or she is holding the first mortgage.
There are benefits to both sides. “With seller financing, a buyer doesn’t have to wait for the loan. The buyer doesn’t have to spend money for the appraisals, the fees and the points,” said Dann Ratanjee, a private real estate investor who has been using seller financing to buy and sell property since 1979. “Escrow can close faster.”
Four months ago, Ratanjee had a difficult time selling a property in Victorville. When he offered to carry the mortgage, it drew several potential buyers. After some negotiations, the buyer agreed to put down 50% of the principal while Ratanjee carried the remaining 50% at a below-market rate. “I got my full asking price and closed escrow in 15 days,” he said.
Although Irvine resident and radio-show producer Benson D. Evans has qualified for a $600,000 mortgage, he wants to buy a seller-financed home. “I want to find someone who will sell their property and hold the paper for one or two years,” he said. “I just want to get in. I don’t want to be bothered with mortgage points, and at the appropriate time, I would refinance.”
A buyer’s ability to refinance does pose potential problems for the seller. All the gain that a seller plans to spread out or defer accelerates when a property is refinanced, Goodfriend says. If the seller-held loan is paid off, the seller has to pay whatever capital gains taxes are owed.
How to avoid it? “Sellers can build in pre-payment penalties in their contracts just like a bank would,” Goodfriend said.
It’s also wise to check a buyer’s credit-worthiness. Ask the prospective buyer to complete the Uniform Residential Loan Application, also known as Form 1003, which can be obtained through a mortgage lender or broker. From this form, sellers can learn the buyer’s educational and housing history, employment information, monthly income and housing expense projections, as well as the buyer’s assets and liabilities. To verify the information, a seller can request the buyer provide federal returns and W-2s for the last two years, most recent statements for all outstanding loans, and award letters and copies of the most recent checks from a buyer’s pension, Social Security or disability income.
In addition, experts urge sellers to obtain a buyer’s credit report. Consumers can check their local yellow pages under Credit Reporting Agencies for such providers or contact larger consumer credit reporting agencies such as Experian, TransUnion and Equifax.
Experts advise sellers to ask for a minimum down payment of 20% to 30%. A large down payment can identify strong buyers, as they would be less likely to walk away.
Experts also suggest having the seller-financing contract serviced by an agency such as Circle Lending, a specialty loan administration company based in Massachusetts that aids in such transactions. Its website is at www.circlelending.com. For a monthly fee, a servicing agency can manage a seller’s bookkeeping, tax records and late notices.
Real estate and mortgage experts urge home sellers to consult a lawyer before committing to any seller-financed transaction.