The Risks and Rewards of Owner Financing

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The Risks and Rewards of Owner Financing

For real estate investors, the current environment has hampered, and possibly severed, our ability to get bank financing for our next investment. As a first-time buyer, for example, perhaps your job security has become unpredictable. Or, as a more seasoned investor, you may have maxed out your borrowing capacity while taking advantage of major price drops during the last year to purchase cheap real estate.

The good news is that there is another avenue worth exploring (for both buyers and sellers) before throwing in the towel: owner financing. Also known as seller financing or seller carryback, this is where the owner acts as a bank and accepts installment payments over a shorter term, such as five to 10 years, usually with the expectation of a final balloon payment to complete the transaction at the end of the term. This allows the buyer some time to gain a better financial disposition so a bank can provide financing for the balloon payment, or it allows the buyer to set aside some savings to complete the transaction on their own.

There are three main types of agreements:

1. Contract for deed

The seller creates a note that outlines the amount borrowed and any other terms and conditions, including interest due and frequency of payments. The seller remains on the title until the debt is fully paid. In case of default, the seller keeps the property and the payments already made. Often, states will even allow eviction of the buyer from the home. Sellers benefit from this option (relative to a lease option, for example) because they can collect larger down payments and charge interest on monthly payments. However, they may take a tax hit once the buyer purchases the home because they have to pay transfer tax and can no longer claim depreciation or use their 1031x to defer capital gains.

2. Note and mortgage

This is the same arrangement as above; however, the buyer is put on the title with a deed in the beginning, upon signing the note and before completing all their payments. In the case of the buyer defaulting on payments, the seller must apply for a foreclosure to evict the buyer, which can be costly and time-consuming.

3. Lease option

Similar to leasing a car, the buyer and seller enter a lease agreement where the buyer has an option to buy out the asset at the end of the lease. Initially, the agreement is similar to a landlord-tenant agreement, and interest rates will be nil or minimal. Once the lease term is over, payments made toward the lease can be used toward the purchase price of the home. If the buyer chooses not to buy the home, they forfeit all their previous payments. With this arrangement, the seller has the option to claim depreciation and defer capital gains using the 1031x if the buyer doesn't purchase the home.

Whether seller financing is right for you as a buyer or seller will depend on a lot of factors — the main one being your respective state regulations. A real estate attorney can help you through the process. Buyers will need to undergo the underwriting process, outlined in the Dodd-Frank Act, which necessitates a licensed mortgage loan originator (LMLO) to create the loan.

In general, owner financing allows sellers the opportunity to gain passive income to then reinvest or simply enjoy as retirement income. Depending on the type of agreement, they may also qualify for tax breaks. Buyers may also qualify for tax advantages, depending on the agreement type. The biggest advantage for the buyer is receiving financing they wouldn't otherwise qualify for through a bank. This route will likely be more expensive for the buyer/investor, which is why it's crucial for the buyer to calculate long-term projections and ensure their investment will pay off — before they sign off.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

Ali Jamal CEO at Stablegold Hospitality, a real estate investment firm.