Seller Financing, Popular In Late 70s and Early 80s, Is Poised For Comeback
The appeal for seller financing or owner carry mortgages is gaining popularity. Not because, as in the 70s and 80s, of double digit interest rates, but rather because of soaring home appreciation and the capital-gains rules.
An owner carry mortgage or “take back loan” is where the seller holds the mortgage for an agreed-upon interest rate and for a period of time.
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.
Today, less than 4% of the nation’s residential sales rely on the seller to finance the deal, as 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-sales 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.
Today, many people are discovering that if they and when they sell, 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.
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. The rest is considered interest income and taxed at ordinary rates.
In short, any time you do a carry back, you’re sheltering that principal amount from taxes until the year it’s paid. You therefore avoid some capital-gains tax by spreading it out.
The Option Appeals To People Who Own Their Home And Desire Steady Income
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. (And 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. A buyer, with seller financing, doesn’t have to wait for the loan, or have to spend money for the appraisals, the fees and the points, and escrow can close faster.
A buyer’s ability to refinance does pose potential problems for the seller, as all the gain that a seller plans to spread out or defer will accelerate when a property is refinanced. If the seller-held loan is paid off, the seller has to pay whatever capital gains taxes are owned.
What’s the way to avoid such a situation? A seller can build in pre-payment penalties in their contracts just like a bank would.
Certainly a seller is 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, sellers should obtain a buyer’s credit report. (Buyers 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.)
Sellers should ask for a minimum down payment of 20% to 30%, as a large down payment can identify strong buyers who will be less likely to walk away from the property.
It’s also wise for the seller to have their seller-financing contract serviced by an agency that specializes in loan administration. For a monthly fee, a servicing agency will manage a seller’s bookkeeping, tax records and late notices. One agency that administers such loans can be found at www.circlelending.com.
A home seller should always consult with a lawyer before committing to any seller-financed transaction.
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