Robert Irwin
Robert Irwin, author of more than 35 books on real estate including Tips & Traps for Negotiating Real Estate. Based in Los Angeles, he has been a real estate broker and investor for more than 25 years.
Title to the home passes to the buyer when you close on the sale—you retain the right of foreclosure if the buyer defaults.
Perhaps you’ve found a buyer who is financially sound and eager to buy your home but who can’t get a mortgage from a bank because of problems with his/her credit resulting from his actions in the past. Or perhaps you have a buyer who can’t come up with a sufficient down payment to get a bank loan.
Seller financing can be the answer. But you must know the pros and cons…
When you finance the sale of your home, you get monthly income from the mortgage payments. You can lock into an income stream that runs for any period of time you set in the mortgage—typically three to 15 years for a seller-financed mortgage (you probably don’t want to wait 25 or 30 years—the way banks do—to recoup your money).
The interest that you charge on the mortgage can be higher than the going rate for a conventional mortgage—after all, the buyer needs your financing to swing the purchase. For instance, if the current 15-year fixed rate charged by banks is 6%, a seller offering a mortgage could charge 8% or 9%, a rate far higher than comparable rates on US Treasuries, certificates of deposit or other fixed-income investments today.
If the buyer sells the home before the end of the mortgage term, you are entitled to be paid in full.
When you sell your home, any outstanding mortgage you have must be paid in full (unless you have an “assumable” loan in which the buyer can take over your mortgage with the same loan terms). Thus typically a buyer will get both a “first” mortgage from an institutional lender, such as a bank, so you’ll get funds to pay off your loan, and a “second” mortgage from you, the seller. Of course, if you own your home free and clear, you can give the buyer a first mortgage for the entire amount of the financing.
Another factor to consider is your need for cash. If you plan to use the sale proceeds to buy another residence, then you probably aren’t in a financial position to offer seller financing—the down payment you receive from the buyer may not be sufficient if you want to buy a new home now.
If, however, you plan to rent your next home or move into a second home that you already own, then seller financing is a possibility.
The mortgage that you hold is secured by the home you sold—if the buyer defaults on the mortgage, you have the right to foreclose on it and recover your home.
As described above, the seller-financed mortgage can be the main loan or a second mortgage on the home—a way for the buyer to qualify for a conventional first mortgage. But, be aware that if you hold a second mortgage and the value of the house drops dramatically, on a foreclosure you may not recover everything owed to you.
While you hate to think the worst—that the buyer will fail to keep up payments on the mortgage—it’s prudent to know your recourse if this happens. You can take steps to foreclose on the mortgage. Contact a real estate attorney to proceed.
Good news: You will have your home back.
Bad news…
Key: Get enough cash up front in the down payment from the buyer to cover legal fees and potential repairs.
Tax-wise, you’ll have to figure your gain (or loss) on the repossession. Any loss is not deductible. How you figure and report gain, if any, depends on whether you resell the home within one year of the repossession. The rules are complex, so work with a tax adviser.
If you want to finance the sale of your home, get expert advice and assistance. Check out the buyer carefully. Have him obtain a copy of his credit report through one of the main credit reporting bureaus (it’s easier than trying to get a copy of the buyer’s report yourself). Look at the full credit report, which may reveal old credit problems. Also ask for current pay stubs and get job verification by calling the buyer’s employer (with his permission).
Hire an attorney to draft the mortgage and other documents and record them in the public records so that you are protected in case the buyer defaults. You want your attorney or accountant to also help you set the monthly payment amount that will reflect the interest you want to earn. Be sure that the mortgage contains specific terms for your protection, such as making the mortgage “non-assumable.” That way, if your buyer sells the home, the new buyer cannot take over the mortgage.
Holding the mortgage does not change the tax rules for reporting gain or loss on the sale of your home. If you have a loss, it is not deductible. All interest earned is taxable. If you’ve owned your home for a number of years, you may still be sitting on a sizable gain even though home values have dropped in this housing market. Up to $250,000 of gain ($500,000 on a joint tax return) can be excluded from tax as long as you have owned and used the home as your main residence for two of the five years before the date of sale. Your tax adviser can help you use the immediate exclusion even though you technically made an installment sale of your home.