Is It S.A.F.E. To Seller-Finance Property?

By: Jeff Shiller, Esq.

What are the advantages and disadvantages of seller-financing a property?  If you’re thinking of doing this, make sure you consider several “categories” of issues: 1) tax implications; 2) legal implications; and 3) practical implications.  Let’s review them briefly.

Definition:  The IRS views a seller-financed deal as an “installment sale,” which is simply a sale in which the seller receives at least one payment after the year of sale.  Various state statutes have additional requirements for a sale to become an installment sale but, for these purposes, let’s just use the IRS definition.

Legal Implications:

• Compliance with S.A.F.E. Act – this is a new thorn in the side of investors.  This federal act was passed last year and requires any seller of property that seller-finances more than one property every few years be a licensed mortgage originator.  Ridiculous? Yes. Avoidable? No.  There are some “workarounds” for this, but that’s a different blog for a different day.
• Compliance with T.I.L.A. – to comply with the Truth-in-Lending Act you will have to, among other things, 1) properly disclose APR (Annual Percentage Rate) of the loan, 2) not make a predatory loan; and 3) make a reasonable determination of buyer’s ability to repay the loan.
• Compliance with State Law – different states regulate installment sales differently.  For instance, there may be special language required in the contract, or a requirement that the contract be recorded at the County Land Records.
• Documentation – To ensure compliance with increasingly complicated laws, and to properly memorialize the terms of your deal, get a local attorney to prepare the conveyance/loan documentation.  This will include a Note, Mortgage, TILA disclosures, and other items necessary to comply with Federal or State law.
• Foreclosure – Unlike a lease/option, the only way to get your property back in the event of default in an installment sale may be a foreclosure.  Not impossible or overly expensive, but definitely a headache.

Tax Implications:

• Calculating Tax on Payments – If you elect the installment method, you will have to properly track which part of the buyer’s monthly payment is: 1) interest; 2) return of principal or basis in the property; and 3) net gain.  This is important because each category is taxed differently.
• Recapture of Depreciation – Many investors forget that even if you receive payments over many years after sale, if you used the property as rental property subject to depreciation, you must recapture any depreciation in the year of sale.  That rate currently stands at 25%.  Ouch.
• Dealers prohibited – If you are classified as a “dealer” under IRS guidelines, you will not be able to use the installment sale method on your taxes.  You can still owner finance, but you will be reporting all income in the year of sale, so make sure you properly prepare for paying those taxes or offsetting the gain with another permissible loss.
• Note Structure – This is critical if you want to properly plan the deferral of gains.  As an example, if you structured a fully amortizing 15 year note, you’d have capital gains every year.  However, if you created a 15 year interest only balloon note, you’d only have ordinary income until the year of balloon payoff.

Practical Implications:

• Need for Liquidity – Can you afford to have your money tied up in a property for years?  Many people claim to buy private notes but, if commercial liquidity is absent, you may be stuck, so make sure you properly plan your cash needs.
• Prepayment – What if you structure a long term cash flow note and the buyer pays off early.  BAM! POW!  A tax hit right in the eye.  Consider prepay penalties in your note to discourage this.
• Default & Litigation – Nobody likes to deal with crap that goes bad.  What if the buyer defaults or lets the property waste away and you are forced to foreclose?  You will likely have to deal with costs, attorney fees, bankruptcy, and maybe even getting personally sued.  Needless to say, make sure your buyer is well-qualified and you have properly “papered” the deal to avoid huge headaches later on.
• Monitoring The Property – Even if you sell the property, you will still have to periodically check on things like the condition of property and the status of taxes and insurance.  Remember that you must be named as an additional insured on the hazard policy to protect your financial interests!

I hope these tips help.  Til’ next Time, J