Seller Financing of Real Estate

Seller Financing of Real Estate

Ken DeLeon and Michael RepkaDecember 6, 2013
Palo Alto Daily Post


Historically, most buyers of real estate borrowed money from an institutional, governmental or individual lender to fund their purchase.  Although many buyers feel compelled to pay cash to make their offer competitive in this hot sellers’ market, many of these same buyers borrow against their home once the sale is complete.  Unfortunately, few real estate agents or clients consider the tax and economic benefits associated with seller financing.    

Home Mortgages Advantages

There are two key advantages to borrowing money against your primary residence:  (1) the rates are often very low when compared to other types of borrowing, and (2) you may be able to deduct the interest you pay on the first $1.1 million borrowed.

The rates for home mortgages are among the lowest in the banking industry because these loans are typically very secure.  If the borrower doesn’t pay, the bank has the ability to foreclose upon a generally appreciating and unmovable asset class.    

The other key advantage to most home mortgages is tax deductibility, which brings the “real” cost of borrowing down even lower.  If one were to assume a mortgage rate of three percent and a combined marginal California and federal tax rate of 51.3%, then the real cost of borrowing is less than 1.5% on the first $1,100,000 borrowed.  

Advantages to Seller Financing—Sellers’ Perspective

Higher Price— some buyers are willing to pay a higher sales price, but they are unable to get the necessary financing from a traditional source.  In the past, many of these buyers resorted to the “no documentation” loans that fueled the housing market around the turn of the century.  Since the mortgage meltdown, however, these loans have been difficult, if not impossible, to find from a bank.  If a seller is willing and able to hold a note with the home as security, then they may be able to get a higher price.     

Interest Rate—after many Silicon Valley sellers enjoy the experience of selling their greatly appreciated home, they are left with the dilemma of where to put the money.  Sure, they could put it in the bank, but few banks pay more than half of a percent in interest.  The stock market may seem better, but there can be much more risk. Some may consider bonds, but again, the returns often fall short of the seller’s expectations. 

Some seller’s may be attracted to the generally higher interest rates that buyers often pay on the seller financed portion of the mortgage payment.  These rates are generally higher than the prevailing mortgage rates offered by bank and much higher than the rates paid by other secure investments. 

Tax Deferral—the often over looked advantage to seller financing is the benefit of tax deferral.  Under the Instalment Sales Rules, taxpayers may be able to spread the recognition of the gain over the period of time that the money comes in.  For example, if the seller receives 50% of the sales proceeds in cash and the remaining 50% evenly over the next 5 years then they would pay half of the tax ratable over that time period.

The tax deferral may be of particular importance now due to the current structure of the capital gains tax.  There are income triggers associated with both the 3.8% “Obamacare” tax and the new 20% capital gains rate.  Similarly, the tax increase implemented as a result of California’s Prop. 30 impacts higher income tax brackets more significantly.  Thus, the deferral of part of the gain may also result in a lower effective tax rate because the taxpayer may stay below the income triggers.   

Advantages of Seller Financing—Buyers’ Perspective

The advantage to the buyer is clear, they may be able to afford a more expensive house than they could afford if they had to pay cash or borrow from a traditional lender.  While the cost of seller financing may be higher than more conventional methods of financing, some buyers anticipate the pace of real estate appreciation will offset this additional expense. 

Recently we have found that seller financing works well for buyers from overseas.  Often these buyers have sufficient cash to reduce the risk to the seller, but they lack the US credit or work history necessary to obtain traditional financing from most US banks.   

While there are significant benefits and opportunities associated with seller financing, this is not a good structure for buyers or real estate agents that lack sophistication.  The security of the arrangement should be of paramount importance and the seller must properly record their security instrument.  Also, the seller has to be able to differentiate between a strong buyer with a legitimate reason for being unable to secure traditional financing and a non-creditworthy buyer.  Whether a buyer or seller, you should speak with a qualified residential real estate attorney and your personal tax advisor before choosing the seller financing road.    

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