Properly Structuring Seller Financing (Revised)

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By PETER ROSENTHAL, President
V.I.P. Trust Deed Company
2002

As I have often indicated many of these articles are triggered by day-to-day transactions that I come across. Often a borrower, seller, buyer, broker or “whoever” ends up with a deal that could have and should have been more properly structured in the first place.

Seller financing can often be a win, win, win deal for buyer, seller AND the broker arranging the sale. Seller financing can help induce a sale when the market is slow and can usually help a buyer with a spotty credit obtain a loan with no points, fees, or hassles. Seller financing is usually structured as an INSTALLMENT SALE with income tax benefits. Advertising “SELLER FINANCING” usually assists the broker in getting the property sold.

Let’s make it simple: an elderly seller owns income “free and clear” and will sell it for $400,000 with $80,000 down payment. The broker arranges a 10-year first at 7 1/2% for a buyer with FAIR CREDIT. Everybody is happy. Six months later one of the sellers grown children has a business failure, medical emergency or other financial hardship. The seller – parent – needs to raise cash, perhaps they need $150,000; there are two easy options: the parents can either sell the note at a discount or hypothecate (borrow) using the note and trust deed as collateral. The first option is probably the worse choice, as this couple was dependent on the income stream to live on. Now they have lost the income stream, have a tax burden because of the loss of installment sale and end up with the remaining cash that they will probably put into a certificate of deposit at a substantially lower interest. The second choice, HYPOTHECATION, makes more sense but also creates a taxable event. Always check with your CPA before selling or hypothecating a seller carry back.

A more sophisticated way to handle this transaction is to create the same seller carry back in the form of a first and second deeds of trust. The same $320,000 financing could have been broken into a $200,000 first and $120,000 second. In this case (with hind sight) the seller would sell or hypothecate the first and keep the second. In this manner they have maintained much of their income stream and suffered less of an income tax bite. Always think ahead to take care of unforeseen emergencies.

OK, you say, but the buyer will resist having a First and a Second, as it will hinder later borrowing. That’s true, but this article is written with the seller in mind. Let me give you a more typical example were this split financing comes into play. In many cases the buyer has 10 or 15% down, this is were split notes are very important. Let’s assume the same $400,000 sale price with a $360,000 first trust deed. In this case the discount (Percentage) would have been substantially higher because the loan to value ratio (LTV) was too high. I would recommend breaking the note into a $200,000 first and a $160,000 second or even a $280,000 first and a $80,000 second. Using this approach either first trust deed would be EASILY sold or hypothecated with the best terms as the carry back was broken into a one -very safe note trust deed and the other so-so. In a 5 or 10% down situation the buyer should be happy to obtain seller financing and the split note scenario should not be a problem.

Peter Rosenthal
VIP Trust Deed Company