The reason you first got into real estate investing was to own property. Buy and hold. Let the tenant pay the mortgage. A strategy that is a solid, conservative, time-tested approach. As time has passed, maybe your objectives have changed. Maybe holding real estate assets no longer fits your goals or lifestyle. Your properties are leased. Selling with a tenant seems challenging. Why not consider selling TO your tenant? Not a lease-option. Sell that investment property your tenant calls “home” to the tenant.
A different investment option is selling with a land contract to your great tenants. Land contract is a frequently used option that allows an owner to sell their property while earning a nice return by creating a paper investment. Some people call land contracts “owner/seller financing.” In some states this type of transaction is called a Contract for Deed (CFD). The IRS refers to these transactions as installment sales.
This post will provide some of the basics of land contracts. We will also discuss the risks associated with land contracts and of course the potential rewards. When discussing such a technical topic, I want to reinforce I am not an attorney or accountant. As a licensed real estate broker and interested investor, I am sharing my understanding and experience. I always will recommend investors put together a team with other professionals who can assist them in reviewing all opportunities from a holistic perspective. I am presenting land contracts as I believe they are an overlooked opportunity and solution for many investors.
There are many great reasons to consider selling your property on a land contract. Like any investment, there are also risks. Lets start with the simple premise that selling on land contract is an exchange of investments. You are trading your real estate asset for a paper asset (a note). In that difference lies the pros and cons of this investment as you consider it for your portfolio.
LAND CONTRACT PROCESS
A land contract is a sale of the real estate to a third-party and the owner of the real estate becomes the lender or mortgagor. A contract sale document is prepared when the decision is made to sell and the terms have been finalized. With a land contract, the buyer gets a contract from the seller stating conditions that must be fulfilled for the buyer to get the deed. The seller retains the deed. The buyer makes payments on the contract. Once the contract is fulfilled, the seller hands over the deed. Pretty similar to the process of buying a car with a loan. The lender holds the title until the loan is paid off. The buyer has possession of the car, but not the title.
As the potential lender in this transaction, the owner gets to control the terms. This is a big advantage as you can insist on terms that work for you such as length of the contract, interest rates, payments. You also can complete background screening to determine if anything might show up about your borrower that causes you to decide not to enter this transaction.
Investment
The seller now holds a note that provides a cash flow stream. The only expenses the seller might incur with that note is in the event of a collection or default. The seller is the bank and will collect monthly payments of principal and interest. Depending on the terms negotiated, the seller will also receive some cash as a down payment at closing.
Very few land contracts are significantly long-term in length (in excess of five years). The objective is for the mortgagee (buyer) to develop credit and the ability to qualify for a conventional, less expensive mortgage. As an investor, you have a balloon payment that is to be expected on the back-end. The seller may also consider offering an extension in the contract so if the buyer is unable to refinance at the given time, slightly different terms go into effect (for example a higher interest rate) with an extension of the term.
Tenant Opportunity
If the home you wish to sell is occupied with a great tenant, this might be a solution for achieving everyone’s long-term goals. If you, as owner, really would like to sell the home, and the tenant would love to become a homeowner, consider a land contract arrangement. This process is much faster and easier than waiting for a tenant to go through all the hoops of purchasing using traditional mortgage financing.
My experience is that if a tenant can qualify for a conventional mortgage they will do so and purchase the home outright. You must accept that you are taking on a risk that the buyer is not creditworthy (as defined by traditional mortgage lenders). There are many steps to determine if this is a risk to accept but remember you have a huge advantage. A contract sale to a tenant should be a tenant that you have experienced a year or more of timely rent payments. These are people who have shown responsibility and a priority to their housing obligations.
BASIC COMPONENTS OF A LAND CONTRACT
So, you are working with a buyer and the land contract option seems appropriate. The following are the basic components that will need to be determined and negotiated if needed. Note: references are made to the “seller” who is no-longer called “owner”. After a land contract is executed, the Buyer becomes the “owner”. These legalities are also reviewed below.
Purchase Price
The selling price of the property. Due to the fact the seller is providing the financing, the purchase price received is often higher than prices for homes being sold via traditional methods receive.
Down Payment
The non-refundable amount the buyer must bring to closing. Totally negotiable but ideally a seller will try to obtain 10-20% of the purchase price. As a landlord, you could assist your tenant in saving for this amount with some terms built into the existing lease.
Interest Rate
The rate the buyer must pay on their principle amount which is stated in annual terms. Interest rates are typically at a premium and above market. Remember, you do not want this to be a comfortable arrangement for the buyer. As soon as the buyer can qualify for less expensive financing you want them to be motivated to obtain it.
Monthly Payment
The combined total of the principle plus interest payment, property tax payment, and homeowner insurance payment. We recommend the seller services the property tax and insurance payments to ensure they are paid.
Balloon Period
The period in which the land contract expires and the entire principle becomes due. This period usually lasts from 3-5 years but is negotiable.
Property Taxes and Insurance
The recommended approach is for the seller to receive these payments and escrow them to pay as they come due. As for the property taxes, the seller still holds the deed so the bills will still come to the seller. The buyer needs to also place the deed holder/seller on their homeowners insurance as “Additional Insured” to protect the sellers interests. It is recommended that you place in the contract the amount the property must be insured for (land and structures). If the property is mortgaged, the seller should discuss with their agent retaining their existing homeowners policy. This may or may not be possible. Since the seller has legal title it should be possible with the policy changing to a non-occupant owner coverage. This also provides some assurance that the mortgage company recognizes their borrowers name on the homeowners insurance where the mortgagee is named as an additional insured.
Legal Components
The land contract contains two legal components: legal and equitable title.
- Legal Title– what the seller retains until the terms of the land contract are satisfied. The fact that the seller continues to hold the deed is a distinguishing fact between a land contract and traditional mortgage financing from a bank. The deed does not transfer until all the terms of the land contract are satisfied.
- Equitable Title– what the buyer is given at closing. Equitable title means the buyer is considered the owner of the property and must pay property taxes and perform all duties required under the land contract (such as providing insurance and maintaining the property’s value).
Risks
This type of transaction is an investment. It is trading one asset for another. The seller is not eliminating risk. Lets review the risks in entering a land contract transaction.
Land contracts, like any investment, are not without risk. Land contracts are an alternative to actually owning the property. Yet, the risk exists you could still end up owning the property again. To make a decision to sell on contract, it is important to know and understand the risks.
Foreclosure
As a holder of a contract note you are still connected to the property. If there is a default, the process to recovery is more expensive and potentially time-consuming. It is called foreclosure. My experience has been that a mortgagee who can’t make their payments to contract holders have a more established, personal relationship with the parties associated with the note. Many times, arrangements can be made for a simple termination of the contract, agreed to by all parties, and a return of the property to the original owner. Not ideal but better than waiting out foreclosure. Then again, desperate people sometimes take desperate actions. So, the risk exists that removing the buyer could be an unpleasant experience.
Due On Sale
One risk that the seller needs to determine if they wish to mitigate or accept occurs if the property you want to sell is mortgaged. In all likelihood, your mortgage contains what is called a “Due On Sale Clause.” This allows the mortgagee to call the mortgage note due in the event of a sale.
In my experience, you will need to default on payments for the mortgage company to trigger this clause..but that is MY experience. I suppose there are a lot of other reasons the mortgagee might decide they need to trigger the clause. The risk is on you, the mortgagor.
You can ask permission to enter into a land contract from your mortgage company, or you can take your chances. I have not heard from anyone who has ever requested a written statement from their lender voiding a portion of the Due on Sale clause and not call their mortgage balance due if the mortgagee enters into a land contract.
Taxes and Insurance
The owner also needs to be prepared to monitor that insurance and property taxes continue to be paid on the property. You could end up needing to pay these expenses while you wait for a foreclosure to occur or to get the buyer to move out.
Recording
You will want your interest publicly known. For the closing use a title company and make sure all documents are recorded. I see a lot of land contract transactions where this step is ignored to save costs. I would suggest that you are adding to your risk if you go that route with your closing.
Political
One final risk is a political risk. As an investor, you will enjoy tax advantages selling on a land contract. Capital gains taxes typically due in a conventional sale will be spread out over the length of the contract. If taxation policy changes and rates on capital gains increase, it could end up costing more in taxes that a conventional sale. Of course, political risks are a part of every investing decision.
In conclusion, we have provided enough information to allow you to consider if a land contract is for you. WILMOTH Group can answer additional questions and also help to structure one of these transactions. Just let us know if you want to change your current investment to a land contract note.
