How to Turn Your Best Investment into an
Even Better One!
DOES ANY OF THIS SOUND FAMILIAR?
“I would sell my property, but I can’t because . . .”
- “I refuse to pay all those capital gains . . . and I don’t want to exchange into another property because I’m tired of managing property and dealing with tenants.”
- “I need the income . . . this is my retirement!”
- “I like my tenants and I would worry about them if I sold the property.”
- “I’ve got tenants/family members that don’t pay me enough, but I just don’t have the heart to raise their rent or kick them out.”
- “I want to give my children a good inheritance. I’m leaving the rental properties to them . . . we already have a trust set up.”
If you hear yourself in any of the above, keep reading. This guide will expand your understanding, and give you more options than you may have previously thought possible.
[Sign up for ‘Seller Financing on Steroids.‘ It will answer many of your questions, and there’s a whole section on Avoiding Capital Gains.]
Hi, I’m Dawn Rickabaugh, the Note Queen. Every day I talk to people who are excited when I introduce them to the concept of Seller Financing (also called Seller Take Back or Seller Carry Back Financing). They like what they hear on the phone, but they want more, something they can hold in their hands and study with family members, accountants and attorneys.
The concept is a simple one, but surprisingly, few people really understand Seller Financing. I’ve put this Special Report together to meet the educational demand for this information. I hope you find it to be of value, now and in the future. The material is meant to serve as an introduction only. There is always more to expand upon, so if you have any questions, please contact me personally. I often help people put their transactions together for maximum benefits.
Many people have wisely invested in real estate over the years to achieve their financial objectives. Acquiring income producing property is one of the best ways to create wealth.
However, at some point, many people tire of managing their properties. They are tired of dealing with tenants and the necessary repairs. Perhaps health problems are forcing them to slow down. They want smart, safe investments that are less management intensive so they can relax, travel, and enjoy life.
With Seller Financing, you can DO LESS and GET MORE, turning your best investment into an even better one. Seller Financing can turn real estate into a paper asset secured by real property. Structured properly, this is one of the safest, most coveted investments in the market today.
BUT I DON’T OWN INVESTMENT PROPERTY . . . SHOULD I STILL KEEP READING?
If you own nothing more than your own primary residence, this information can be extremely valuable when the time comes for you to sell. I’ll address this more in detail later on, but for now, LET’S GET STARTED!
WHAT EXACTLY IS SELLER FINANCING, ANYWAY?
Seller Financing is when a seller becomes the bank (the beneficiary) by acting as a lender to finance all or part of the sale of their own property. The seller is literally “carrying back,” or “carrying paper,” on the property being sold.
Instead of a buyer giving the seller a down payment and getting a loan from a bank for the balance, the buyer gives the seller the down payment AND the monthly payments. The seller receives payments according to the terms agreed to in a Promissory Note, which is secured by a Deed of Trust (in California) against the seller’s property until the note is paid off.
Seller Financing applies to all types of real estate: homes, land, mobile homes on land, apartment buildings, condos, office buildings, farms, commercial, industrial, and warehouse properties to name a few. Seller Financing is also frequently used in the sale of businesses and certain items considered personal property: cars, boats, airplanes, and mobile homes in parks.
WHY WOULD ANYONE CARRY BACK PAPER?
Many people, including professionals, (What You Don’t Know About Notes Can Cost You Listings, Sales and Closed Escrows!) mistakenly believe that only desperate sellers agree to carry paper and finance the sale of their own property. While it is true that some sellers (who would rather have all cash) carry the financing just to get their property sold in a timely manner, many sellers use Seller Financing intentionally to meet certain predetermined objectives.
It is estimated that there is somewhere around $94 billion is existing seller-financed real estate notes. Each year, there are approximately $2.8 billion in new seller-financed real estate notes created. It is my belief that if more people understood this technique, the numbers would be much higher.
Here are some of the benefits of Seller Financing:
- Defer capital gains
- Maximize the sales price by offering terms
- Keep your equity working for you, often at interest rates higher than a bank CD
- Get a good cash down payment now
- Collect hassle-free monthly income for years
- Your note is secured by a property you understand and whose value you know
- Sometimes you get more each month than you could collect in rent
- Never worry about dealing with tenants or maintaining the property
- Pay no more property taxes or insurance
- If the buyer stops paying, you keep everything and get the property back
- If you or your heirs ever need money, you can sell all or part of the note for cash
1. Defer capital gains
Let’s face it . . . federal capital gains will probably be going up. For this reason, more and more people are looking for ways to avoid paying them (which means revenues for our government will go down, not up . . . tsk, tsk, tsk . . . when will they ever learn?).
When someone in California sells a non-owner-occupied investment property, they will incur a 25% capital gains tax liability. For example, someone who makes a $400,000 profit on the sale of their rental may immediately owe the government $100,000 right off the top. This leaves them with only $300,000 to invest. That $100,000 is no longer available to work for them.
To get around this, many people use the 1031 exchange. They can defer capital gains indefinitely using this technique, moving from one type of investment property to another. But what about people who don’t want any more real estate to deal with? Is there a way for them to defer capital gains?
Seller Financing allows you to defer capital gains as well. You only pay capital gains on the amount of principal you collect each year. You will pay capital gains on the down payment you receive, and then on the amount of principal you receive in each subsequent year.
Keep in mind, however, that if you amortize your note over 30 years, you are initially receiving interest payments (which are taxed at regular rates). There is only a small amount of principal reduction, which means your capital gains liability is minimal for quite some time.
Another seller carry back strategy that allows you to defer capital gains is the Title Holding (Land) Trust. It also has the added benefit of eliminating foreclosure exposure.
2. Keep your equity working for you, often at interest rates higher than you could get with a bank CD or money market fund
Many people think that they need all cash when they sell a piece of property, but do they? Some do, some don’t. What most people need, more than a huge pile of cash, is income. If you had enough income on a regular basis, would you need a large chunk of change all at once?
Going back to the previous example . . .
You sell your property for $400,000, and you hand Uncle Sam his $100,000. What are you going to do with the $300,000 that you have left? Put it in a money market account?
Let’s see… as of this writing, you could put that $300,000 to work at about 3.4%. That works out to $850 of interest income per month.
What would happen if your decided to carry the financing instead of cash out at the close of escrow? Instead of $400,000 cash, what if you only took $40,000? Your tax liability would be $10,000 instead of $100,000.
That would leave you with a $360,000 note secured by a first deed of trust on your own property. You would have $360,000 working for you instead of $300,000. So what kind of rate can you expect to receive on your trust deed?
It all depends, but let’s take a really conservative approach and say that you are going to compete with prevailing mortgage rates (even though you can sometimes do much better). Let’s say you decided to carry at 6.25% amortized over 30 years. This gets you a monthly payment of $2,216.58! Sounds a lot better than $850, doesn’t it?
3. Get a good cash down payment now
Carrying the financing does not mean you can’t walk away with cash at the close of escrow. Many people don’t need all of their cash out, but they usually want enough to cover closing costs, and maybe a few thousand to buy a new car, pay off credit cards, or put a new roof on their primary residence.
How much cash should you take out? That’s a personal decision, and also depends on what you and the buyer agree to. Many different scenarios can make sense given the circumstances, but a good rule of thumb is to get a minimum of 10% down.
This gives you adequate protective equity should the note ever go into default. You have a cushion that covers you in the rare case that the payor quits paying and you have to spend time and money foreclosing on the property.
Getting at least 10% down also makes your note look very solid to an investor. This means that if you ever decide to sell your note for cash, you will take a smaller discount on the remaining balance of your note.
4. Collect hassle-free monthly income for years
There’s nothing easier than depositing a note payment. Collecting rent can be effortless, but you still have to deal with tenants, maintain the property, and pay property taxes and insurance from time to time.
If you are receiving payments on a note, all you do is cash the check! Or better yet, pay a note servicing company a small fee to collect it for you and have them send it straight into your account! If you collect the note payments yourself, keep track of the amount of each payment, and exactly when it was received.
Solid documentation of payment history will be important if you ever decide to sell your note. A potential note buyer will want to know if the payor makes his payments on time.
How many years should I get payments if I sell my property and carry the financing? Again, what do you and the buyer agree to? What are your objectives? It is common to amortize a real estate note over 30 years, but some people want a balloon payment in 5, 10, or 20 years (which can also increase the value of the note).
Going back to our previous example, here’s your note:
Note balance: $360,000
Interest rate: 6.25%
Term: 360 (30 years)
Monthly payment: $2,216.58
What if you didn’t want to wait 30 years to get all of your money? What if you only expected to live another 10 years, and after that, you wanted your children to have a lump sum of cash, instead of monthly note payments? What could you do?
Simply negotiate a balloon payment. You get your $40,000 cash down payment at closing, and $2,216.58 each month thereafter until you want to be paid off. Your balloon payment would be:
$336,014.23 in 5 years
$303,256.09 in 10 years
$197,416.28 in 20 years
Just keep in mind that you will have to pay capital gains on that balloon payment. You will also have a much higher capital gains liability than you expect if your note pays off early. Some people don’t mind being paid off early. For others, early payoff defeats the whole reason that they carried the financing to begin with.
What can you do?
Make sure your note contains the maximum prepayment penalty permitted by law. Make it financially unpalatable for the note payor to refinance and pay you off. In the event they need to sell, you can explore the opportunity of carrying for the new buyer.
In life there are few guarantees. Many people agree that it’s worth the risk even if they are only able to defer gains for a few years. If you sold for all cash the gains would be substantial, so there isn’t a lot to lose by giving it a shot, especially when offering Seller Financing can increase the price you can ultimately sell your property for.
5. Your note is secured by a property you understand and whose value you know
Because you have owned the property that is securing your note, you know what you’re getting into. You know its strengths and its weaknesses. If you had to take the property back, it’s unlikely that you would have any huge surprises. You would have a pretty good idea of its approximate market value at any given time. (Read: What Happens If the Buyer Quits Making the Payments?)
As I mentioned earlier, notes secured by residential real estate are very popular. Structured properly, they are considered a very safe investment. Besides, who do you trust? The stock market? Hedge fund managers? Investment bankers? Any bankers? The government? Al Capone?
Many people are real happy to be secured by real estate. The returns may not be as exciting as what the stock market can sometimes deliver, but to most people, a solid return in the real estate sector is better than losing money.
Personally, I consider collateral I can drive to, stand on or hold in my hand to be superior to promises of governmental agencies and corporate entities. I’d bet on real property, gold or silver before I’d bank on the promises of the FDIC.
6. Generally, you get more each month than you could collect in rent
Many sellers of residential property can get much more per month by selling their property and carrying the financing than they could possibly collect in rent.
I don’t know how it is where you live, but in my town, a $400,000 house (more like condo or townhouse) would probably rent for $1,500-$1,800, and out of that, I would have to pay taxes, insurance, and make a few repairs. Alternatively, if I carry the note, then I’m getting $2,216.58 per month, and I don’t have any of those expenses.
7. Never worry about dealing with tenants or maintaining the property
When you use the Seller Financing technique, you become the beneficiary, not the owner. Who calls Washington Mutual (Now J.P. Morgan Chase, see what I mean about banks?) when they have a leaky faucet? No one! As the note holder, you will never receive a phone call from tenants, or have to worry about replacing the roof.
The Title Holding (Land) Trust is also a great way to maximize monthly cash flow and greatly reduce or eliminate management issues, you because you have occupants with an ownership mentality. They’ll take much better care of the property.
8. Pay no more property taxes or insurance
That’s it . . . there are no more expenses related to the property. If you choose, (and I would recommend you do) you can pay someone to service your note but that shouldn’t cost more than a few dollars a month. The only other expense that you may have in setting up your transaction is completing a credit check on the buyer. And usually you can get the buyer to cover the cost.
You should have the prospective buyer fill out a credit application and run a credit report. You’re going to need their Social Security numbers! Keep them! Any note buyer down the road will need to pull credit on the Payors to know how much to pay for your note.
Depending on what type of report you request, it will cost anywhere from $10 to $35. Keep these documents (the application and report) in a safe place, right alongside your original note and deed of trust.
You need to know the credit history of the person or entity paying on the note. It is an important indicator of the financial responsibility of the buyer. It lets you know whether you have a high-risk or low-risk investment on your hands. Even a note that theoretically yields 18% isn’t worth much if you don’t receive the payments!
9. If the buyer stops paying, you keep everything and get the property back
The fear that the note could go into default, requiring foreclosure, is one that causes undue angst among prospective sellers. If you’ve structured the note properly, and given yourself adequate protective equity (i.e. you got a good down payment), you should almost hope the note goes into default so you can get the property back and sell it all over again for full market value!
The foreclosure process is not as intimidating as most people imagine it is. In California, you pay a trustee something like $7,500 to handle it for you. In 150 days the property is your again. You keep the original down payment, and all the payments made to date. The buyer who defaults on the note is out of luck.
Again, to avoid the potential of foreclosure, but get the benefits of owner financing, consider using the Title Holding (Land) Trust.
10. If you or your heirs ever need money, you can sell all or part of the note for cash
A properly structured note, resulting from a wisely constructed transaction, is highly marketable. Just like property can be sold for cash, a note secured by real estate can be sold also. The great thing about notes is that if you end up needing a lump sum of cash, you may not need to sell the entire asset to get it. You may only need to sell part of the note. Have you ever tried to sell just 1 bedroom of a 4 bedroom house?
Remember that $360,000 note you carried that is giving you $2,216.58 per month? Let’s say you’re happy with that for a couple of years then, all of a sudden, your car dies, or you have unexpected medical expenses, and you need $25,000 right now.
What can you do?
You can call and tell me that you’re considering a partial sale of your note. The exact numbers will vary depending on a few key factors, but it’s safe to say that you would only have to sell about 13 of those $2,216.58 payments to get $25,000 in your pocket today. At the end of those 13 months, the note payments revert back to you, and you are back track receiving $2,216.58 per month.
I can pay more for your note if I’ve helped set up the transaction from the beginning. Understandably, if I’ve been involved in underwriting the buyer from the start, then I feel like I have an investment that I’m comfortable with. Less risk equals smaller discount on the note.
Many people are concerned about leaving their children a good inheritance. Maybe they’ve promised to leave certain properties to each of their heirs, and have even set up a trust.
Owners who are worried about leaving a good inheritance behind often do not consider what a great asset a note is, especially one that is secured by a first deed of trust. It is just as easy to leave a note to heirs as it is to leave them a piece of real estate. Notes can be held in a trust just like property is.
In fact, a note can be a superior asset depending on the person doing the inheriting. Instead of inheriting something that needs to be managed, they simply inherit a hassle-free stream of monthly income. They can either accept the monthly payments for years into the future, or they can sell it, just like you can, for instant cash.
BUT WHAT ABOUT MY TENANTS?
Many property owners won’t sell because they are concerned about their tenants and don’t want to displace them. Sometimes family members live in the rental, often paying far below market rents. Even when owners are struggling financially, they are often reluctant to raise rents or kick these low-paying tenants out because of the emotional repercussions. These owners often feel trapped by the situation.
What can they do?
If you feel protective of your tenants, (you can’t bring yourself to raise rents or evict them), there is still a way to sell and get the benefits you’re looking for. Let’s have a chat.
I DON’T HAVE INCOME PROPERTY, AND YOU PROMISED THAT I WOULD GET SOMETHING OUT OF READING THIS . . .
Let’s say you’re ready to sell your primary residence. You don’t have the same capital gains concern (unless the value of your property greatly exceeds your home owner’s exemption). Is Seller Financing still something you should consider?
WITHOUT A DOUBT!
If you own your property free and clear, or have great underlying financing, you can use Seller Financing to sell your property quickly, for full price, regardless of market conditions. In these times, everyone should evaluate their options for carrying paper. There is no liquidity crisis for flexible sellers!
Advantages of using Seller Financing on your primary residence:
- Getting a top price by taking terms rather than all cash
- Deferring taxes on any gain by using an installment sale
- Receiving a higher interest rate than if you put the proceeds from a cash sale in the bank, a CD, or money market fund
- Monthly income secured by property you understand and whose value you know
- Much larger number of prospective buyers and a quicker sale because you offer seller financing. SELLER FINANCING or OWNER WILL CARRY are words you can add to your FOR SALE sign or classified advertisement. These words can easily double the amount of interest in your property, which means a quicker sale and a higher price for you. And because you’re the bank, you have an escrow that can actually close!
For high-end residential properties, home owners can still get slammed with capital gains. Some are getting around this by turning their primary residence into an investment for 12-18 months before selling. Then they get the best of both worlds: home owner’s exemption AND the ability to do a 1031 exchange with the rest of it.
The luxury property can be leased for a while to a renter, or ‘sold’ and put in a Title Holding (Land) Trust for maximum protection and cash flow. The beneficial interest in the trust can be exchanged into a ‘like kind’ property once the trust is terminated.
BUT WHAT IF I REALLY DO NEED ALL CASH AT CLOSING?
Seller Financing can still be a great tool, especially in a slow market. Even good buyers are having trouble getting a loan right now, so if you provide the financing, then you have removed yourself from many of the effects of the “credit crisis” in the economy at large. This will attract more buyers and close your deal quickly at the highest possible price for your property.
If you structure the deal well, you can turn around and sell your note immediately, a double escrow. The term for this is Table Funding, or Simultaneous Closing. Sometimes, you may need to receive one regular payment before you sell your note.
Back to our previous example . . . let’s say you sold your property for $400,000. You took a 10% down payment and amortized the note over 30 years with a 5 year balloon. Here’s how it works:
Sales Price: $400,000
Down Payment: $40,000
Note Amount: $360,000
Term: 360 (30 years)
Due In: 60 (5 years)
Interest Rate: 6.25%
Monthly Payment: $2,216.58
Balloon Amount: $336,014.23
An investor comes in at the close of the first escrow in which the house was sold, (sometimes the seller may need to collect one payment) and buys all the monthly payment for the next 60 months, plus half of the balloon payment:
TD Investor Gives Seller: $222,086.48
Buyer’s Down Payment: $40,000
Half of Balloon (in 60): $168,007.12
Closing costs: ($30,000)
TOTAL to Seller: $400,093.60
This example gives you a rough idea of how the numbers work out. Even selling the note immediately for a discount, the Seller still walks away with what he wanted.