The basics of owner financing
When you enter into an owner finance agreement, you do so directly with the person selling the property. As the buyer, you will make monthly installments with interest directly to the seller. The agreement will specify the monthly payment as well as the applicable interest rate.
Under traditional mortgage methods, you would agree to make monthly installments, but you would pay a financial institution like a bank or credit union, not the person selling the property . The financial institution would provide the funds to buy the property, and you would agree to pay the financial institution back over time. Owner financing, therefore, allows you to enter into an arrangement directly with the seller without having to go through a financial institution or other lender.
Legal stipulations within the state of Texas
When entering into an owner finance transaction, there are certain legal requirements under Texas law that must be complied with. The disclosure of certain charges and fees is required under recently passed legislation for any transfer made on or after January 1, 2014. Recent amendments to the DTPA make certain affirmative misrepresentations to a debtor in default a violation of the act. DTPA claims can be assert by a borrower against a lender or other entity seeking to take action on a defaulted note secured by real property.
In addition to the required disclosures, the Contract must legally bind the parties, and there are certain requirements under the TREC Contract requiring the buyer to do certain things to prevent arising over time. For example, the Contract requires the Buyer to obtain insurance and maintain the insurance during the entire term of the Contract. If for some reason the Buyer didn’t do this, the Seller has the right to obtain insurance and charge the Buyer back. Accordingly, the Seller should always verify Child Support Payments before executing the contract.
Pros of opting for an owner finance agreement
Owner financing can be beneficial to both buyers and sellers. With owner financing, not only do you have an easier process, you execute that process with lower costs and within a more flexible time frame.
For sellers, owner financing expands your pool of buyers. You can sell your house to someone who can demonstrate meaningful monthly payments – even if their credit is poor. You also get significantly more money for the home than if you had accepted a cash or conventional mortgage. Seller financing provides you with taxable income generated without the owner having to pay capital gains tax. The higher selling price provides you with more cash flow during your retirement years.
In Texas, closings are fast and inexpensive. Our closings usually take 45 minutes to an hour. This is significantly less than traditional mortgages. The seller benefits from the fact that they do not have to negotiate with banks for their buyer’s mortgage, which can sometimes take forever. Further, there are the added costs of closing a bank mortgage, including the mortgage insurance. There are no appraisal fees associated with the appraisal of the property. Gone are the title company fees for that appraisal. In Texas, appraisals are never mandatory for an owner-financed transaction. The buyer of the property hires their own counsel to prepare the closing documents, so there are no costly title company fees. The standard government-backed VA or FHA mortgages may have additional costs such as mortgage insurance – not with seller financing.
From the buyer’s perspective, they will pay lower closing expenses with owner financing. Examining the numbers, it is easy to see why so many buyers prefer a seller-financed home. Owner financing makes it possible for buyers to purchase a home in good condition that is desirable and affordable. Many of these buyers could never qualify for a conventional or FHA mortgage. It can certainly be a much faster process, too. When you consider the fact that many traditional loans take 45 days or more to close, with a seller-financed loan, closings can occur in about a week. It is quicker and undeniably easier for someone to qualify than it would ever be to obtain permanent financing for the property. Because the seller becomes the lender, you get terms that suit you and save money throughout the term of the contract.
Cons and drawbacks of owner financing
Like all real estate transactions, owner finance deals are not without their risks and challenges. For the lender (i.e., the seller), default by the buyer can be a significant headache. Even aside from requiring the lender to institute a foreclosure proceeding, default can mean years of lagging or underperforming investments. A foreclosure isn’t just a matter of getting the house back; the lender also has to get new tenants or re-sell the property.
For the borrower (i.e., the buyer), the risks and challenges are often financial in nature. Borrowers who don’t make their payments on time may owe late fees, suffer damage to their credit, pay more in insurance premiums, or face foreclosure.
One other oft-overlooked risk involves the condition of the property for sale. Seller-financing typically involves properties that are in less-than-conscious condition. If the buyer buys in "as-is" condition, he or she assumes the risk that the property suffers from any one of a variety of defects. Those defects could severely affect the value of the property.
One recent development that many in the real estate community have noticed is the increasing trend towards offering owner financing for the purchase of commercial real estate property. The benefits of such transactions are appealing to both buyers and sellers. However, the aforementioned risks and challenges are no less likely in commercial transactions than in residential ones.
How to draft an owner finance agreement from scratch
The following is a list of the general steps to be taken when one is preparing to draft an owner finance agreement. Many of these steps could be handled by a lawyer, and indeed, the entire process of drafting an owner finance agreement can and should be overseen by a real estate lawyer. However, it is also possible to do much of this without legal assistance. We suggest strongly that the various steps discussed below be completed with the help of a licensed real estate attorney.
Steps to Follow:
- Write or obtain an up-to-date Title Commitment.
- Obtain a survey of the property.
- Have a third party inspect the property (note: it may also be necessary for the buyer to assume the seller’s loan – Recording denied.)
- Create the various documents that will be needed.
- Review the various documents for completeness, accuracy, and potential traps for the unwary.
- Have documents reviewed by all necessary parties (a lawyer, a title company, the lender, if any , etc.).
- Prepare final copy of documents for signing and notarization.
- Close the transaction.
- Record the Deed of Trust (and any other documents necessitated by the transaction).
- Send a copy of the recorded documents to all parties involved.
Foreclosure of an Owelty Lien
As discussed above, an owner finance transaction creates a lien in the property by the buyer. As a matter of practical concern, this lien is usually granted in the Deed of Trust as a purchase money lien. However, when the buyer defaults on the loan, the seller has a few options. The seller can be even more creative and subdivide the property, creating a lien in the buyer on what is commonly known as an owelty lien, for a specific amount. In order to foreclose on an owelty lien, a notice must be provided according to a statutorily prescribed period. Then, a judicial or non-judicial foreclosure is conducted in very similar fashion to either a mortgage foreclosure or a home equity foreclosure. If the underlying property was encumbered by a mortgage, then, in Texas, foreclosure on the owelty lien cannot occur unless under a judgment of foreclosure against the original mortgage.
The role of taxes in owner finance agreements
There are tax implications for both parties to an owner finance agreement. The following is a brief summary of some of the issues that may arise.
Taxable Income
The lender seller will typically be required to recognize a taxable gain on the installment sale. The amount of gain would be the selling price, minus basis. If the loan is secured by real property, the gain would be taxed as long term capital gain. If the loan is secured by personal property, the gain would be taxed as ordinary income unless the note is secured by real property and the two year rule applies.
The borrower purchaser is generally permitted to deduct interest on the installment loan, but is not permitted to deduct points or other fees.
Foreclosure
The lender seller will recognize a taxable gain upon foreclosure of the owner finance loan. The lender may be entitled to a deduction for a loss if the loan amount exceeds the value of the foreclosed property.
The borrower purchaser is generally permitted to deduct interest on the unpaid installment note even if the loan is in foreclosure if the loan is secured by real property. However, if the loan is a short-term loan with a maturity of less than five years, the borrower purchaser may be prohibited from deducting the interest if the lender will not extend additional credit to the borrower.
Mortgage Interest Deductions
In many cases, the borrower purchaser may deduct interest payments on an owner finance loan if the property sold has not yet been acquired by the lender supplier as its primary residence. Thus, even though the borrower purchaser has purchased the property with financing from the seller, the borrower purchaser can often deduct the interest, and often, points paid in connection with the loan, as if the borrower purchaser were paying mortgage interest to a bank or savings and loan.
Avoidable blunders in owner finance agreements
Owner finance agreements can be legally complex and costly. The majority of the issues that arise are a result of failing to understand the intricacies of these agreements. That’s why it’s essential to avoid these common mistakes: Not Structuring the Terms Properly – Owner finance agreements can take on an array of different terms. It’s essential to structure these terms appropriately, and to do this, both parties need to be in agreement on the terms. Having an attorney create the owner finance agreement at the outset can help the Lone Star State buyer and seller avoid issues later on. From setting up repayment terms to deciding on what happens in the event of foreclosure, an attorney can help match the terms of your contract to the laws in the state so that both parties are protected. Not Obtaining a Legal Opinion – It’s important to have a deal secured and guaranteed in writing and with an attorney’s approval. This is particularly true for owner finance transactions. Without this, the buyer or seller could end up exposing themselves to potential losses or liability — a good attorney reduces this risk by protecting all parties involved. Using Insufficient Documentation – Be sure that you’re using as much documentation as possible about the property, including survey results, inspections, and title. In addition to protecting yourself legally, you’ll be able to rest easy knowing that you’re making a good investment. Also, be sure that any agreements you make with the buyers or sellers that go beyond the financial arrangement are documented in writing. Verbal agreements aren’t a good idea for any real estate transactions and should not be relied upon when it comes to obtaining legal protection. Ignoring the Property Fraud Warning Signs – Owner financing is a popular arrangement for many people because they can afford to buy a home much more quickly without having to satisfy the requirements of traditional lenders. However, prospective buyers should be cautious. There is a documented trend of fraudulent acts occurring more frequently in owner finance transactions than in traditional transactions. If you are the buyer or seller in an owner finance agreement, do your due diligence and thoroughly screen the buyer/seller to avoid a transaction that could result in fraudulent acts and lead to potential litigation. Closing Without an Attorney – When it comes to owner finance deals, an attorney is invaluable. They will help explain the process to both parties, draft the appropriate documents, submit all papers to the appropriate parties, and make sure that the transaction actually closes. It’s even better if both the buyer and seller have representation in the transaction, as this protects both parties. Insisting on Buying/Selling Properties With Legal Issues – There are a few ways that you, as a buyer, can run afoul of Texas law and open yourself up for expensive litigation. One issue involves the purchase of property that has a legal issue that both the buyer and seller are aware of. In this case, the seller will not be obligated to disclose the issue to a third party, like a title company or attorney. However, the seller will be required to abide by their written agreement with the buyer. That’s why it’s crucial that the buyer and seller discuss the particulars of the property with their attorneys before moving forward with the sale.
The importance of consultation
A vital step in the owner finance process is to enlist the help of an attorney and/or accountant to sort through the many pitfalls associated with lending money. You will need legal assistance for writing the note and deed of trust, and for documenting any assignments of the note. These things are not always simple, and you could end up losing a lot of money if you do them incorrectly or incorrectly follow the legal procedures to sell your note. You should consult both an attorney and an accountant before determining the interest rate on the deal as usury laws apply in Texas.
In addition , the deed of trust and other security agreements should be carefully drafted to ensure your personal rights and interests are protected. Adequate protection may include restrictions on the owners ability to encumber the property or sell the property without prior approval, or provisions that require the owner to maintain insurance on the property and to provide the lender with evidence of insurance. The lender should also require access to the property and the right to inspect the property to make sure it is being kept up to the lenders standards. Drafting penalties and default interest rates into the contract can also protect you regarding a default. We encourage you to work with a Texas attorney who has experience in handling these types of transactions.