With interest rates soaring, conventional forms of financing have made the purchase of many properties unattainable for a large sector of buyers. Many consumers assume high interest rates will push down the value of real estate, but so far supply and demand has kept this from happening in the Montana market. As a result, it has become common for buyers to look at alternative ways to structure a purchase. It’s always important for a buyer and seller to consult with their accountant and attorney prior to entering into any purchase agreement involving a purchase over time, but there are a few options to consider if looking to avoid the interest rates currently imposed by the traditional financing market. Here we will explore a few of those options.
Contract for Deed: In the case of a purchase structured with a Contract for Deed, the Deed to the property remains in the seller’s name until the balance owed is paid in full. An attorney writes the contract document, stipulating the terms of the agreement; notably the purchase price, the amount the buyer is to pay upfront as a downpayment, the interest rate at which the seller will “carry” the remaining balance and the length of time the buyer has to complete payments. An “Escrow Account” is set up, typically at a bank, but a title company may also serve this role. This allows a 3rd party to record payments, avoiding discrepancies. Upon “Closing”, which is conducted by a title company or attorney as it would be in any other property sale, the buyer pays the seller the down payment amount agreed upon in the contract. The Contract documents are signed at this time, as well as the property deed, which is not recorded but instead held by the bank in the escrow account and recorded only when the balance owed the seller is paid in full. In order to provide public notice of the contract (to protect the buyer against the property being “sold” again) a Notice of Purchaser’s Interest is recorded at the courthouse. A few things to remember when utilizing a Contract for Deed; oftentimes a generous seller will offer to carry the contract at a rate of 0% interest. This is not allowable by the IRS and will be considered debt reduction and penalized if either party is audited. The interest in a seller financing contract must be at least the Applicable Federal Rate at the time the contract is signed. This is stipulated each month by the IRS and can be found within this link. Applicable Federal Rates for 2023 | Evans Estate Law Resources (evans-legal.com) As of September 2023, the Applicable Federal Rate is 4.19%, much less than the current mortgage prime rate of 8.5%.
Trust Indenture: A Trust Indenture is often utilized as a means of financing properties consisting of under 40 acres. In this case, the property again “closes” as in a traditional sale with a title company or attorney. A Trust Indenture is written by an attorney stipulating the terms of the seller financing agreement (purchase price, downpayment, amount financed, interest rate, length of contract, etc.) as well as a Promissory Note, which is the buyer’s “promise” to repay. Public notice is established by the recording of a Warranty Deed, transferring title of the property from the seller to the buyer. In addition, an Abstract of Trust Indenture is recorded to create a record of the “mortgage” owed to the seller. As in the case of a Contract for Deed, an escrow account is established at a bank or title company to keep record of payments. A Request for Reconveyance is singed by the seller and held within the escrow account to be recorded releasing the mortgage when the balance has been paid in full. A Quit Claim Deed is also recorded and held in the Escrow Account, allowing for the property to be deeded back to the seller should the buyer fail to make payments as agreed, defaulting on the loan. Again, with a Trust Indenture as with a Contract for Deed, interest must be charged at the Applicable Federal Rate.
Lease with an Option to Purchase: A Lease with an Option to Purchase is not considered a sale but can be utilized to pay for a property over time, with a few differences from the Contract for Deed and Trust Indenture. This route is preferred at times by sellers who wish to utilize a 1031 Exchange or by buyers who are on the fence about whether they want to purchase the property. In this case, a Lease is drafted for the property as well as a buy sell agreement stipulating an eventual purchase price. It is common for some part of the lease payment to be applied to the purchase price. There is often “Option Money” which is paid at the onset of the lease as compensation to the seller for taking the property off the market and waiting to receive payment in full. Option Money can be negotiated between buyer and seller and can be applied to the purchase price in whole or in part, or not at all, and can be fully refundable, partially refundable, or entirely non-refundable. An Option to Purchase document is recorded at the courthouse to give public notice of the buyers “Option” protecting the buyer from the seller selling the property to another as long as the buyer’s Option to Purchase is in place. There is typically a time frame stipulated for the lease and a date by which the buyer must exercise their Option. At that time the buyer must purchase the property according to the previously agreed upon terms or the Option is released, and the lease is terminated. An escrow account is typically not utilized with a Lease/Option and the buyer and seller are expected to maintain records of payments made and amounts deducted from the purchase price for the duration of the lease.
A seller may benefit from any of these agreements if they are selling an investment property but should always consult with their accountant prior to entering into an agreement to sell. In the case of a Contract for Deed or Trust Indenture, a 1031 Exchange is only allowable for the funds received as a downpayment, while the remainder of the payments are considered ordinary income and taxed as such. It is possible to utilize the entirety of the funds as a 1031 Exchange if the party from whom the seller is purchasing is willing to accept the contract as payment, but again, the seller’s attorney and accountant should be involved in any decision, as each person’s financial structure and position is entirely different. The Lease with an Option may be preferred by a seller because while the lease payments are considered ordinary income, the large lump sum paid if/when the buyer chooses to exercise their option to purchase can be utilized in a 1031 Exchange. Throughout the Lease with Option the buyer can write off lease payments entirely while also, often times, chipping away at the eventual purchase price. In the case of a Contract for Deed or Trust Indenture, similarly to a bank mortgage, only the interest portion of the payment may be categorized as an expense to be written off. In addition, the Contract for Deed or Trust Indenture can only be utilized if the property is lien free, or as long as the downpayment is sufficient to pay any liens in full. In a Lease/Option scenario, debt may remain on the property with the intention of the debt being maintained by the seller for the duration of the contract and with the understanding that debt will be paid in full if/when the property is eventually purchased. In any case, it is important for a buyer/seller to obtain a Preliminary Title Commitment from a Title Company prior to entering into any agreement to determine if any liens or encumbrances are attached the property.
While the term “Seller Financing” is often used interchangeably, the options for Seller Financing are very different and have differing results for both buyers and sellers. If considering any of the above 3 options, as either a buyer or a seller, it is important to look further into the details of each and how they affect your individual situation before agreeing to any type of Seller Financing contract. With the proper preparation I have seen each of the 3 options result in successful sales with long-term benefits for both buyer and seller. If you would like to discuss any of the above options for buying or selling feel free to reach out, I’m happy to go through the details in person as they apply to your specific situation to give you an idea of whether Seller Financing is right for you. I can be reached any time at 406-390-6746 or by e-mail at Carly@NorthWestRealtyMT.com