A little used investment opportunity is the Seller-financed home mortgage; however, it has earned the unfortunate reputation of being a tactic used only by the more desperate Sellers. The argument against Seller financing is logical enough – if the property is owned for the purpose of providing monthly income then why not simply rent the property? Although not for everyone, Seller financing to a home buyer can provide material benefits over owning a rental property and may also provide some protection of the income as well as provide security to the Seller and their potential heirs. (Refer to Disclaimer below.)
Often one of the more costly, as well as unpredictable, aspects of owning rental property is the maintenance of the property. Leaking plumbing, stopped up toilets and backed up drains, air conditioning and furnace repairs, leaking roof and broken appliances are the landlords’ responsibility. Even if a management company is used for these repairs and maintenance, the cost is still assessed to the landlord and comes out of rental revenue.
Strictly speaking the property that is supposed to generate income may not be reaching its full potential when the cost of maintenance is constantly siphoning from the revenue stream.
Seller financing can alter this picture substantially. The Seller, not a bank, holds the note to the property but is not the “owner” of the property, at least not strictly speaking in most states. The owner of the property, the one making the payments, is responsible for all maintenance and upkeep of the property. When the financing is done correctly a costly and inconvenient investment can be turned into an excellent source of passive income. (Be sure to check the real estate laws in your state as these vary and make sure that you have a qualified real estate attorney review the loan agreement.)
Every landlord knows that one of the most difficult parts of being a landlord is the tenants. If tenants damage or destroy the property, it not only directly affects the value of the property, but the ability to rent the property and continue to make money. Meanwhile, the landlord must pay for costly repairs and time off the rental market which could be weeks.
Every landlord must occasionally deal with a tenant who just could not or would not make their payments. Late payments result in the hassle of badgering the tenant, perhaps getting the payment late, or the absolute nightmare of filing an eviction notice and even taking tenants to court over back payments. Also, a slow rental market in the area can result in months of a rental property sitting vacant with no rental income leaving the property owner with a deep negative cash flow situation.
All of this is a recipe for diluting cash flow and causing a direct capital loss. As property investors, the idea is to make money, not bleed it out in attorney fees and the courts or holding the property waiting for a tenant.
Seller financing eliminates this potential quagmire of rental investments. As the note holder, if the borrower defaults on the loan, everything reverts to the Seller, and they retain all payments, including the initial down payment.
A Word of Warning! Although quite different than an eviction process, foreclosures are not free from legal expense and also costly both in terms of time and loss of the loan payment cash flow as once the foreclosure process begins the property owner will stop making payments unless trying to recover the property. Again, the foreclosure laws vary from state to state and should be investigated before committing to this opportunity. Mortgage states have a slightly more complicated process, but if you are lucky enough to live in a “Deed of Trust” state like Texas, North Carolina, California or Maine, the process can have a much quicker turnaround time.
Free from Market Fluctuations
The current housing market has limited the fluctuations typically seen in the rental market, in fact, the price of rentals appears to be continuing to escalate as the housing inventory for both sales and rentals continues to be decreasing. As a neighborhood becomes more desirable, the amount you can charge in rent goes up. If potential tenants begin flocking to another part of town, the rent must be reduced to entice the renters to return.
Payments in Seller financing are not subject to such instability, because of two factors. First, homeowners have more of a commitment to the property, they are purchasing it and so tend to remain in a property longer than tenants. Abandoning the property is seldom an option due to their investment in the property and the greater consequences of such action to them as an owner. Second, the terms of the loan agreement are not influenced by rental rates but by the location and condition of the home and residential property sales at the time of the sales contract. Because of this there is far less risk of owners simply abandoning the property for a more attractive offer as rental tenants often do.
The Seller financing a home has less concern over fluctuations in the property market because they already hold the note. If the buyer wishes to sell their property, it is their responsibility to find another buyer willing to pay enough to cover the full amount. Either way, the Seller is increasing their liquidity without the downside concerns whether they will have a tenant, that the rent will cover their cost of ownership or they don’t get hit with large expenses.
Be a Banker – Collect Passive Returns
If you choose to sell a rental property, and especially one that is still occupied, it would be cumbersome at best, to only sell part of the property or the entire property for only a certain amount of time.
However, this flexibility is quite easily accomplished with Seller-financed mortgage notes and without the need for a realtor to list and market the property because only the “paper,” or note, is being sold. These private “mortgage backed securities” are bought and sold on the market daily and a Seller holding such a note can sell their note, at a small discount, quite easily.
Notes can be sold, in part or in whole, depending on the quality of the loan agreement, the note purchaser and the homebuyer’s credit worthiness. What this simply means is that, depending on the quality of the paper, all or part of the note can be converted to cash. This creates an investment that is not only a long-term, monthly source of steady income, but a ready source of cash if the situation warrants.
Meanwhile, the value of the mortgage note continues to be an asset on the Seller’s net worth which can be leveraged for additional property or other collateral backed financing.
Reduced Taxes and Better Return
Possibly the most attractive attributes of seller financing is the ability to minimize the amount of taxes paid. Fewer taxes = more money in your pocket and in your portfolio.
Because of the way seller-financed mortgages are structured there is typically no capital gains tax until the principal of the loan starts being collected, which in a 30-year loan may allow capital gains to be deferred for many years. This assumes, of course, that you fall into certain categories under the Dodd-Frank legislation.
As the beneficiary, and not the property owner, the Seller also avoids both the burden of property tax, homeowner’s insurance, and fees to homeowner’s associations (HOAs), all of which are the responsibility of the property owner.
In addition, there is typically a much better Return on Investment (ROI) than with a rental agreement. For instance, one could certainly take all the earnings from a rental and put them away in high-interest savings or money market account at 0.26%.
On the other hand, a Seller-financed mortgage loan will involve a reasonable down payment on the property, likely 10% or more, as well as financing charges at a nominal 3% based on other private money mortgage rates. Not only is the mortgage note generating a solid monthly income at an interest rate several times higher than simply investing the rental earnings (minus maintenance and other costs) that might have been obtained by investing these proceeds in the bank as well as the 10%+ down payment that is the Seller’s from the closing of the sale of the property.
There is need for caution, of course, as there are other things to consider. For instance, if the property is not owned free and clear a re-selling of the property could trigger what is called a “due-on-sale” clause in many, but not all mortgage agreements, that could require the balance owed on the property to be paid in full or face foreclosure. While lenders are not required to do this, it does constitute a risk that must be considered.
As an investment property owner, deciding to convert a rental property into a Seller-financed mortgage note is a decision requiring careful consideration and the advice of seasoned legal and tax counsel. Seller financing offers the benefit of keeping cash in your pocket with the elimination of management companies, rental maintenance, homeowner’s association fees, higher rates for insurance on a nonowner-occupied property and the inevitable taxes without the benefit of a homestead exemption (in some areas) that come with property ownership. The lure of long-term passive income in the Seller-financed mortgage has arrived.
The information provided in this blog does not, and is not intended to, constitute legal or tax advice; instead, all information, content, and referenced materials are for general informational purposes only. Further, information in this blog may not constitute the most up-to-date legal or other information or be consistent with the laws in your state. Geni Manning and the Geni Manning Real Estate Group recommend seeking the advice of a legal and tax professional if the reader is interested in pursuing seller financing of their property.
Geni Manning and the Geni Manning Real Estate Group operate in strict conformance with the Texas Real Estate Commission (TREC) Rules & Regulations and the Texas Real Estate Licensing Act and do not provide legal or tax advice. Nothing in this blog should be construed as a recommendation to act without consulting a legal and/or tax professional in your state.
Contact Geni at 469-556-1185 or RealEstate@GeniManning.com for a No Obligation phone consultation!
Geni is a native Texan and has spent her life in the Dallas/Fort Worth Metroplex as a professional real estate agent. Her reputation is impeccable, and she has personal contacts across literally thousands of brokers and agents throughout the area. Geni and her Team know how to SELL, what works and what does not! She has a proven track record of selling homes faster and for a higher price than most agents, even in the very difficult markets! With Geni and her Team on your side you can be assured of the most professional and successful marketing strategy. Geni’s credentials include 100s of Five Star Reviews, knowledge, and decades of experience that have earned her the title of Master of Real Estate.
This article under Copyright © February 2021 by Geni Manning, Geni Manning Real Estate Group, Frisco Stars, Frisco, TX.