Many people can afford a down payment and monthly mortgage payments but do not qualify for traditional home loans. Perhaps they had a recent problem that destroyed their credit rating but not their ability to pay bills on time. Often, massive medical bills, credit card problems, or business reversals push people into bankruptcy. They emerge with a clean slate but a terrible credit score. While they might still be able to borrow money somewhere, they will have to pay much higher interest rates on the money they borrow. Many such people are good credit risks. They have few choices in homes, because they must buy a home that offers seller financing. If you have such a home for sale, you will have little competition on the market.
There are two methods of selling a home and holding the financing. Both require the cooperation and approval of your lender. You probably borrowed money on a short-term basis to acquire the house and then flip it fairly quickly. Things are now different. You and your lender will need to agree on a longer term for your loan with regular monthly payments. Because almost all mortgages contain a due on sale clause, which makes the loan due in full if the property is sold, you will need your lender to agree to waive that clause.
The first financing method is a traditional sale, in which you give the buyer a deed and he or she takes the property subject to your lender’s first mortgage. The buyer also gives you a mortgage, which wraps around the first mortgage. The buyer makes payments to you, and then you make payments to your lender.
You need to know, however, that there are severe tax consequences if you do not structure this exactly type of financing exactly right. In a nutshell, if the buyer makes payments directly to your lender, or does anything to make sure their payments to you will result in payments to your lender, you could owe huge taxes but without the cash to pay them. This is because the IRS will take the position that you made all your profit in the year of the sale, even though your money will come in over several years. With normal seller financing, the seller splits each mortgage payment into two parts, a refund of his investment and a profit on his investment. Only the profit portion of each payment is taxable during that year. A seller who spends $120,000 to buy and fix up a house, and then sells it for $180,000 and holds the financing, might have only a few hundred dollars of taxable profit in the first year. A seller who does a wrap around mortgage, and who does not follow the IRS rules exactly, will have $60,000 of taxable profit in the first year. Please consult a tax professional for advice on how to avoid this consequence with proper planning.
The second popular method of seller financing for flippers is the contract for deed, also called a bond for title and sometimes a land sale contract. In this arrangement, the buyer does not receive a deed to the property until they have made all payments in full. It is a good arrangement for the seller, because if the buyer defaults, the seller can usually evict the buyer immediately. There is no lengthy foreclosure process, and even a last-minute bankruptcy will generally not save the purchaser and allow him or her to remain in the property. These are the same factors that make this very risky for buyers. As a result, usually only the most desperate buyers, or the most unsophisticated ones, will agree to such an arrangement. The process is strongly disfavored by many states and courts because of the high risk that a buyer might forfeit substantial equity as a result of a minor default. For that reason, some states have consumer protection laws that heavily regulate such relationships and provide safety nets for defaulting buyers. Call your state’s real estate department or consumer affairs office, and find out the law in your jurisdiction.