Buyers Are Getting Home Loans From an Unlikely Source: The Seller of Their House
Home sellers: Have you considered financing a buyer’s purchase of your home by taking back a mortgage? You’ll be in a tiny club, and there are good reasons it is so small. According to an analysis by Realtor.com, as of May 2023, just 1.04% of all U.S. active listings mentioned some type of private financing, down from 1.08% in February and March, which was the highest that figure has been in three years. (News Corp, owner of The Wall Street Journal, also operates Realtor.com.)
According to Hillery Dorner, a real-estate attorney with Dorner Law & Title Services in Concord, Mass., seller financing arises most commonly in sales of investment properties. But real-estate professionals are reporting that they are increasingly seeing an interest in seller financing for transactions involving residential properties due to the rise in interest rates. “The use of seller financing has become strategic in recent months given our current state of the finance markets,” said Daniel Hershkowitz, senior director of risk management for The Agency, a brokerage in San Francisco.
Hershkowitz said that seller financing most often occurs when buyers seek to increase their purchasing power by saving on closing costs or paying lower interest rates, and by sellers who want to encourage buyers to make a full-price or higher offer on the home. In these transactions, the seller hands title to the property to the buyer at closing, as with a traditional mortgage. That kind of financing primarily benefits buyers, who might get more generous credit from the seller than they would from a bank, and who avoid closing costs, such as application fees or escrows. (Other types of seller financing in which sellers hold on to the title until the loan is repaid are risky for buyers and prone to abuse.)
By giving buyers title upfront, sellers face significant risk when they provide financing: If the buyer defaults, they may be forced to foreclose, a daunting process that took anywhere from 104 days in Wyoming, to 2,601 days in Michigan in the second quarter of 2023, according to ATTOM, a property-data provider.
That is why David Dweck, a private investor from Boca Raton, Fla., whose portfolio consists of single-family homes in Florida and North Carolina, carefully vets his buyers when he agrees to provide financing. “I underwrite it as if I’m a bank,” he said. “I want to have a reasonable expectation that the borrower will pay me back.” He requires a down payment of at least 20% and will only consider seller financing if the buyer pays full price or above.
Danny Hertzberg, an agent with The Jills Zeder Group at Coldwell Banker in Miami Beach, said that while owner financing is often discussed between buyers and sellers, it is rarely consummated. He said it is most likely to occur when the house has either been languishing on the market without any offers, or the offers that have been made have come in too low. “There has to be some carrot for the seller to consider it,” he said. “Usually that carrot is a buyer offering full asking price or close to it.”
Experts say that seller financing only works when sellers either own the property outright or have sufficient funds to pay off their existing mortgage, since they won’t be walking away with the cash proceeds of the sale. Still, when all the pieces fall into place, seller financing can be a win/win for both buyers and sellers.
When Dweck paid $500,000 in 2015 to purchase a two-bedroom condominium as his primary home, his seller, a widow in her 80s, offered to hold an 80% mortgage at 6% interest, which was higher than the prevailing rate at the time. He has offered to pay off the loan, but she has refused. “She loves the income,” he said. “It’s like an annuity.”
Here are some things to consider before you finance the sale of your home.
- Consult your tax adviser. Normally, gain on a home sale is treated as a capital gain, and, for primary residences, exclusions may be available that reduce or eliminate taxes. But seller financing may be treated as an installment sale for tax purposes, meaning that at least one payment will be made after the tax year in which the sale occurred. According to Rob Wall, a tax partner with Akerman LLP in Winston-Salem, N.C., an installment sale may allow sellers to defer some of the capital-gains taxes they would have otherwise paid on the sale without losing their exclusion.
- Charge sufficient interest. The Internal Revenue Code requires sellers taking back a mortgage to charge a minimum interest rate to avoid “imputed interest” rules, which could tax them on interest they didn’t actually collect. The minimum interest rate, called the Applicable Federal Rate, is published monthly by the IRS. For loans closed in July, the minimum is 4.69% for short-term loans (less than three years), 3.78% for midterm loans (three to nine years) or 3.91% for long-term loans (over nine years). Most home sellers charge more, Wall said.
- Protect yourself against default. Vet the buyer to minimize the risk of default. “We added a condition in the contract where during the 10-day inspection period, the buyer had to produce credit information and complete a generic loan application,” said Sally Daley, a broker associate with Douglas Elliman in Vero Beach, Fla. “The seller could inspect the finances and opt not to move ahead.” Sellers should also get a down payment high enough to ensure that buyers have skin in the game. When Michael Turner, a broker associate for LIV Sotheby’s International Realty in Colorado Springs, Colo., represented the seller of a 1,280-acre tract of land in November 2021, the seller financed $780,000 of the $1.28 million purchase price at 4% for a term of five years. “Putting down $500,000 made the seller feel secure knowing that if they did have to take the property back, they would be in a pretty good equity position,” he said.
