At a time when banks are making borrowers jump through hoops to obtain mortgages and houses are sitting on the market with no offers, it’s tempting to consider owner financing. Also known as selling through a land contract or a contract for deed, financing the buyers has some distinct advantages, but there are a few potential pitfalls as well. Your house is probably your biggest investment, so weigh the pros and cons carefully before entering into a deal that will tie up your finances for some time, and hire a real estate attorney to assist you with the transaction.
How it Works
Owner financing is an option when buyers can’t get conventional financing. Both buyers and sellers sign a contract that allows the buyers to make a down payment and then make monthly payments on the balance. A balloon payment can be figured into the contract after a few years, by which time the buyers are expected to obtain a bank mortgage and pay off the sellers. The date of a balloon payment is negotiable, and both parties can opt not to have a balloon payment, in which case the buyer continues making payments to the seller, just as they would to a bank. Once the buyers pay off the balance, the seller transfers the deed to the house.
Financing as an Investment
While you won’t get all the money from the sale of your house upfront, you will get a chunk from the down payment and you’ll get monthly payments, which include interest. Owner financing contracts stipulate that if the buyer defaults on the contract, the property returns to the seller. That’s a pretty good deal for you. If your buyer walks away – you get to keep the money and you get the house back.
The Dangers of Defaulting
Of course, it won't be a good deal if the buyer defaults on the contract but doesn't walk away. If a buyer can no longer make the monthly payments, but doesn't leave the property, you must, in effect, foreclose on your own property. Depending on the laws in your city and state, it can take months before you finally remove the buyer. During that time, you're not only losing the amount of the monthly payments, you're probably also incurring legal fees and other costs. If you were depending on that money as a source of monthly income, or using it to offset the cost of a mortgage on your new residence, you may find yourself in financial jeopardy. When you finally remove the buyer, it's possible you won't collect the full amount owed.
Another downside to owner financing deals: You might not get the house back in good condition if the buyer defaults. The buyer might alter the house; add an addition, tear out a wall or fill in the swimming pool with sand. In the end, the alterations or, in some cases, outright vandalism might lower the value of the property, or force you to make costly repairs and renovations before putting the house back on the market. You can minimize the risk of property damage by carefully screening your buyers and requiring a sizable down payment, but you can’t eliminate the risk.
The IRS taxes the capital gain, or profit, you make on the sale of your house when it reaches a certain amount. Not all home sellers will pay capital gains taxes, but if you will owe the IRS, you can spread out the payments over the length of the contract instead of owing the money in one lump sum as you would if you sold the house through a conventional deal. During the term of the contract, however, you can no longer claim depreciation on the house or take property tax deductions. Talk to a tax accountant about the potential benefits and drawbacks, which will also depend on whether the house was your primary residence.
Payment to a Real Estate Agent
If an agent is listing your house, you might still owe that agent a commission, even if your house does not sell through conventional means. Real estate listing agreements differ, but most include a clause stipulating that the agent is due a commission if you sell the home yourself during the listing period. You might also owe a commission if you sell the home during a specified number of months after the listing expires, if you sell to a buyer that found your house through the efforts of the agent.
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