Owner Financing Explained
Owner financing in Texas refers to an agreement where the owner of a property provides financing to the buyer to purchase the property. In this case, the parties enter into a contract of sale which will give the buyer both the right to occupy the property as well as the duty and obligation to pay for the purchase of the property on an installment basis. The owner will be responsible to provide a deed to the purchaser. From a practical perspective, owner financing is usually relevant and important in a context where the buyer of the property is unable to obtain financing from a traditional lender because either their credit is not good enough or the property does not meet the lender’s requirements.
From a technical perspective, owner financing contracts are known in Texas as executory contracts for the conveyance of real estate. Under the Executory Contracts Concerning Conveyance of Real Property statute ("Executory Contracts Statute"), as set forth in Section 5 . 062 of the Texas Property Code, a seller of real property has the right to sell the property under an installment contract. For a residential property, a residential property buyer may sign an executory contract as long as the total payments (which include the subtracting of all discounts, rebates, and interest) for the property divided by the number of payments under the contract is no more than $50,000.
Unlike a real estate mortgage, which transfers legal title in the property to the lender, an executory contract does not transfer legal title to the lender. Rather, title to the property remains with the seller until the promissory notes are fully paid. Once the last note is paid, at that time, the buyer would be entitled to legal title. During the payment period, the buyer has equitable title and the seller has a vendor’s lien or equitable lien.
Legal Aspects of Owner Financing in Texas
The legal framework for owner financing contracts in Texas is delineated in Title 6, Chapter 5, Subchapter A of the Texas Property Code. It’s important to note that owner financing is very strictly regulated so all parties involved must have a firm understanding of the rules under which these contracts must be executed.
The main term everyone needs to know is: "contract for deed" is not a contract at all. It’s a deed of trust.
For those that don’t have a firm grasp on all the proper real estate terminology, a contract for deed ("CDD") is a simple contract wherein a seller finances a portion of the purchase price of property to the buyer that agrees to tender the purchase price in the form of installment payments, therefore securing the property to the buyer. The overarching premise of a CDD is that the payments are made directly to the seller rather than through a lending institution.
We all know what a deed of trust is. A CDD may also be referred to as an executory contract for the conveyance of real property. Under a CDD, the buyer (also commonly known as the "vendee") gives the seller (a.k.a. the "vendor") a tool to foreclose on real property in the event the buyer defaults under the terms of the purchase contract. In order for the transaction to meet the legal requirements of a CDD, the payment of the purchase price is the only obligation imposed on the buyer.
The most common misconception people have of CDDs is that the transaction actually conveys title to the vendee. The Texas courts have made it abundantly clear by way of case law that execution of a CDD does not pass "legal title" to the vendee. A CDD is used merely to convey equitable title from the vendor to the vendee. Because legal title does not pass, if the vendee fails to comply with the terms of the CDD, the vendor is able to rescind the agreement and regain equitable title to the property.
If the CDD describes the property to include a dwelling, the following statutory provisions apply:
- The payments must be paid in money, lets, notes, bonds, or other good or lawful consideration.
- A defect in performance of the obligations under the CDD defers only the vendor’s right to receive any money, lets, notes, bonds, or other good or lawful consideration from the sale of the property described by the CDD.
- The purchaser (vendee) is considered the owner of the property for all purposes except for the purpose of perfecting the vendor’s lien.
- The vendor must extend and continue possession of the property to the purchase (vendee) under the CDD even if the vendee breaches any obligation under the CDD until:
o The purchase price has been actually paid, or
o The property is lawfully foreclosed upon because of the vendee’s default in the payment of any part of the installment
– The vendor’s rights under a CDD can only be assigned to a mortgagee that has extended credit to the vendee or a subsequent vendee with knowledge of any problem with the property.
Essential Terms of an Owner Finance Contract
The essential elements of an owner finance contract or deed of trust include:
Payment Terms – Number of payments, due dates, late charges, interest rate.
Loan Amount – The amount that will be paid back over time, typically the sales price minus any down payment.
Interest Rate – The rate at which the buyer will pay back the loan amount, expressed as an annual percentage.
Due Dates: Payment Interval – The schedule for payments to be made, such as monthly or bi-weekly.
Due Dates: Number of Payments – The number of payments that will be made to satisfy the loan.
Late Charges – Specifies the penalties for late payment, typically a percentage of the due amount.
Default Conditions – The stipulations regarding what happens in the event of a default, including remedies available to the seller (lender).
Pros and Cons of Owner Financing
The key benefits and risks to both sellers and buyers are outlined below:
Advantages to Sellers
A seller will find it easier to sell his or her home if an owner finance option is available, as the buyer pool is expanded. Additionally, sellers, for a variety of reasons, may be unable to afford the sales price or be able to get a loan due to poor credit or other reasons, so the owner finance option is a great way to get the deal done.
The seller also benefits because the sale is typically done in a lump sum in future value terms. For example, instead of paying 5 percent for 30 years he or she will get 7 percent for the first 5 years and then a balloon payment after that time period.
So the seller has a cash-out deal today and extra equity in future dollars. He or she also gets interest for a period of time and then a cash settlement.
The seller also does not have to deal with having the home on the market for a long period of time since there are a lot of buyers out there for whom owner finance is the only option. The process is also less stressful to the seller. For example, there are no inspections, houses are categorized as they are seen, and other conditions are not included as they are in a loan situation.
Finally, the seller has the security of a note and deed of trust that provides him or her with the recourse to foreclose.
Advantages to Buyers
Owner financing is an attractive option for buyers, particularly first-time purchasers, as they are often shut out. The advantages of owner financing are:
The Bottom Line
If you are considering the owner finance option, these are some factors to consider as you evaluate the risks and benefits.
Structuring an Acceptable Owner Finance Deal
The key to structuring a fair owner finance deal lies in clear, mutually beneficial terms for both buyer and seller. An owner finance transaction is a negotiation where compromises may need to be made by both parties to reach a positive sales agreement.
Owner financing can be a useful tool for sellers who may otherwise have difficulty selling their property. Online blogs often paint owner financing as a quick fix for investors or attempts to grow an investor’s portfolio. While the marketing of owner financing deals may find their "sweet spot," buyers must approach them in good faith and respect all parties involved.
The total price of a home in an owner finance agreement can often be higher than the market rate because the seller is taking on more financial responsibilities. For example, owner financed homes are not eligible for FHA financing. This added responsibility for the seller may need to be reflected in the purchase price , along with the added risk placed on the seller if the buyer defaults.
For an owner finance deal, both buyer and seller must negotiate the interest rate, repayment amount, amount of down payment, payment period, prepayment penalties, late fees, age of the loan, default provisions, and disclosures required by law. When negotiating, it is key to consider what you can and cannot live with, including the timing of payments, prepayment penalties and whether the buyer is responsible for the upkeep of the property; if the property gets run down, the seller will still be on the hook for taxes and insurance.
In addition to the mortgage terms, the parties must consider the closing costs, title insurance policy, seller disclosures, and the costs of any repairs to bring the home up to City Code. TREC promulgates the One to Four Family Residential Contract (Resale) form (TAR-1604), which contains most financing contingencies, so it may be beneficial to start with this form and make changes accordingly for your specific agreement.
Owner Finance Mistakes: What Not To Do
One of the biggest mistakes we have seen is assuming there is no lease agreement if you have an owner finance contract. Unfortunately, that is not true; so, you will need to pay attention to the details. Texas has certain rules concerning residential leases that create certain rights and obligations between a landlord and tenant. For example, the landlord/owner is obligated to make a wide variety of repairs. If the owner/landlord fails to do so and it is serious enough, the tenant can terminate the lease/contract. Adverse possession is another area where we have seen mistakes. A buyer must actually, successfully possess the property for decades in order to have proper title using adverse possession instead of a warranty deed. Many times we have seen buyers just wait for more than a decade but without proper records and filings, they have very little to show for it legally. Owner financed contracts also fail on the basis that the buyer does not pay. We are not talking inability to pay, but simply refusing to pay. You must understand that as there is a mortgage company, there is also a lien and foreclosure process along with a deed of trust. As a buyer, you will pay closing costs and then monthly amounts until the principal and interest is paid in full. At that time, you will receive either a deed or a bill of sale. If the buyer fails to pay, the seller can exercise the right to foreclose and retake possession of the property. Proper recording and financial statements are critical in the event of this scenario. One of the most common causes of default is the lack of understanding by the buyer. Most impulse buyers do not conduct due diligence properly, fail to read the contract, and end up failing to honor the terms of the contract.
Tax Issues Associated with Owner Financing
The tax implications of an owner financing deal are an important consideration for both the buyer and the seller both at the time of the transaction and after. The seller must report the gain from the sale and the buyer is able to deduct interest paid on the note secured by the property.
The seller must use Form 6252 to report a gain from the sale of real property financed over time. The report is due with the sellers income tax return for the year in which the sale takes place, or the year in which any money is received pursuant to the installment sale contract, whichever comes last. The report must include the following: The buyer is able to deduct interest paid on the note secured by the property. The buyer may be able to deduct all or a portion of points and origination fees for obtaining the financing. However, some points and origination fees must be capitalized as part of the basis of the property and are not immediately deductible. Points and origination fees used to pay for services connected with the purchase of the property are not deductible.
When You Need a Real Estate Lawyer
Whether or not a party decides to engage a real estate attorney under an owner finance contract is up to the individual. However, the likelihood of needing an attorney is probably increased in the following scenarios:
- All parties are not in agreement on terms of the transaction; In Texas, two or more parties must agree on the offer and acceptance of the terms in order for a deal to be valid. If there are any concerns about the deal, clarity from a legal standpoint is more likely to occur if it comes from an experienced real estate attorney.
- Change of circumstances occurs; People do buy and sell houses all the time, but it is not something typically done without any hitches. A trusted attorney can be invaluable when it comes to troubleshooting a change of circumstances.
- More than one party involved in the transaction; There can be many facets to a real estate transaction involving multiple parties. A knowledgeable real estate attorney can provide clarity and direction for all parties involved.
- Issues in the title; There could be every sort of issue in a title , which can include the inability of the seller to make good on the sale due to an issue in the chain of title. It is up to the buyer to understand the full history of the property. A real estate attorney can help with this process.
- Multiple offers on the same house; If your dream home has multiple offers on it, and you are not able to put in your highest offer, you may want to know what other buyers are offering. In this situation, a real estate attorney can be invaluable in helping you navigate the waters and get what you want at the price you are willing to pay.
- Dual role of the real estate agent; If you are buying or selling a home, you may need an attorney to help with any liabilities that could crop up due to the dual role of a real estate agent in the process. If there are any contingencies in the real estate agent’s commission, a real estate attorney can help settle any questions that are unclear.