Seller financing's dark side

DEAR BERNICE: I hope you might be able to help (or at least point me in the right direction). I am in communication with an investor who is liquidating seven single-family residences. We were about to use seller financing until one of his friends told us how he: 1) sold his property "subject to"; 2) the bank exercised the "due on sale" clause; and 3) called the note due.

Long story short, I would like to buy and hold these properties. They have already been rehabbed; they cash-flow well; and they have Section 8 tenants. I need to find approximately $500,000 of long-term financing. --David C.

DEAR DAVID: This is an interesting scenario because it points out the challenges sellers/buyers can encounter when they are either unfamiliar with the terms of their loan or try to circumvent those terms.

Many years ago, a seller could legally sell her property "subject to" the existing note. This meant that the seller would not have to pay off the loan even though she had conveyed the property to another party. The most common vehicles for these types of sales were an all-inclusive trust deed (AITD) or a land sale contract.

For example, if I had a first mortgage of $80,000 at 5.5 percent, a second of $50,000 at 6 percent, and my property was worth $300,000, I might "wrap" those two existing loans into an AITD of $250,000 at 8 percent. For each year that I kept the loan and the new buyer kept up the payments, I would earn 2.5 percent (8 percent minus 5.5 percent) in interest on the $80,000 first, 2 percent (8 percent minus 6 percent) on the second of $50,000, and 8 percent on the remaining balance of $120,000. The blended rate on the three loans was 5.04 percent.

In an AITD, the title transferred to the new buyer. The lenders normally couldn't call the note due on sale. The buyer paid the monthly payments into a trust account. The trust account paid the underlying loans and the balance was sent to the seller. If the buyer fell behind on payments, the seller could step in and foreclose on the property. The seller was still responsible for the payments, even if the buyer didn't pay.

In the cases where the lender did have a due-on-sale provision in the note (i.e., the note has to be paid in full if the seller conveys the property), you could circumvent that provision by using a land contract (land sale contract). This instrument does not convey title to the buyer. Instead, the title remains in the seller's name.

The buyer (at least in California) holds "equitable title." Title would pass to the buyer when the buyer refinanced or paid the loan in full. This could create issues for the buyer because the buyer cannot refinance or place additional loans on the property while the property is still in the seller's name.

This activity was common when mortgage rates were 16 to 21 percent. We were writing "subject to," AITD and land sale contracts at 10 to 12 percent. The lenders wised up to this practice and had the federal government make changes that allowed federally chartered banks to enforce due-on-sale provisions. ...CONTINUED

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