When selling real estate, an owner may realize its equity by receiving cash or by “carrying” a note. Because mortgage interest rates exceed interest rates banks pay on deposits, there can be a significant financial advantage of carrying one’s equity, rather than taking it in cash at closing upon the sale. There may also be tax advantages. By carrying the financing, the seller may be able to defer gain recognition.
For example: Mr. Seller’s property is worth $200,000 and has a loan against it of $150,000. After subtracting the costs of sale, Mr. Seller has $30,000 of net equity in his property. He has the choice of realizing upon his equity by taking $30,000 from the closing, or carrying a note for $30,000 secured by the property. If Mr. Seller accepts cash from the closing, he can deposit it in a bank and earn 5% per annum. If he carries the note, it can bear interest at the rate of 9% per annum with monthly payments based upon a fifteen year amortization.
If Mr. Seller deposits his $30,000 in a bank, it will earn interest compounded on a monthly basis. If he never withdraws any of his principal and allows all of his interest to compound, after fifteen years, his money will more than double and his bank balance will be approximately $63,000.
If Mr. Seller carries the note, he will receive payments of approximately $304 per month. He can then invest that $304 per month in a bank account also bearing interest at the rate of 5%. Under this scenario, at the end of fifteen years, Mr. Seller will have over $81,000 in his bank account, a sum almost 30% more than had he not carried the financing. Even if the borrower pays off the note prior to its full amortization, Mr. Seller comes out ahead under the seller carry option.
This benefit can be magnified if the property sold is investment property. An investor who receives cash from a sale must recognize its gain at once. An investor who carries a note can defer gain by recognizing it as he receives payments on the note. (This tax consideration can be significant. Remember that an investor’s taxable gain from a sale is the difference between the sales price and his adjusted basis. Because of depreciation an investor can have much taxable gain and no equity in a Property.) Sellers of residential property can also defer gain recognition by carrying financing. However, they typically do not need to do so because of special rollover provisions in the tax laws allowing homeowners to defer gain by “rolling” it into their new home.
Of course, seller carry financing is not without risk. Funds deposited in a bank or savings and loan are typically insured by the full faith and credit of the United States government. A note is merely backed by the creditworthiness of the makers of the note, its guarantors, if any, and any collateral for the loan. Anyone who carries a note should thoroughly investigate the creditworthiness of his purchaser and insure himself that there is sufficient equity in the property pledged as collateral to cover the amount owed. When confronted with his purchaser’s default, the seller’s ultimate remedy will be to reacquire his property through a foreclosure. The seller’s ability to pursue the borrower for losses may be limited by the borrower’s lack of assets and income, or by a bankruptcy.
While there are some disadvantages of seller carry financing, there are many advantages which a sophisticated investor should consider.