By Chris Watkins

These days, as many sellers are in a desperate struggle to sell their homes, and many potential buyers are having trouble qualifying for conventional mortgages (because of tougher loan underwriting policies), the result is that seller financing is on the rise.  One form of “seller financing” is the contract for deed.

WHAT IS A CONTRACT FOR DEED?

A Contract for Deed, sometimes referred to as a “land contract” or an “installment sale agreement,” is a form of seller-financing for real estate.  In a typical real estate transaction, the seller transfers title to the buyer (by signing and delivering a warranty deed), and the buyer finances the purchase by borrowing funds from a lender in exchange for a promissory note secured by a deed of trust (or a mortgage).   In some cases, instead of a third party lender getting involved, the seller acts as the “lender” and takes the promissory note and deed of trust.   In either case, title to the property transfers to the buyer at the closing.  If the buyer defaults on the loan, then the lender can foreclose on the property.

With a Contract for Deed, the buyer agrees to make payments to the seller over time, but does not take title until the purchase price is fully paid – often many years in the future (if ever).  If the buyer ever defaults, the seller has the option to take back possession of the property (foreclosure is not necessary because title was never conveyed), and the buyer is out all of the money paid up to that point.

Contracts for Deed are commonly used in situations in which the seller needs to quickly sell the property, but can find no buyer who can qualify for a conventional loan.  In many cases, the seller still owes money on the property and can no longer afford the mortgage payments, so he is looking to the buyer to provide the funds with which to make the monthly payments.  This is very risky, as discussed below.

WHAT ARE THE RISKS?

Whether you are the buyer or the seller, there are numerous risks involved with a contract for deed.

Buyers’ Risks:

• Homes sold through contracts for deed are often sold on an “as is” basis with little disclosure from the seller of defects in the property.  It is highly advisable for buyers to get a thorough inspection.
• If the seller has an existing mortgage/deed of trust on the property, the mortgage document will almost certainly have a “due on sale” clause that will be triggered by a contract for deed.  This means that, unless the lender consents to the contract for deed, the lender can declare the entire loan to be due immediately.  If you are not in a position to pay off the balance of the loan, the property could be foreclosed right out from under you, and you’d have little or no recourse.
• Another risk is that you do everything you are supposed to, and upon making the final payment, you discover that the seller is unable to deliver clean title to you (or any title). For example, there may be liens on the property from the seller’s creditors.  Or perhaps the seller divorces or dies, and various other parties claim ownership.  These are all problems that could require expensive litigation to sort out.
• It is very unlikely that a buyer will be able to get title insurance on the property, at least not until title is conveyed.
• The buyer has no equity in the home until it is fully paid off.  This means that even if you make payments religiously and on time for several years, but if you fall on hard times and fail to make a couple of payments, you could lose the house and all of the money you paid to the buyer.

Sellers’ Risks:

• One obvious risk is that the buyer in a contract for sale transaction is typically someone who could not qualify for a conventional loan.  There are all kinds of reasons why a buyer would not qualify for a loan (poor credit scores, little or no income, high debt, etc.), but they all mean that there is a pretty good risk that the buyer will default at some point.
• If the seller has a mortgage on the property and the buyer fails to make payments or if a “due on sale” clause is triggered, the seller’s lender/mortgage holder may accelerate the loan, thus forcing the seller to come up with funds to pay off the loan or risk foreclosure.
• If there is a fire or other casualty on the property, there may be a dispute about who is entitled to the insurance proceeds.  The seller needs to make sure his interest is insured.  Furthermore, the seller, whose name is on the title, could be forced to defend himself in a lawsuit if someone is injured or killed on the premises.

CONCLUSION

The risks associated with a contract for deed are great and neither buyers nor sellers should enter into such a transaction without careful consideration, and it is advisable for all parties to seek legal counsel.  Even if conventional financing is not an option, there are other alternatives that may be better, such as a simple lease or a lease with an option to purchase, or even seller financing in which the seller conveys title and takes back a promissory note and deed of trust.

By Chris Watkins

The economic crisis we are facing is affecting millions of homeowners.  Many people are facing situations in which they can no longer afford their mortgage payments.  Perhaps they lost their job, or the interest rate on their adjustable rate mortgage has increased.  Whatever the reason, foreclosure rates are skyrocketing.  And to make things worse, property values are falling dramatically.  This means that for many people, their homes are worth significantly less than their mortgage balances.

If you are in a situation in which you can no longer afford your mortgage, and foreclosure is inevitable, you might want to consider a short sale.

WHAT IS A SHORT SALE?

A short sale is an arrangement with your lender whereby your lender consents to your selling your home for less than the balance of your mortgage.  It is, in effect, a negotiated settlement with the lender.  Often lenders will write off whatever debt remains after the sale.

HOW DOES A SHORT SALE BENEFIT A HOMEOWNER?

Whether a homeowner succumbs to foreclosure or negotiates a short sale, either way they are going to lose their home.  So why bother trying to negotiate a short sale?  There are several reasons:

• Deficiency.  A foreclosure can be an expensive process, and often leaves the debtor owing a substantial amount of money to the lender after the sale.  The debtor is liable to the lender for the deficiency, along with any costs incurred by the lender, including attorneys’ fees.  The lender can sue the debtor for these amounts and obtain a court judgment.  In a short sale, since it is a negotiated transaction with the lender, the amount of the deficiency is often forgiven.  This means that once the short sale is complete, the debtor can walk away with the comfort of knowing that his or her debt has been satisfied, and he or she will not be sued by the bank in a deficiency suit.
• Credit Score.  Whether you do a foreclosure or a short sale, your credit score (FICO score) is likely to take a massive hit.  Most experts, however, believe that a short sale is less harmful to your credit than a foreclosure.  Furthermore, with a short sale, it may be possible to negotiate with the lender how they will report you to the credit bureaus.  For example, the lender may agree to report that the debt was “paid as agreed” or something similar that would be less harmful than reporting “foreclosure” or “deficiency judgment.”

HOW DOES THE LENDER BENEFIT?

Lenders have no obligation to accept a short sale.  Once you default on your loan, it is entirely at the lender’s discretion as to whether or not to commence foreclosure proceedings (short of you filing for bankruptcy).  Banks, mortgage companies, and other lenders are businesses, and deciding whether to foreclose on a home or to accept a short sale is a business decision.  When a homeowner has defaulted on his or her mortgage, it usually becomes a matter of the bank cutting its losses.   So what are the reasons a bank would be willing to accept a short sale as opposed to a foreclosure?

• Lenders stand to lose more money in a foreclosure than in a short sale.  The reason is that there are a lot of expenses involved in a foreclosure (including legal fees and trustee fees).  Also, there is no guarantee that a buyer will show up at a foreclosure auction, and if they do show up, that they will make a good bid.  Although technically the debtor is liable to the lender for the costs of foreclosure, it can be hard to collect – people going through foreclosure usually don’t have sufficient assets with which to pay debts. 
• In many foreclosure sales, there are no buyers, and the lender ends up taking possession of the property.  Lenders want to avoid this for several reasons.  For one, they make no money on the property while in their possession.  Also, foreclosed properties are often in a state of bad disrepair, so lenders often have to spend a lot of money to get the property in a sellable condition, not to mention maintenance costs, utilities, insurance, and other such costs.  And of course, the lender will have to pay marketing costs (realtor commissions, etc.) to resell the property. 

WHAT DOES THE SHORT SALE PROCESS INVOLVE?

If you are in a situation in which you want to try to negotiate a short sale, then it is necessary to prove to your lender that your financial condition is so bad that you have no choice but to default on the mortgage.  This is usually accomplished by delivering a “hardship letter” to the lender, along with copies of bank statements, tax returns, W-2s, etc. 

You will also need to obtain an appraisal or market analysis so that you have a fairly accurate idea of the value of your property.  With that information, your real estate agent will have a good idea of what price to list the property.  The goal is to price the property high enough that your lender will be willing to sign off on the sale, yet low enough that you get quick offers.  The sales contract should say that the sale is “as is” and that it is contingent upon your lender’s approval. 

THE BENEFITS OF USING AN ATTORNEY IN THE SHORT SALE

There are several reasons to use an attorney when trying to negotiate a short sale:

• Unlike non-attorney organizations that provide short sale services, an attorney has a fiduciary duty to zealously act on your behalf, and is regulated by rules of professional conduct that apply to all attorneys.  These rules require attorneys to maintain strict confidentiality and to avoid conflicts of interest.  Furthermore, most attorneys are covered by malpractice insurance. 
• Attorneys generally have more training and experience in negotiations – particularly negotiating settlements in adversarial or semi-adversarial situations.  Remember, a short sale is, in effect, a settlement agreement with your lender.  Important negotiation points are (1) whether the bank will release you from further liability after the sale; (2) what the bank will report to the credit agencies; and (3) whether the bank will permit you to pay some or all of your expenses (such as realtor commissions and attorneys’ fees) from the proceeds of the closing.
• Lenders often will be more likely to take your matter seriously and devote more attention to it if they know you have hired an attorney. 
• If you have an attorney, lenders have a little more incentive to avoid foreclosure if a viable alternative (such as a short sale) exists.  The reason is that foreclosures have very specific notices and other procedures that must be followed to the letter – otherwise the foreclosure sale could be delayed or invalidated.  The bank knows that a good attorney will closely scrutinize the foreclosure process and look for reasons to invalidate it.

ARE THERE INCOME TAX IMPLICATIONS TO A SHORT SALE?

When a lender forgives a debt owed by a borrower, as is often the case in a short sale, there is an issue of whether that constitutes taxable income.  The general rule is the amount of debt discharged by a lender is included in the borrower’s gross income for federal tax purposes.  However, legislation passed in 2007, called the Mortgage Forgiveness Debt Relief Act of 2007, allows many debtors to exclude such income, provided that the mortgage covers their principal residence and borrowed funds were used to buy, build, or substantially improve the residence.  If the debt forgiveness does not qualify for exclusion on this basis, there are other grounds for exclusion that may apply.  For example, there is an “insolvency exclusion” that may apply to the extent a borrower was “insolvent” (i.e., liabilities exceeded value of assets) immediately before the discharge of indebtedness.

When indebtedness is forgiven, it will be necessary for the borrower to file IRS Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) with his or her federal tax return. 

CONCLUSION

If foreclosure is inevitable, and you are willing to move out of your home, then you should consider exploring whether a short sale would benefit you.

If you would like a complimentary consultation on the benefits of attorney representation through this process and of Jones & Watkins LLC to serve as Legal Counsel for your Short Sale call (573) 234-1130 or email us through our Contact Form.