Housing Counsel: Creative Financing -- A Wrap-Around Mortgage
Written by Benny L. Kass on Sunday, 03 September 2006 7:00 pm
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In a slow real estate market, sellers, potential buyers and real estate agents begin to think about creative financing. Last week, we explored installment sales. Another approach is known as a "wrap-around" (wrap) mortgage.
Here is how it works.
You want to sell your house for $500,000 and have an existing mortgage loan in the amount of $200,000, with an interest rate of 5 percent. You have found a buyer, who has sufficient income but may have difficulty obtaining a mortgage loan.
You agree to sell the house. At settlement, you will sign a deed over to the buyer which will be recorded on land records. Your buyer will give you $50,000 in cash at settlement and agrees to make the monthly mortgage payments on the first trust of $200,000.
However, your buyer will sign a promissory note to you in the amount of $450,000, which is the difference between the sales price and the $50,000 deposit. This loan will carry an interest rate of 6 percent, and the monthly payment, based on a 30 year amortization, will be $2,698.00. This note will be secured by a second deed of trust recorded against the property.
The buyer will make the monthly payments directly to you, and you will in turn continue to make your payments to your lender as you have in the past. From the buyer's point of view, these payments are just like they would be from any commercial mortgage lender, although at a lower interest rate. Additionally, the buyer will not have to pay the various lender closing charges.
The sellers, on the other hand, are making a small profit. They are paying off their old mortgage at the 5 percent rate, but are receiving 6 percent from their buyer. So the sellers will effectively receive more than the 6 percent which the buyer is paying.
More importantly, this may be the key to making the sale.
This kind of transaction is called a "wrap-mortgage" because the second trust is wrapped around the first. But as mentioned, there are risks:
First, the Seller must have an assumable mortgage on the property. While these are not common in today's economy, there are still many Veteran's Administration or FHA assumable loans on the books. And some adjustable rate mortgages are also assumable.
Otherwise, if and when the seller's lender learns that the property
has been sold to a third party, that lender may decide to foreclose on the property, using the so-called "due on sales" clause.
There are, of course, people who will take a chance that the lender will either not learn of the sale, or will allow the assumption to go forward. But sellers must fully disclose the risks to their prospective purchasers.
Even if the seller's existing loan is fully assumable, what happens if the buyer defaults on the mortgage obligations to the seller? The seller might have to foreclose on the property, and should the buyer's opt for bankruptcy protection, this could take a long time to be resolved.
If the seller does not make the mortgage payment for whatever reason to the original lender, that lender can foreclose on the property. It must be noted that even though the buyer is on title, the prior lender remains in first place on the land records, and is legally in front of the buyer. Accordingly, buyers will insist that they receive proof that the mortgage payments are being made. Indeed, some buyers may even insist that a neutral party, such as a bank or an attorney, make the first trust payments.
Under a wrap-mortgage, the seller receives the benefits of the additional interest payments. Accordingly, sellers may insist that the buyer cannot prepay the loan without a penalty. Obviously, buyers may object to such a condition, since it inhibits their right to refinance or even sell the house.
What are the taxable consequences of such a transaction?
The second trust will be recorded on land records in the jurisdiction where the property is located. This allows the buyer to deduct all of the interest which is paid on a yearly basis. Additionally, since the buyer will be paying the real estate tax, this can also be deducted. However, there is a minor problem. If the original lender is escrowing money for the real estate tax, at the end of each year, the lender will send the IRS and the seller the appropriate 1099 form which shows the amount of interest received and the amount of taxes paid. These deductions properly belong to the buyer, however, so an explanation will have to be given to the IRS as to the nature of this transaction.
Under proper circumstances, a wrap-around mortgage is a potentially useful tool for both buyers and sellers. However, if the existing loan can be paid off by the seller, it would be best for the seller to go to settlement, and take back a first deed of trust.