Many property-owners encounter opportunities to sell their properties in unconventional ways. Often, these opportunities involve selling to a buyer who will not fully pay the purchase price, whether with cash or lender-financing, up front. There are situations beneficial to the seller to consider such options. This article will summarize two common scenarios for deferred payment sales. They include seller-financing and the option to purchase agreement. We’ll examine the pros and cons of each alternative to help potential sellers decide what works best for them.
SELLER-FINANCING AGREEMENT
The first consideration is whether the owner wants to continue being title-owner of the property until the purchase price is fully-paid. The alternative is to transfer title-ownership to the buyer on the front end of the deal with security to allow the seller to take back the property in the event the buyer fails to perform on the agreement by defaulting on payments. There are pros/cons to each choice and this article will discuss them to help a seller decide how to structure the best deal for them.
Transferring title-ownership on the front end has the seller playing “the bank” to seller-finance the purchase. The main advantage to playing the bank and transferring title at the closing is to avoid the ongoing legal liability and responsibility for the property. The seller/lender has legal rights to the property through a mortgage that is filed in the public records and acts as a lien on the title. This means the buyer can’t sell or refinance without paying off the seller/lender.
The buyer/borrower also signs a promissory note creating a personal liability to pay the debt. That obligation to pay the promissory note is secured by the mortgage that gives the lender the right to foreclose on that lien to take back the property or get paid by a third-party bidder at a court auction. This is the same framework under which institutional lenders are protected. Individual investors can get the same protections through a seller-financed sale.
All property owners take on some risk from the liability of ownership that they may want to discard. In recent years, short-term rental properties have become a popular investment strategy, especially in Florida. With the emergence of Airbnb and other marketing platforms, many investors have developed a business model of effectively running a hotel.
The owner of any rental home, whether used for vacation rentals or long-term tenancies, should consider liability issues. Should anything happen at the property that’s the basis for a legal claim, it’s nice to not be the owner. A lawsuit could be filed for any number of reasons (use your imagination) including a guest or tenant injury.
Of course, having a lot of insurance, including an umbrella policy, will reduce a great deal of the liability risk, but it never goes away completely. When you’re the bank instead of the owner, you’re not legally responsible for such claims. The lender is also not directly responsible for property taxes, HOA dues, special assessments, code enforcement fines, etc. but does have a vested interest in making sure they’re paid and should structure the lender agreement to require the borrower to pay these bills or face foreclosure.
The main downside to not being the owner is having less legal control over the property. If the borrower defaults, the lender will have to foreclose on the mortgage to recover their investment. That means filing a lawsuit with costs and delays.
One creative and more complicated way to avoid foreclosing would be to use a land trust. The title-owner would be the trust and the buyer would be the beneficiary of that trust. The beneficiary would assign its rights to the lender in advance. In the event of default, this assignment would allow the lender to replace the beneficiary and step in to control the trust and the underlying property. This is known as a “contingent assignment of beneficial interest.”
Through the contingent assignment, the beneficiary pre-signs away their rights to the property. The transfer of the beneficiary’s rights to the lender is contingent on their failure to pay. The trust agreement and a separate contract would state that if the beneficiary/borrower fails to pay, the lender could give written notice to cure. If the borrower still fails to pay, they will sign their rights to the lender. The lender would then take over as beneficiary and assume full legal control over the property without having to file a foreclosure.
It may be more difficult to convince a buyer to agree to such terms that give so much power to the seller. If the seller wants that additional security and has the freedom of walking away from any deal where the buyer rejects such terms, the seller can hold-out for the right buyer.
OPTION TO PURCHASE AGREEMENT
The alternative to signing over title on the front end and playing lender is to structure the deal as an option or lease-option agreement. That means the owner (seller/optionor) sells the right to buy the property later, known as an “option” to the buyer/optionee.
The option is the right to buy the property at a price and under a deadline set forth in the option contract. The buyer must pay some valuable consideration to acquire this right to make the agreement enforceable. The option is the exclusive right to buy that takes the property off the market because no one else may buy it during the option period.
The transfer of title wouldn’t be complete until the buyer pays under the terms of the option agreement and actually exercises the option right. Typically, the option fee will be credited toward the final purchase price, but it’s almost always non-refundable if they fail to close. The exclusive right to buy remains with the option-holder during the option period, so long as the optionee is complying with the terms of the deal.
The advantages and disadvantages to the option agreement are mirror-images of the pros and cons of seller-financing. Under the option agreement arrangement, the seller retains title-ownership and full legal control over the property. Alongside those benefits are the ongoing legal liability and responsibility for the property that sellers choosing to play the bank get to avoid.
A lease-option agreement would have the buyer renting the property from the seller until the buyer is able to exercise the right to buy the property. The buyer would act as a tenant with the right to sublease the space for a higher amount (if sub-leasing is allowed under the contract), whether for a short or long-term rental agreement, and pocket the “spread.” Under this arrangement, there would be two separate agreements between the seller and buyer.
One agreement would be an option contract and the other would be a lease agreement under which the seller is the landlord and buyer is the tenant. In some cases, the buyer moves into the property and simply rents it until they’re able to exercise the option to buy, without renting it to another tenant under the sublease arrangement described above.
The seller could agree to credit the buyer’s rent payments toward the purchase price or not. There is a legal pitfall in crediting rent payments. In the event of default, the buyer/tenant would have a better argument that by crediting the payments, the agreement should be deemed an “installment purchase agreement.” The legal significance to that is the court could decide the buyer has an “equitable interest” in the property. This finding would require the owner to file a foreclosure action rather than a much more simple and inexpensive eviction case.
This same result is more likely if the option and lease agreements are merged into one contract instead of having two separate agreements. The better practice for the seller is to have an option to purchase agreement and separate lease agreement and not to credit lease payments toward the purchase price.
In summary, seller-financing and option agreements, with or without a lease-option component, may be beneficial alternatives to property owners willing to consider selling without getting the full purchase price up-front. Investors should consider whether either arrangement works for them and if so, structure the deal carefully to make sure they’re fully-protected.
If you have questions about financing and option agreements, contact real estate attorney Charles Castellon today.
