LAND SALES CONTRACTS: A USEFUL TOOL

Written by Benny L. Kass

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Many buyers are being priced out of the real estate arena because of two important factors: prices are high and concern that interest rates are starting to creep up.

If the circumstances are right, sellers have yet another option to consider, namely a land sales contract. It is also referred to as a contract for deed or an installment sales contract.

Under this arrangement, the seller and the buyer enter into a real estate contract. The parties agree that the deed to the property will be held in escrow by a neutral third party — usually the settlement attorney. The buyer agrees to pay the seller a fixed dollar amount each and every month, and when the agreed upon price has been reached — or when the buyers are finally able to obtain commercial financing — the seller will be paid in full and the deed will be taken out of escrow and recorded in favor of the buyer.

Let’s take this example: Seller has a house that he wants to sell for $400,000. The house is free and clear; there is no mortgage. The buyer signs a contract, whereby a deposit of ten percent will be given to the seller ($40,000) and agrees to pay the buyer the difference on a monthly basis, based on a mutually agreed upon interest rate. In our example, if the parties agree on a six percent rate, the buyer will have to pay the seller $2, 128.43 per month. The buyer will also agree to pay the real estate tax and the home owner’s insurance.

The advantage to the Seller is that they have been relieved of their obligations to maintain and care for the house, and will be getting a decent rate of return on their money. There are taxable consequences involved with such a transaction, and your tax advisor should be consulted before you enter into such an agreement.

The disadvantage, of course, to the seller is that they will not receive all of the sales proceeds up front.

From the buyer’s point of view, if they can afford the monthly payment, they have a house in which to live, and are getting a loan — albeit above current market rates — but which they might not have been able to afford from a commercial lender.

This is an easy example. But what if the seller has an outstanding mortgage. Almost all commercial loans nowadays contain what is known as a “due on sale” clause. This means that when the property is sold — and this includes a long term lease or a land installment sale — the entire mortgage is due and payable.

Many people — especially in the early l990’s when interest rates were high –tried to end run the lender by entering into a installment sales contract, and attempting to hide the fact from their lender. The buyer would make the monthly payments to the seller, who in return would pay the mortgage In many cases, the lender did not find out about this transaction — although many people throughout the country were in fact caught, and their mortgage was called.

Accordingly, if you are the seller and have a mortgage, you must confirm with your lender that they will allow the land installment sale transaction to go forward. If your loan is an adjustable rate mortgage (ARM) your lender may not object, although it will want to determine the credit worthiness of your buyer and it will insist that you remain legally obligated under the loan, in case the buyer defaults.

These contracts are not new. As far as I could determine, they date back to the wild west in the l800’s. A rancher had many acres that some of his farmhands wanted to buy. Each would cost $500. The farmhand would give the rancher $10 as a down payment, and would pay the rancher $10 per month until the balance of the purchase price ($490) was paid in full. In some cases the rancher would charge interest on the outstanding balance; in other cases, no interest would be charged. Finally, when the full amount of the purchase price — namely the $500 — was paid, the rancher would then transfer title to the real estate “in fee simple” to the buyer. A deed would be recorded, and the buyer would then be the rightful owner of the property.

If the buyer defaulted before making all of the monthly payments, , the buyer could lose all of his rights to purchase, and the buyer might also forfeit all of the monies previously given to the rancher.

Many years ago, the Internal Revenue Service took the position that such a land sales contract transaction was a sale for tax purposes. The seller would have to report the sale and, depending on the circumstances, pay tax on any profit that was made (albeit on an installment sale basis). The purchaser, on the other hand, would be considered the owner of the real estate, so that any mortgage interest and real estate taxes paid would be deductible from his/her income tax return.

The seller remains the legal owner of the property, but the buyer becomes the “equitable” owner.

The theory behind this concept is that it is anticipated that in the years to come, the buyer’s income will increase — as will the value of the house — so that the buyers will ultimately be able to refinance with a commercial lender and pay the seller off in full.

Logistically, it works this way. There are two settlements.

In the “first settlement”, the parties will sign a contract, spelling out all rights and obligations of both parties. The sellers will sign a deed which will be held by the settlement attorney or title (escrow) company in escrow. The contract will spell out the requirements for taking this deed out of escrow. If, for example, the purchaser fully complies with all of the terms of the contract, and is finally able to pay off the full amount of the outstanding note, the deed is to be recorded in the name of the purchaser. This would be the “second” or “final” settlement.

On the other hand, if the buyer is in arrears on the monthly payments, and the seller gives reasonable notice of this default to the buyer, the deed will be taken out of escrow and returned to the seller. At that time, the purchaser will become a “tenant,” and — subject to the existing landlord/tenant laws of the jurisdiction where the property is located — the buyer may be evicted. Buyers and sellers under this kind of arrangement should negotiate — before a contract is entered into — all of the important terms and conditions, especially what will happen on a default by the Buyer. Sellers want the buyer to move out of the property and also to forfeit all of the moneys paid to the date of the default. Buyers are prepared to move out, but do not want to forfeit any of their moneys. This issue must be resolved, in writing, before the transaction has been completed.

Some people consider it unfair that the buyer should lose all of the moneys which have been paid to date, should the buyer default. However, the answer to this is that the buyer has had the use of the house, and in effect has paid rent to the landlord/owner. And unlike a tenant, the buyers can deduct the mortgage interest which they pay to the owner as well as the real estate taxes.

It must be pointed out that in order to take these deductions, there has to be a recorded deed of trust (mortgage) recorded on the land records. This should be arranged at the first settlement.

Some state laws — such as Maryland — require that a land contract be recorded among the Land Records in the jurisdiction where the property is located. This is for the protection of the buyer, so as to put the world on notice that the buyer has equitable title to the property. If the deed is not recorded, and the buyer is dealing with a dishonest seller, there is nothing to stop that seller from fraudulently selling the property to a third party, who may have absolutely no knowledge about the land sales contract.

The land sales contract clearly raises many legal problems — although they are not unsurmountable. If you wish to pursue such a transaction, make sure you discuss these issues fully with your tax and legal advisors. A carefully drafted land sales contract must be entered into, touching all of the points discussed above.