By Robert L. Cain
So you want to sell that rental property, and you’re going to carry the paper. That has long been an excellent way for investors to sell rental property while keeping an income stream. But watch out; in order to protect us from ourselves, Congress stepped in. They passed two laws that butt up against each other and contradict each other in a couple of places. But that got worked out enough so that they now work in tandem—almost.
The first one is the SAFE Act, which stands for Secure and Fair Enforcement for Mortgages Act. That was passed in 2008 and signed into law by George W. Bush. That law protects us from incompetent and sleazy mortgage brokers, but it also affects people who would sell their properties with owner-carry loans. It requires that anyone who is in the business of writing mortgage loans be licensed. Whom that covers varies state to state so that one state might require anyone who writes a loan, ranging from owners who would carry the paper on even one property to only those who write and carry the five or more loans a year to be licensed as “mortgage originators.” It is up to each state to make its own rules unless those rules don’t suit HUD, and then HUD intervenes with its own “acceptable” rules.
The second one is the 900-page Dodd-Frank Act that went into effect January 2014. It’s had two years to work its way into the economy. The main purpose of the act was to regulate banks and securities dealers so that we wouldn’t have a repeat of the housing crisis that began in 2008. However, a small piece of Dodd-Frank deals with seller financing.
Here’s where they combined SAFE and Dodd-Frank. The law exempts the following:
- a natural person, estate, or trust who provides seller financing for only one property in any 12 month period.
- any type of seller financing entity that finances the sales of three or fewer properties in any 12 month period. (§1026.36(a)(4) and (5))
And if someone meets either of those criteria, the rest of the regulations take effect:
Specifically, under the first special exclusion, if a seller financer is a natural person, estate, or trust, he or she is not a loan originator if:
- provides seller financing for only one property in any 12 month period.
- owned the property securing the financing.
- did not construct, or act as a contractor for the construction of, a residence on the property in the ordinary course of business.
- financing meets the requirements below.
The financing must:
- Have a repayment schedule that does not result in negative amortization.
- Have a fixed rate or an adjustable rate that resets after five or more years. These rate adjustments may be subject to reasonable annual and lifetime limits, 2 percent per year and 6 percent lifetime.
There are two more wrinkles: one, the seller must “qualify” the buyer, and two, the seller can’t write a “high-cost” loan. Qualifying is to ensure that the buyer can actually make the payments. You would do that through income statements and credit reports. The debt-to-income, that’s gross income, cannot exceed 43 percent. There’s nothing unreasonable about that since we most likely would make sure the buyer could actually make the payments, if we have any sense at all, much as we would a prospective tenant.
A “high-cost” loan is any loan that exceeds 6.5 percent above the “average prime offer rate,” the rate people with excellent credit would pay for a first mortgage. If the loan is for less than $50,000, such as a manufactured home, the rate goes up to 8.5 percent above the “average prime offer rate,” likewise for a second mortgage. For loans of less than” $20,000, the points and fees can’t exceed 8 percent of the loan or $1,000; for loans over $20,000, the points and fees can’t exceed 5 percent of the loan.
And there’s more. For high-cost mortgages, the new rule also bans:
- Fees for paying all or part of your loan early (refinancing a mortgage).
- “Balloon” payments–big payments at the end of loans that are more than twice the regular payment amounts–except in special circumstances.
- Late fees larger than 4 percent of the regular payment.
- Most fees for getting a statement of how much is still owed on the mortgage (called a payoff statement).
- Fees for loan modifications, if someone has trouble and can’t pay the mortgage.
- Creditors or brokers from advising homeowners refinancing into high-cost mortgages not to make their payments on an existing loan
There is an exception, and it’s a big one. These laws apply only to sales to residential owner-occupants. If we sell to an investor, there are no restrictions. Likewise if we sell commercial property or vacant land, we don’t have to follow any of those rules.
So what’s the catch? Let’s look at two hypothetical, but real-world, examples.
George bought a mobile home park where there were 10 vacant units. He wanted to actually make money on this park, so he advertised the vacant mobile homes for sale with owner financing. George offered $500 down with the remainder amortized over 20 years at 6 percent and a balloon payment in year five. After all, he didn’t want to carry the paper forever.
They all sold within three months.
John is a builder of small single-family homes. He usually sells homes to buyers looking to rebuild their credit possibly because of foreclosure or bankruptcy and don’t have enough money for a traditional loan’s down payment. Once he sells a house, he sells the note to a note buyer. The loans John writes are usually 30-year amortization, 7.5 percent interest, 5 points, and a 5-year balloon. (Thanks for Clint Coons of clintcoons.net for these examples.)
Right away you can see the problems by looking back at the SAFE Act and Dodd-Frank rules. George not only sold more than three properties in a 12-month period, he also threw in a balloon payment. So the win-win situation turns into a lose-win situation if the buyers can’t make payments and hire Kevin the “consumer protection lawyer,” who will immediately see that the loan was illegal and sue George.
And poor John, he can’t even sell these homes with owner-carry because he’s a builder, much less add a balloon payment. So those people who want to rebuild their credit and own a home again are out of luck, assuming John follows the law. Otherwise, look for attorney Kevin to enter the picture again.
What’s an investor to do? It is possible to sell more than three properties in 12 month if you structure the ownership of the properties appropriately. For example, you could sell three, your IRA could sell three, your spouse could sell three, and his or her IRA could sell three; that’s 3+3+3+3. That’s assuming that the financial regulators don’t try to get you anyway.
I checked the Dodd-Frank website for enforcement actions for 2015 and there were no actions against people selling with owner-carry loans. Does that mean there were no “illegal” loans made? I can’t say, but I suspect it doesn’t. Selling owner-carry loans is still an excellent way to sell a property and keep income; just be extremely careful. These laws are beyond complicated and have numerous referrals to other parts of the laws and to other laws. Figuring everything out conclusively is all but impossible. We need to look no farther than the tactics of the Fair Housing enforcers to see what can happen to people who have done nothing wrong but have been prosecuted nonetheless and exonerated. Fighting a legal battle with the federal government unless you are Google or Microsoft will result in your bankruptcy win or lose.
No matter how you decide to sell, though, run everything by an attorney who knows real estate law and both these laws.