LAND CONTRACTS, PURCHASE MONEY MORTGAGES, AND THIRD PARTY FINANCING
Many of our clients wish to buy or sell real estate but are unsure how the purchase price should be financed. If the buyer does not have the entire purchase price in cash, the three main ways to finance a real estate transaction are by: (1) land contract; (2) purchase money mortgage; and (3) third party financing. Each of these methods of financing is legitimate and the decision simply depends on the facts and circumstances.
If the buyer insists on receiving the entire purchase price at closing, then the buyer will need to obtain a third party loan from a bank or other source. However, there are situations where the buyer cannot obtain a third party loan and does not have the cash on hand. In those situations, the seller may wish to consider a land contract or a purchase money mortgage.
A land contract is a written agreement between a seller and a buyer for the sale of real estate where the buyer makes payments over time and the seller continues to hold legal title to the property until the purchase price is paid in full. Both residential and commercial property can be sold on land contract. The seller will only deliver a deed when the buyer has paid the purchase price in full.
Land contracts are generally used when: (a) the buyer cannot get alternative financing (generally because of bad credit) but the seller really wants to get the property sold (e.g. cannot find another buyer); (b) family members are involved; or (c) there is a high interest rate environment and the seller is willing to accept a lower interest rate. In certain instances, a seller will desire a land contract because it provides an income stream over a period of time (receipt of principal and interest).
One of the most important issues to consider is the consequence of the buyer defaulting under the land contract. In most instances when a buyer defaults, the seller will initiate a “forfeiture” proceeding in district court. This will allow the seller to terminate the buyer’s interest in the land contract, take the property back, and retain all money that was previously received from the buyer.
The forfeiture process can take many months to finalize and, during that period, the seller generally is not receiving any payments. As a seller, it is very important to receive a large enough down payment at the beginning of the land contract to cover any potential legal fees, lost revenue, and for the buyer to have “skin in the game” to complete the payments under the contract.
Again, land contracts are a good idea in certain situations. However, the seller (and the buyer) should understand the issues and risks involved in these types of transactions.
Purchase Money Mortgages
A purchase money mortgage is essentially when the seller is acting as a bank in the sale of the seller’s own property. The seller will “loan” the money and the buyer will execute a promissory note and a mortgage. At closing, the seller will deliver a deed to the property.
There are two main differences between land contracts and purchase money mortgages. First, in a purchase money mortgage, the buyer will own the property immediately upon closing. Second, in the event of the buyer’s default, the seller will need to foreclose the mortgage (rather than forfeit a land contract). The foreclosure process generally takes longer to accomplish.
It is relatively rare to see purchase money mortgages since the seller wants to retain legal title to the property until the purchase price (and interest) are paid in full. However, when the buyer has a good credit record and insists on a deed at the closing, this may make sense to both parties.
There is definitely no “one size fits all” for every real estate sale transaction. There are also various tax implications to be considered that are outside of the scope of this article. If you need assistance in navigating through these real estate issues, you may want to consult with an attorney or other specialist in this area.
Scott A. Breen is an attorney and shareholder at Willingham & Cote’, P.C. in East Lansing, Michigan. Mr. Breen also has a Master of Laws degree (LL.M.) in taxation. He specializes in the areas of business and real estate transactions as wells as hospitality and alcohol beverage law. Mr. Breen may be reached at 517-324-1021 or firstname.lastname@example.org.