Real Estate Strategies in a Post-Pandemic World, Part 3
In parts 1 & 2, we considered refinancing and a 1031 exchange. In Part 3, we are taking a closer look at an Installment Sale. This option is a hybrid solution to disposing of assets that have little or no debt at the time of sale. The owner of the property becomes a lender and finally gets to experience what its like to be the bank for a change. In an installment sale, the buyer and seller agree on a price, the down payment and the terms of a senior loan in the form of a promissory note in favor of the seller, secured by a 1st Deed of Trust on the property being sold.
The parties can agree on terms that suit one another without the restrictions or limitations imposed by conventional third-party lenders. The owner has the same opportunity to evaluate the creditworthiness of the borrower, and the collateral for the loan is an asset that he knows well, having owned it himself for many years.
In the event of a default, you (the former owner and current “bank”) take the property back through foreclosure and then free to restart the process with another buyer. Many property owners see the installment sale as less risky than exchanging into another property because the asset securing the loan is one they are already familiar with. In this day of scarce supply, exchangers are often forced to buy assets in markets and of a type they are not as familiar with so an installment sale can be an attractive option.
Installment sales are particularly popular with investors who are looking to streamline and simplify their portfolios. As a lender, you do not have the management responsibilities and none of the maintenance risk that you had as the owner. When the property is sold, all the risk becomes the new owners to bear and buyer’s today are ready and willing to take it on just to get their hands on a property.
So, for property owners unwilling or unable to take on expensive items of deferred maintenance like roof and HVAC replacements, the installment sale is a good option because they are essentially replacing their rental income with loan payments that carry none of that risk.
In fact, the only significant risk is having to take the property back from a defaulting borrower at a value less than the remaining balance of the loan. This is very unlikely assuming a reasonable down payment was made when the property was sold.
You’re probably asking, “where does Uncle Sam fit into this scenario”? The answer is it’s a pay-as-you-go affair. You will consult with your CPA and each year you will pay a portion of your tax liability equal to the percentage of your gain that you receive. So, if you accept a 20% down payment and carry the balance, you pay 20% of your total tax liability, plus tax on the principal portion of the loan payments in the same year. The tax must still be paid, but some find it more palatable to pay overtime. Interest earned on the loan is taxed as ordinary income just as rental income would be.
You will need to accept the fact that your yield will be fixed for as long as the loan is in play, but if the idea of a monthly deposit into your bank account is appealing, then the installment sale might be the right play for you.
The borrower will get the benefit of further price appreciation, but will also be taking on the other risks and responsibility that go with property ownership.
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