Is Seller Financing Right for Your Next Transaction?
The commercial real estate market has been steadily making improvements since the 2008 financial crisis. While traditional financing is readily available, seller financing may be another viable option for many investors. Here’s what you need to know.
Using seller financing
In seller-financed transactions, the seller generally gives the buyer a secured loan to finance part of the property’s purchase price. Seller financing advantages include:
- Expanding the pool of qualified buyers,
- Fostering greater flexibility when negotiating loan terms, and
- Increasing the chances of producing an outcome that meets both parties’ needs.
A seller-financed mortgage loan is secured by a lien on the property; a seller-financed mezzanine loan is secured by a pledge of ownership interests in the purchasing entity. Sellers might use this type of arrangement to obtain cash to pay for operations or debt, or to satisfy investor redemption requests. Or, a seller might choose seller financing to raise capital for other business ventures or to generate liquidity for the overall portfolio.
Reviewing seller risks
Sellers must be cautious when entering into such transactions. First, sellers must ensure that they’re qualified to become a lender. Reviewing their organizing documents, any joint venture, fund or upper-tier debt agreements, and applicable regulatory requirements should help sellers determine if they’re allowed to make and hold loans. If needed, sellers can amend some documents to make them eligible to lend.
Sellers must comply with all applicable lending laws, including those related to state licensing, debt collection and securities. They should also assess whether they possess the needed capabilities to originate and service loans. Finally, sellers must determine if the property is appropriate for this type of arrangement. A financially robust property will produce optimal results for the buyer, seller and any third-party lender. However, a property with many vacancies may not generate the returns needed to allow the buyer to pay off its obligations to the seller and lender, let alone reap a profit.
Another consideration is to be sure that any current loan on the property gives the seller the right to prepay without incurring a penalty. The cash proceeds from the sale should be adequate to pay off the existing loan.
Additionally, transactions involving third-party lenders will likely place the seller in the position of a subordinate lender. However, a seller in these circumstances might be able to command a higher interest rate because of its increased risk.
Finally, once a buyer is found, the seller must conduct thorough due diligence to confirm that the buyer is creditworthy. The seller will need to review the buyer’s financial statements, credit history, tax returns and similar records. Sellers should also request banking and business references.
Considering tax effects
Seller-financed transactions have some potentially vexing tax implications. If, for example, the seller is a real estate investment trust (REIT), it must determine whether the loan constitutes a “qualifying asset” that generates “qualifying income.” A seller-financed loan could jeopardize the seller’s status as a REIT under the Internal Revenue Code (IRC) if the loan isn’t properly structured.
The IRC’s original issue discount (OID) rules can also come into play if the loan’s redemption price exceeds its issue price. If OID does enter the picture, the seller must recognize interest income, and the buyer must recognize interest expense, based on economic accrual. Under certain circumstances, a seller might be required to pay interest on the deferred capital gains tax liability typically enjoyed under the IRC’s installment sale provisions.
Real estate investors should take the time to review any available seller financing. Address the issues discussed in this article with your financial and legal advisors before making a final decision.