Seller carryback financing, also known as seller financing, occurs when the seller of a property provides financing to the buyer instead of the buyer obtaining financing through a bank or mortgage company.
In this article, we discuss the basics of seller carrybacks. We’ll get into how this creative financing method works, what the benefits are, and what risks sellers need to know about when using this method to sell their property.
What is Seller Carryback Financing?
Seller financing in a real estate transaction means the seller takes on the role of a bank or lender and extends better credit terms to the buyer for the purchase price of the property, minus any down payment the buyer will provide to the seller.
And since buyers don’t have to negotiate with banks, they too can benefit from a seller carryback deal by avoiding paying loan origination points, appraisal fees, and any other fees that come with traditional financing.
Here are the main terms that are typically negotiated in a seller carryback deal:
- Purchase price of the property
- Down payment amount
- Interest rate
- Length of the loan
- Any prepayment penalties
Once these terms are established, the buyer will sign a promissory note with the seller, provide a down payment, and begin making instalment payments over time. What this means for the seller is that the sale proceeds are received over time instead of a lump sum.
How Carryback Financing Benefits a Seller
If a seller is having trouble selling his property because interest rates are high, seller financing can help because the seller can offer a better rate than the banks. As a result, it makes the transaction smoother. Here are some of the benefits for a seller.
Defer Capital Gains Tax
Carryback financing deals enable the seller to postpone paying capital gains taxes. As a commercial property seller, you would generally be subject to capital gains tax on the sale of your property if you earned a profit. The IRS taxes between 15% and 28% on capital gains you make on assets sold after at least one year.
An installment sale, a.k.a. carryback financing, means the interest payments you receive as a seller are taxed like rent, and the principal payments are taxed like partial dispositions (partial sale). This means that your income over time will be recognized on the portion of cash you receive that is attributable to the gain from the property sale.
You can calculate this percentage at the time you sell the property by dividing your gross profit by the total sales price. You will apply this percentage each year to the cash you receive to determine the amount of your deferred gains.
A Hypothetical Transaction:
If you sell a commercial property for a total sales price of $600,000. The property has a cost basis of $100,000. With a standard financing arrangement, you would recognize a gain of $200,000.
Alternatively, if you use seller carryback financing under an installment arrangement with $60,000 in principal to be paid over the next 10 years, you would recognize $20,000 in income every year for those 10 years. ($200,000/$600,000 x $60,000).
Income Stream
In comparison to other investments, seller carryback financing can also provide a reliable monthly income without the hassles of being a landlord.
Higher Sales Price
In a seller carryback scenario, the seller is able to market the property at a higher price because of their ability to offer more favorable lending terms.
Lastly, since there are no banks involved, this method drastically reduces the escrow period, which is beneficial for both parties.
Risks of Seller Carryback Financing in California
Seller carryback financing comes with inherent risks. For sellers, that means a buyer could default on the loan. And for buyers, it usually means they’ll pay a higher price for the property. We highly recommend parties consult with a legal and tax professional to review all liabilities and exposures when involved in this type of transaction.
Seller Carryback Financing Pros and Cons
The seller carryback financing strategy has pros and cons for commercial property sellers and buyers.
| Pros | Cons |
|---|---|
| There are no guidelines or regulations, meaning sellers have the flexibility to negotiate interest rates and loan terms. | It is challenging to find sellers willing to provide financing. |
| Excellent for properties that don’t qualify for conventional mortgages. | This is not a government-regulated loan, which means it doesn’t benefit a buyer’s or seller’s credit. |
| Provides financing for buyers who cannot access standard bank loans. | Typically have a maturity date, requiring a balloon payment or refinancing at the end of the term. |
| Faster processing and closing than traditional loans, and the seller typically absorbs closing costs and extra fees. |
Who is Eligible for Seller Carryback Financing in California?
There are several factors that affect a buyer’s eligibility for financing. An experienced local commercial real estate broker can help you evaluate potential buyers and guide you through the process. Remember, there’s no bank or institution that approves this type of financing; it’s completely up to the seller.
What Sellers Should Look For When Structuring a Seller Carryback
Before sellers consider this type of deal, you must own your property free and clear of any existing mortgages. If you still have a mortgage on your property, you won’t be able to offer a seller carryback deal to a buyer. Assuming you do own your property free and clear of any mortgages, here are a few important things to keep in mind for a seller-carry deal:
- As a seller, performing due diligence before entering into a carryback financing agreement is critical to protecting yourself from bad actors who may default on the loan. Sellers should thoroughly examine the buyer’s financials, tax returns, and bank reserves.
- Ask the buyer for proof of their income, credit score, and other financial information to ensure they can make regular, on-time payments. You may need to examine the buyer’s tax returns to verify their income or a copy of their credit report to identify red flags like a history of late payments or defaulting on loans.
- As a seller, you may also review the buyer’s bank statements to ensure they have sufficient bank reserves to cover the promissory note.
- As a non-financial consideration, investigate the buyer’s reputation in the real estate industry. Ensure they have a good track record of managing properties, such as making necessary repairs and upgrading existing commercial investments.
In his most recent seller carry-back deal, Alex Matevosian visited the buyer’s existing business location to inspect the buyer’s operation. Observing the buyer’s operation, customer base, and overall space can teach you a lot. Let Alex and his team help you procure and qualify any future buyers if you’re considering selling your property with a seller carry.
Does the Type of Property Matter?
There are no standardized regulations regarding the types of properties that can be purchased or sold under seller carryback financing. Commercial properties such as office buildings, retail spaces, and warehouses can all be sold using seller carryback financing.
What Elements of Seller Carryback Financing Are Negotiable?
All elements of a seller carryback loan are negotiable, including interest rates, purchase price, down payment amount, and length of the loan. Sellers can set an interest rate that yields a fair profit. The average interest rates on seller carry notes range from around 5% to 15%.
The following example illustrates a real property Alex’s team helped close for a buyer in North Hollywood, CA.
These are the main negotiated terms in a seller carry deal. The seller in this deal, will receive $11,025 in interest-only payments for 60 months.
- Purchase Price: $3,150,000
- Down payment: 20%. The seller receives $630,000 upon the close of escrow.
- Term: 5 years (60 months)
- Interest rate: 5.25% (interest only)
Documents for Seller Carryback Financing
Buyers typically need to provide proof of financial stability. This may include submitting the following documents to a seller:
- Credit score and credit history report
- Bank statements
- A statement listing your assets, such as properties, cars, and investments
- Tax returns
- Proof of income (Form W-2 or Form 1099)
- Statement of income and net worth
Calculating Down Payment and Interest Rate
When seeking approval for a carryback loan, most commercial loans require a 25% down payment, but carryback loans have negotiable down payment terms. Discuss down payment options with the seller based on what you can afford and what they will accept.
The interest rate is 100% negotiable and decided between the seller and the buyer. For example, the seller may prefer a fixed or adjustable-rate loan.
For most buyers and sellers, a fixed-rate loan is preferable because it offers predictability for both parties.
Need More Details? Speak with Alex Matevosian
Alex specializes in the sales and leasing of commercial and industrial properties in Los Angeles County and surrounding areas.
While it can be advantageous for both parties, there are financial and legal risks. It’s important for buyers and sellers to weigh their options and seek professional legal and financial advice before making any decisions.
For a free 30-minute consultation on the benefits and risks associated with seller carry financing, please give Alex a call at 818-482-3830. Alex specializes in the sale and leasing of commercial and industrial properties in the greater San Fernando Valley.