If you’re an investor who’d like to increase your commercial real estate holdings but lack the financing to do it, then a contract for deed might be a good choice for you.
I say might because although a contract for deed could help you own a property that would otherwise be out of your league, if it isn’t structured properly it could end up leaving you high and dry, with no property in sight.
What is a contract for deed?
A contract for deed is essentially a “rent-to-own” agreement between you and the seller of the property.
Instead of turning to a bank or private lenders for financing, the seller acts like a bank by carrying the financing of the loan. As the buyer, you make monthly payments to the seller, who holds legal title to the property until the loan is paid in full.
As the buyer, you receive equitable title, which means you have the right to lease the property and improve it as you deem fit. Even according to the IRS, the contract for deed is considered a sale, allowing you to claim any deductions or tax credits just as any other investment property owner would.
The interest payments can be deducted as mortgage interest, and you must report the transaction to the IRS.
There are several reasons why some investors find a contract for deed an attractive option.
As the seller, you can ask for a higher down payment, higher interest rates, and a higher sale price. All of these combined allow you to make more money than you would leasing the property. As a bonus, you no longer have the headache of managing tenants, filling vacancies, or any of the other day-to-day headaches of owning a commercial income property.
As a buyer, you have the opportunity to purchase a commercial property even if you’re unable to find financing from a bank or a private lender. You can start filling vacancies or leasing to tenants as soon as the ink on the lease is dry. As a bonus, you can even sell your interest in the contract for deed if you are successful in increasing the value of the income property.
Any profits you make due to value-adding or rent increases are automatically yours, and can be applied to payments to help you pay down the loan.
For both the buyer and seller, a contract for deed is quicker and costs less than a bank mortgage, or even a private loan. Closing the deal is also less expensive, since there aren’t any closing fees or settlement costs.
But like everything, there are some downsides to using a contract for deed instead of more traditional methods.
Risks of Using a Contract for Deed
No Foreclosure Rights
For buyers, one of the most dangerous risks involved in a contract for deed is the lack of buyer rights.
Although laws may differ depending on the state and some courts extend the rights as mortgage owners to a contract for deed owner, there are still states where a seller can exercise their right to foreclosure after just one missed payment.
In some states the time period to file a default notice is just 60 days, compared to the six month period afforded mortgage holders. This leaves the buyer with little time to negotiate with the seller.
Thus even if the buyer is 17 years into a 20 year contract, one missed payment can entitle the seller to foreclose on the property while claiming past payments as part of damages. Sellers can process a default more easily than banks can, which means hundreds of thousands of dollars down the drain for a buyer who may have little time to negotiate with an unethical seller.
Complicating matters, a contract for deed is generally structured so that a balloon payment comes due after just a few years of monthly payments. This means that owners must refinance the loan or risk losing the property entirely.
You’re Responsible for Taxes and Insurance
As a contract for deed owner you are now recognized by the IRS as the legal owner of the property, you will be responsible for paying all property taxes and insurance.
You’re also responsible for repairs, which means if a roof needs to be replaced or the property is damaged during a hurricane or other weather event, you’ll need to fork up tens of thousands of dollars unless you’ve done your due diligence beforehand.
The seller can still acquire liens and additional mortgages on the property
Shockingly, although the income property might be technically yours, the seller can still take out a mortgage, or acquire a lien on the property due to non-payment.
Thus even if due diligence showed the property was free and clear of any encumbrances, the seller is not obligated to keep the property free of liens or additional financial obligations for the life of the contract.
That means you, the buyer, could end shouldering the burden of an additional mortgage or lien on top of all your other financial responsibilities to the property… a situation that nearly all investors would find untenable.
In most cases, a contract for deed should you be a last resort.
A sandwich lease offers more buyer protections and far fewer risks, with nearly all the same benefits. If you must use a contract for deed, I strongly advise you to consult a lawyer beforehand.
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