Understanding Seller Financing: Key Questions and Legal Considerations

Seller financing, also known as a seller “carry back,” is when a property seller extends credit to a buyer to assist with the purchase. This approach can simplify transactions but requires compliance with various state and federal regulations. Here’s an overview of crucial points and common questions regarding seller financing.

Key Questions to Consider in Seller Financing

1. Specific Disclosures:

   • California law mandates specific disclosures for certain seller financing transactions. For instance, the Seller Financing Addendum and Disclosure (C.A.R. form SFA) is necessary for 1-4 unit residential properties when an arranger of credit is involved.

2. Arranger of Credit:

   • Typically, the buyer’s real estate agent acts as the arranger of credit. This role can be played by anyone who is not a party to the sale and who is involved in developing or negotiating credit terms and receives compensation for their services.

3. Balloon Payment Disclosure:

   • If the loan involves a balloon payment, a specific disclosure is required. A balloon payment is defined as a final payment significantly larger than previous payments.

4. Broker Licensing:

   • Brokers involved in seller financing transactions may need a Mortgage Loan Originator (MLO) endorsement under certain conditions.

5. Prepayment Penalties:

   • Seller-financed loans can include prepayment penalties, but there are specific restrictions and conditions under California law.

6. Late Fees:

   • Seller financiers can impose late fees, but these are capped by state regulations. For owner-occupied residential properties, the late fee cannot exceed 6% of the installment due or five dollars, whichever is greater.

Disclosures

1. Disclosure Requirements:

• • Sellers must provide various disclosures depending on the type of financing extended. Notably, a specific disclosure is required for 1-4 unit residential properties when seller financing is arranged by a credit arranger.

2. Balloon Payment:

• • If a balloon payment is involved, the disclosure must include details about the payment amount, due date, and rights to refinance.

3. Adjustable Rate Loans:

• • If the seller financier makes more than 10 loans in a year, they must provide an adjustable rate disclosure, which includes information about how the rates can change over time.

4. Servicing Transfers:

• • If the loan servicing is transferred, the seller financier must notify the borrower with details about the new servicer and payment instructions.

5. High-Cost Mortgages:

• • Federal and state laws require additional disclosures for high-cost mortgages, which include loans with high interest rates or fees.

Licensing

1. Seller Financier Licensing:

• • Generally, seller financiers do not need to be licensed with the Department of Real Estate (DRE) unless they are “in the business” of making loans, defined as selling or exchanging eight or more real property sales contracts or promissory notes secured by real property in a year.

2. MLO Endorsement:

• • An MLO endorsement is required if the seller financier acts as a mortgage loan originator, which involves taking a loan application or negotiating loan terms for compensation.

Loan Restrictions and Prepayment Penalties

1. Ability to Repay:

• • Under the Truth-in-Lending Act (TILA), seller financiers must determine the borrower’s ability to repay the loan for certain residential properties.

2. High-Cost Mortgages Compliance:

• • Seller financiers must comply with both state and federal regulations on high-cost mortgages, which include additional disclosure and substantive requirements.

3. Prepayment Penalties:

• • Loans can include prepayment penalties, but these must be clearly stated in the loan agreement. There are specific limits on these penalties, particularly for owner-occupied residential properties.

Limitations on Note Provisions

1. Mandatory Arbitration and Waivers:

• • For transactions under TILA, notes cannot include mandatory arbitration clauses or waivers of federal statutory rights.

Late Fees

1. Imposing Late Fees:

• • For owner-occupied residential properties, late fees are capped at 6% of the installment due or five dollars, whichever is greater. Only one late fee can be charged for each late payment, and no late fee can be charged if the payment is made within ten days of the due date.

Interest Rates and Amortization

1. Interest Charges:

• • Seller financiers can charge low or no interest, but if the interest rate is too low, the IRS may impute interest based on the Applicable Federal Rate (AFR).

2. Negative Amortization:

• • Charging an interest rate that results in negative amortization or a non-fully amortizing loan can classify the seller as a loan originator under TILA.

Deficiency Judgment

1. No Deficiency Judgments:

• • California law prohibits deficiency judgments for seller financing, meaning the seller cannot pursue the borrower for the remaining debt after foreclosure or short sale.

Discrimination

1. Prohibition on Discrimination:

• • Seller financiers must comply with federal and state anti-discrimination laws, including the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA).

Security Instrument

1. Deed of Trust:

• • The extension of credit is usually secured by a deed of trust, but seller financiers can also use installment land contracts, which carry different risks and implications.

2. Risks of Installment Land Contracts:

• • Buyers face risks such as potential attachment of liens if the seller incurs judgments or fails to pay existing mortgages.

Taxes

1. Tax Compliance:

• • Seller financing transactions must comply with the Foreign Investment in Real Property Tax Act (FIRPTA) and capital gains tax regulations. Sellers can use the installment method to report gains over time.

2. Interest Income:

• • Interest received from seller financing is taxable and must be reported as income.

Subordination

1. Subordination Agreements:

• • These agreements allow subsequent loans to take priority over the seller’s lien. They are crucial for buyers seeking construction loans.

2. Risks and Enforcement:

• • Both executory and automatic subordination agreements must meet specific legal standards to be enforceable.

Additional Tips

1. Professional Assistance:

• • It is advisable for seller financiers to hire an attorney to draft necessary documents and consider using a loan servicer for managing payments and records.

2. Request for Notice:

• • Filing a request for notice ensures the seller is informed if a senior lien holder initiates foreclosure proceedings.

For more detailed information, speak with an attorney.

By understanding the nuances of seller financing, buyers and sellers can navigate these transactions with greater confidence and compliance with the law.