Understanding Seller-Carried “Wrap-Around” Transactions

With the slowdown in real estate and the increasing difficulty in obtaining bank financing, some home sellers have begun to consider carrying the financing themselves with “wrap-around contracts” and “wrap-around trust deeds.”[1]

They work like this:

• The seller has one or more existing trust deeds on his/her property.  Say the total underlying mortgage debt is $350,000, with a blended (i.e. combined) interest rate of 5.50%.  The sellers want, or need to move, perhaps to relocate for other employment, or other important reasons.  However, due to the marketplace, they cannot sell their home. On the other side of the equation, buyers who have recently come out of a distressed transaction, such as a short sale, may not be able to qualify for financing – even though they have steady jobs and good income.

• Together, the sellers and buyers agree to enter into a land sale contract or a note and trust deed.[2] The contract/trust deed and note would be for the full purchase price, say $550,000, less earnest money deposit and down payment of $100,000.

• The sellers will “carry the paper” – there is no third party financing.  By mutual agreement, the underlying lenders are not notified of the transfer. The term of the arrangement is for a relatively short period, such as three or five years, with the idea that the buyers will refinance and pay off the sellers.  During this time, the buyers are to pay the sellers on the secured indebtedness of $450,000, amortized over a thirty-year term at an agreed-upon rate of interest, 6.50%, which is one percent more that the 5.50% blended rate on the underlying loans.

• Thus, while the sellers pay 5.50% on their mortgage debt of $350,000, they receive a stream of payments at 6.50% on $450,000.

If they used a wrap contract, a memorandum of that contract will be recorded on the public record.  (See, ORS 93.645) The memorandum is a very abbreviated version of the entire contract. If they used a note and trust deed, the latter document will be recorded.  In both instances, the act of recording protects the purchaser against the risk that a lien creditor of the seller could later record a claim against the property that would take priority over the buyers’ recorded interest.

What are the risks and rewards in this arrangement?  Here is a list of the more immediate ones:

• The obvious risk to both parties is that the lender – primarily the first lender – may find out and accelerate the indebtedness for violation of the anti-transfer provision of the trust deed.  This is known as the “due-on-sale” clause.  How real is this risk today?  Frankly, I haven’t heard of any cases in the last few years.[3] This is not to say a lender would not foreclose if they found out.  But contrary to 30 years ago, when these transactions were more common, lenders were foreclosing.  But that was when interest rates were approaching 20% and homes actually had equity.  By calling a loan due, the banks knew they could force the seller or buyer to refinance and pay off the existing low interest rate loan, thus allowing the lender to lend the money out again at a higher rate.  At worst, the bank foreclosed, but it normally was for an amount significantly less than the value of the home.

• The “reward” to the sellers is that they get out of the property, albeit at some remaining risk, have some of their equity back, have “arbitraged” the stream of payments[4], so they can move on.  However, since the loan is still in their names, they may face some difficulty in securing a loan to purchase another residence.

• The “reward” to the buyers is that they have acquired a property they could not have financed conventionally, due to credit and qualification issues.  However, when the balloon payment comes due, the buyers will have to hope that their credit picture, the credit market, and the housing market, all improve so they can obtain financing to pay off the underlying loans.  Otherwise, they will default to their seller and lose their $100,000 downpayment.

• The big issue between the sellers and buyers is who will assume the risk of the bank calling the loan? It is the seller’s credit that could be damaged should a foreclosure result, if the buyers are unable to secure funds to pay off the accelerated underlying loan(s).  Regardless of risk, both parties will have to address the reality of this issue before entering in the wrap transaction, and it should be clearly described in their written agreement.

• One big trip wire is casualty insurance.  If the buyers want to insure against the risk of fire or other such risks[5], they may have difficulty if the insurance company demands that the current lender(s) be named as co-insured.  Similarly, and change in the sellers’ insurance, such as an additional insured, will, of necessity, result in notification to the lenders – who will immediately see that the property has been transferred.  Thus, the buyer will need to secure their own independent policy of insurance, which, as noted above, may be difficult to do.

• Another issue is how the lender will be paid after the wrap is completed.  In most cases, the sellers will continue to pay.  But this means that the buyers’ payments will have to come in earlier than the sellers’ go out (since most sellers want to use their buyer’s funds to service the remaining debt).  This requires enough lead time for the buyers’ payments to be received, deposited, and collected, before the sellers’ check to the bank clears.  Timing is critical.

• Tax and insurance impounds should not be forgotten.  Specifically, the sellers likely will have three, four, or more months in property tax impounds that remain with the underlying lender.  Some sellers forget about this, but it should be repaid by the buyers at the time of closing. Then, when the balloon is paid off, the buyers get to keep the extra reserves then held by the bank.

• If the lender should foreclose (either because of the transfer itself, or because the buyer cannot continue making payments and the seller cannot cover the mortgage payments) there could be a serious income tax issue for the seller.  Under Section 108 of the Internal Revenue Code, most owners of a primary residence will not be taxed on the cancellation of debt that may occur, should the property be foreclosed or sell for less than the remaining mortgage indebtedness.  However, in order to gain that protection, the following must occur: (a) The home must have been used as a primary residence for two of the last five years; (b) Both loans (if there are two) must have been used to build, buy, or substantially improve the home; and (c) This safe harbor protection under the Mortgage Forgiveness Debt Relief Act of 2007 is scheduled to expire on December 31, 2012.  Thus, a foreclosure after 2012 could result in a state and federal tax being levied on the seller if (a) there is and debt cancellation or (b) the “two of the last five years” calculation period had expired.

Interestingly, notwithstanding these risks, some sellers and buyers today are agreeing to wrap transactions.  In the balance, it would seem that sellers are at greater risk than buyers, since it will be their credit, and possibly their tax liability that could be affected, should the buyer default.

For Realtors® whose seller-clients are consider this option, “caution” is the watchword.  In all cases, both parties should always be encouraged to secure independent and competent legal counsel familiar with these issues.  Also, Oregon Realtors® should check with their managing brokers to determine company policy.  Due to the several risks inherent in wrap transactions, some companies may simply forbid their brokers to become involved.

By now, most Realtors® have heard the rumblings about defective bank foreclosures in Oregon and elsewhere.  What you may not have heard is that these flawed foreclosures can result in potential title problems down the road.