By Benny L. Kass
Saturday, August 26, 2006

In a slow real estate market, would-be sellers and potential buyers begin to think about creative financing.

Last week, I wrote about transactions in which the seller holds the entire mortgage, a type of arrangement that is treated as an installment sale for tax purposes. This type of creative financing works best when the seller has no mortgage or a small one.

There's another approach, known as a wrap-around mortgage, that can be used in some situations where the seller has a larger existing mortgage.

Here is how it works. Say you want to sell your house for $500,000 and have an existing $200,000 mortgage loan with an interest rate of 5 percent. You have found a buyer who has sufficient income but might have difficulty obtaining a mortgage.

You agree to sell the house. At settlement, you will sign a deed over to the buyer to be recorded on land records. Your buyer will give you $50,000 in cash for the down payment.

But instead of taking out a standard mortgage for the rest of the purchase price, the buyer will sign a promissory note to you for $450,000, the difference between the sales price and the down payment. This loan will carry an interest rate of 6 percent. The monthly payment, based on a 30-year amortization, would be $2,698.00. This note will be secured by a second deed of trust recorded against the property.

The buyer would then make the monthly payments directly to you. You in turn would continue to make your payments to your lender on that $200,000 first mortgage.

From the buyer's point of view, these payments would be just as they would be from any commercial mortgage lender, although at a lower interest rate. Additionally, the buyer would not have to pay the various lender closing charges.

As the seller, you would make a small profit. You are paying off that old 5 percent mortgage but are receiving 6 percent from their buyer.

Even more important, offering this type of financing might be the key to making the sale.

This kind of transaction is called a wrap-around mortgage because the second trust is wrapped around the first. It has some risks, though.

First, the seller should have an assumable mortgage on the property. While these are not as common as they once were, there are still many Department of Veterans Affairs or Federal Housing Administration assumable loans on the books. Some adjustable-rate mortgages are also assumable.

Otherwise, if the seller's lender learns that the property has been sold to a third party, that lender may decide to call the loan, using the so-called due on sales clause.

There are, of course, people who will take a chance that the lender will not learn of the sale or will allow the assumption to go forward. But sellers must fully disclose the risks to their prospective purchasers.

Even if the seller's existing loan is fully assumable, what happens if the buyer defaults on the mortgage obligations to the seller? The seller might have to foreclose on the property. If the buyer has filed for bankruptcy protection, this could take a long time to be resolved.

The buyer takes a risk, too. If the seller does not make the mortgage payment -- for whatever reason -- to the original lender, the lender could foreclose on the property. (Even though the buyer is on the title, the prior lender remains in first place on the land records, and is legally in front of the buyer.) Accordingly, buyers should insist that they receive proof the mortgage payments are being made. Indeed, some buyers may even insist that a neutral party, such as a bank or lawyer, make the payments on the first mortgage.

With a wrap-around mortgage, the seller receives the benefits of the higher interest payments. Accordingly, the seller may insist that the buyer cannot prepay the loan without a penalty. Obviously, buyers may object to such a condition, because it inhibits their right to refinance or even sell the house.

What are the taxable consequences of a wrap-around mortgage?

The second trust will be recorded on land records in the property's jurisdiction. This allows the buyer to deduct all the interest that is paid on a yearly basis. Additionally, because the buyer will be paying the real estate tax, this can also be deducted.

However, there is a minor problem if the original lender is escrowing money for real estate taxes. At the end of each year, the lender will send the IRS and the seller the appropriate 1099 form that shows the interest received and taxes paid. These deductions properly belong to the buyer, so an explanation will have to be given to the IRS as to the nature of this transaction.

Under proper circumstances, a wrap-around mortgage is a potentially useful tool for buyers and sellers. However, if the seller can pay off the existing loan, it would be less risky for the seller to hold the entire first mortgage.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.