Creating Carryback Financing Carryback financing in lieu of cash Chapter 1 This chapter introduces the concept of carryback financing and presents the various forms of documentation and risks of loss involved. Chapter 1 Outline Seller financing supports the price Tax benefits and flexible sales terms Variations on carryback financing Carryback risks for the seller Chapter 1 Terms Private mortgage insurance (PMI) Promissory note Seller financing Trust deed lien Wraparound security device m pl e All-inclusive trust deed (AITD) Credit sale Installment sale Nonrecourse paper Portfolio category income Seller financing supports the price Under most circumstances, the note will be secured by a first if the property is free of trust deed liens, or a second trust deed on the property being sold. Sa Most real estate sales involve the financing of some portion of the purchase price. During economic periods of plentiful and inexpensive mortgage money, the financing needed to fund the purchase of real estate is provided by an institutional or private lender, or more likely a mortgage banker. Thus, the carryback seller takes a secured creditor s position in the property for the amount of the price remaining to be paid, comparable to that of a mortgage lender. On closing, the legal rights and obligations of real estate ownership previously held by the buyer are shifted by the transfer to the buyer, while the seller carrying back a note and trust deed takes on the rights and obligations of a secured creditor. However, when economic conditions tighten and reduce the availability of real estate loans to previously qualified buyers, a seller hoping to sell his property and maintain his asking price must consider financing the purchase himself if he is to obtain a buyer. Carryback financing offers considerable financial and tax advantages for both buyers and sellers of real estate when the installment sales transaction is properly structured. Seller financing, also called an installment sale or credit sale, involves carrying back a note for the unpaid portion of the price remaining after deducting the down payment and the amount of the loan the buyer is assuming. The seller who offers a convenient and flexible financing package to prospective buy3
Creating Carryback Financing Creating Carryback Financing, 4th Edition ers makes his property more marketable and defers the tax bite on his profits. Qualified buyers who are rational are always willing to pay a higher price for real estate when attractive financing is available, regardless of whether it is provided by the seller or a mortgage lender. The carryback note, in a rising market, typically provides for a higher interest yield than is available on other investments with a similar level of risk. The converse is true in a recessionary market. Additionally, the seller has first hand knowledge about his security the property he is selling. For buyers, seller carryback financing is a situation that generally offers a moderate down payment, competitive interest rates, less stringent terms for qualification than those imposed by lenders and no origination (hassle) costs. Even the most qualified buyer will agree to a higher price when he can defer payment of the price through financing provided by the seller. This is especially true when the rate of interest on the carryback financ ng is competitive or below the rates lenders are charging on their purchase-assist loans, or when market prices (and rents) are trending upward which is economically equivalent to reducing the fixed rate of interest paid to the seller. pl e Tax benefits and flexible sales terms Mortgage lenders typically require a minimum down payment of 20% for the buyer to avoid the additional burden of qualifying for private mortgage insurance (PMI). In a carryback sale, the amount of the down payment is negotiable between the buyer and seller without outside influences, such as the requirements of the secondary mortgage market pools and PMI underwriters, which mortgage loan brokers and borrowers must contend with. Sa m Taxwise, it may be preferable for the seller to carry back a portion of the sales price, rather than be cashed-out on the sale. The seller taking a significant profit on a sale will be able to defer a meaningful amount of profit taxes, spreading the payment of profit taxes over a period of years. Thus, he avoids a premature tax bite in the year of the sale on his non-exempt transaction. Finally, the seller needs to understand the tax impact he will receive on his carryback financing is portfolio category income, without concern that the property sold was in another income category (passive/business/ personal). The seller converts his real estate equity into a note which generates a constant cash flow. Otherwise he is cashed-out of his equity, pays profit taxes (unless exempt 1031 or excluded principal residence) and reinvests what remains of his diminished after-tax sales proceeds. Also, the buyer is logically able to negotiate a lower-than-market interest rate in exchange for agreeing to the seller s higher-than-market asking price. The seller can have one or the other, but not both, if the buyer (or the buyer s broker) is knowledgeable and everyone involved is rational. Variations on carryback financing Seller financing is documented in a variety of ways, including land sales contracts, lease-option sales, sale-leasebacks and trust deed notes. Legally, the note and trust deed is the most certain, as well as the most universally understood, of the various documents for structuring seller financing. Importantly, the note and trust deed are combined to evidence the 4
Creating Carryback Financing Chapter 1: Carryback note in lieu of cash the existing financing. Here, the lender will need to approve of the seller carryback of a second trust deed. debt owed the seller and provide security for repayment on the seller s grant deed conveyance. The carryback documentation consists of: If the seller s borrowing power is greater than the buyer s, the seller might refinance the existing loan on the property himself and draw out a portion of his equity by placing new conventional financing on the property. a promissory note executed by the buyer in favor of the seller as evidence that a portion of the price remains to be paid for the real estate; and The buyer assumes the new loan and the seller carries back a regular note and junior trust deed for the remainder of his unpaid equity in the property. pl e a trust deed lien on the property sold to secure the debt owed by the buyer as evidenced by the note. Another alternative which reduces the seller s risk of loss and defers more profit taxes than a regular second trust deed note, is the all-inclusive trust deed (AITD) note, called a wraparound security device. m The promissory note states the exact amount and terms for repayment of the debt the buyer owes to the seller. On the other hand, the trust deed creates a lien on the property which acts as security for payment of the debt. The trust deed requires the buyer to maintain the secured property, and gives the seller the power to foreclose through a trustee s sale should the buyer default on note payments or trust deed conditions. Sa In an AITD carryback arrangement, the amount owed the seller on the carryback note is always secured by a junior trust deed (AITD) lien on the property. However, the note secured by the AITD is for a dollar amount equal to the balance of the entire purchase price remaining unpaid after the down payment, and is not a regular note limited to the amount of equity remaining unpaid after the down payment. The note and trust deed can be structured in regular or all-inclusive terms to meet the financial needs of the buyer and seller. For instance, if the real estate is encumbered by a first trust deed which a qualified buyer can assume with the lender, the seller can carry back a regular note secured by a second trust deed. The note will be for the balance of the seller s equity which remains unpaid after deducting the buyer s down payment. Thus, the AITD wraps the senior financing by including the dollar amount of the first trust deed in the principal amount of the AITD note. The buyer makes payments to the seller on the AITD note. In turn, the seller continues to remain responsible for making payments on the senior loan from payments received on the AITD. However, if the lender or servicing agent for the existing loan will not allow the loan to be assumed by the buyer, the buyer might arrange a new first trust deed loan to pay off 5
A chronology for syndication After reading this chapter, you will be able to: explain the activities of a syndicator needed to form a group investment structured as a limited liability company (LLC) for the acquisition and ownership of an income-producing property; and appreciate the steps taken by a syndicator to locate property, solicit investors, form an LLC and acquire income producing real estate. Consider a real estate broker or agent who gathers investors into a group for the purpose of buying, operating and ultimately selling income-producing property. Here, the broker is involved in a process known as syndication or syndicate brokerage. A broker who arranges the acquisition of income-producing property, organizes the group of investors and will oversee property management is known as a syndicator or manager. Unlike sophisticated real estate investors who tend to operate alone, individuals who join together in syndication programs are generally uninformed and inexperienced about: the legal aspects and accounting of co-ownership; the economic factors that influence the movement of real estate rents and values; the responsibilities of property management; and the compensation a syndicator or manager is entitled to receive. Chapter 1: A chronology for syndication 1 Chapter 1 syndication syndicator Key Terms Sample Learning Objectives Guidelines for forming a group syndication The activity of a syndicator to bring together a group of investors in coownership formed as a limited liability company to fund the purchase of a propety, and perform property management during ownership and eventually resell the property.
2 Forming Real Estate Syndicates, Fourth Edition syndicator An individual who solicits cash contributions from investors to fund a limited liability company which will acquire real estate for investment purposes. The broker acting as a syndicator, sometimes called syndicate brokerage, undertakes agency duties to: conduct a competent due diligence investigation into the property to be acquired; and fully inform each individual prospective investor of all aspects of the property and the investment program that might influence a prudent investor s decision whether or not to contribute funds for its acquisition. Checklist of syndicator activities When a broker or agent decides to solicit investors and form a limited liability company (LLC) in a syndication effort to acquire ownership and operate an income-producing property, they need to consider all the steps set out in the following chronological list of activities: Research available residential or nonresidential rental properties and select one to be investigated and confirmed as suitable to purchase. [See first tuesday Form 185 and 279; see Chapter 2] Editor s note Non-income-producing property acquired by an LLC will require modification of the documents in this material. Analyze the property selected, including its physical condition, the economic risks, environmental and natural hazards of the property s location, personal security, title conditions and property operating data. [See first tuesday Form 304, 314, 321, 324 and 352; see the first tuesday Income Property Brokerage suite of forms; see Chapter 22] Contract to purchase the property in the name of the syndicator under a(n): purchase agreement [See first tuesday Form 159]; option to purchase [See first tuesday Form 161 and 161-1]; or escrow instructions with a vesting provision allowing the syndicator to assign their right to purchase the selected property to the LLC. [See first tuesday Form 401] Open escrow in the name of the syndicator, not the LLC, as the buyer. Prior to closing and after the LLC has been formed, the syndicator will assign their right to buy the property to the LLC. [See first tuesday Form 161 and 401] Complete a due diligence analysis and confirm the seller s disclosures regarding the condition of the property s improvements, operations, location and title. [See Chapter 2] Apply for new financing or an assumption of the existing financing as called for in the purchase agreement. [See first tuesday Form 159] Review plans for the formation and management of an LLC entity with competent legal and accounting advisors. [See Chapter 6 and 19] Prepare the investment circular (IC), subscription agreement, LLC-1 (Articles of Organization) and LLC operating agreement, along with their exhibits and addenda, naming the syndicator as manager of the LLC. [See first tuesday Form 371 and 372; see Chapter 19] Sample
Chapter 1: A chronology for syndication 3 Deliver copies of the IC to prospective investors to solicit them to become members and fund the LLC so escrow can close and the property be acquired. Obtain the signature of each investor on a separate subscription agreement and the signature page of the LLC operating agreement, and receipt of their funds by the syndicator or escrow. [See first tuesday Form 373] Enter into a property management agreement to employ a syndicator to manage the day-to-day operations of the property. This agreement needs to be signed by each investor who became a member of the LLC. [See first tuesday Form 590] Arrange mortgage financing and sign loan documents for an assumption of an existing loan(s) or the origination of a purchase-assist loan, either in the name of the syndicator or on behalf of the LLC, as demanded by the lender. File the LLC-1 Articles of Organization, prepared and signed by the syndicator, with the California Secretary of State. Assign the syndicator s right to purchase the property to the LLC in an amendment to the escrow instructions, and vest title to the property in the name of the LLC on closing. [See first tuesday Form 370 or 401-2] Fund the purchase price and closing costs from cash contributions received from the members of the LLC and mortgage financing. Close escrow and take possession of the property. Send copies of all closing documents to each member of the LLC. File an LLC-12 with the Secretary of State within 90 days after filing the LLC-1 and biennially thereafter, and identify the manager as the agent for service. Operate the property on behalf of the LLC during the LLC s ownership of the property and distribute earnings to the members. Sample Lastly, the syndicator will resell the property when its ownership no longer meets the objectives of the investment group, or when the initial goal was to sell or exchange the property after a period of time. Checklist of syndicator activities, cont d Resale of the property The manager will negotiate the sale and the net proceeds to be distributed to the members on closing. All these activities will be discussed in greater detail in later chapters of this material.
4 Forming Real Estate Syndicates, Fourth Edition Chapter 1 Summary The process of syndication occurs when a real estate broker or agent gathers a group of investors together to form a limited liability company (LLC) for the purpose of buying, operating and ultimately selling incomeproducing property. A broker who arranges the acquisition of incomeproducing property and organizes the group of investors is known as a syndicator or manager. A broker acting as a syndicator undertakes the agency duty of investigating and fully informing each individual prospective investor of all aspects of the property and the investment program that might influence a prudent investor s decision to contribute funds. Chapter 1 Key Terms When forming an LLC for the acquisition and ownership of an incomeproducing property, the syndicator performs numerous activities, including but not limited to: researching available properties and selecting one to be investigated as suitable for purchase; analyzing the property selected, including its physical condition, the economic risks, environmental and natural hazards of the property s location, personal security, title conditions and property operating data; contracting to purchase the property in the name of the syndicator; opening escrow in the name of the syndicator as the buyer then assigning their right to buy the property to the LLC; and reviewing plans for the formation and management of an LLC with competent legal and accounting advisors, and completing the required documents for formation. Sample syndication...pg. 1 syndicator...pg. 2
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