Note Solutions For You - Part 2

Table Of Contents
Mindset
Seller financing and secured promissory notes are a big part of what is considered creative real estate financing. The concepts involved are mostly used by real estate investors yet they can be valuable tools for business owners and residential home buyers and sellers.
The values and benefits required by various individuals lead to different courses of action.
Whatever category applies to you, you may find yourself in a situation where the financing you need is not available. Or you may not find desirable traditional financing soon enough. The best creative financing source available might be more costly than you want, but still allow you to make a profitable transaction.
The secured promissory notes that you create can be sold for cash. Either the entire remaining balance of the note can be sold or a partial sale structured to meet your needs.
When you are ready to sell your note or part of it, as a note broker NoteSolutions will do the work to maximize the value of your note.
Here are some ways that creative financing might work for you, along with related insights.
Pay Rent Where You Want To Own
In the “Mindset” section above I mentioned that residential home buyers and sellers can apply some of the same concepts used by real estate investors. I offered some of these ideas in How Do You Overcome The Barriers To Homeownership In 2024 And Beyond?
Another idea used by investors and business owners is sale and leaseback. A business looking for cash can sell the building they own and occupy. But they can continue to occupy the building by leasing it back.
If you are a first time home buyer, you could pursue a rent to own opportunity. These deals are also known as lease options. They involve two contracts. A lease to live there and an option contract giving you an option to purchase in the future based on terms agreed upon when the option contract is drawn up.
What if you find a house that you want to purchase and make it your first home. The house needs work and you're ok with that. The price is right and you have a vision for doing the work.
Then you find out that based on the condition of the property and your debt-to-income ratio you can’t get a bank mortgage. Now what?
You approach the owner and request a rent to own transaction. The owner says no.
You could look for private financing. What if you find a private lender, and the monthly payment you can afford doesn’t match the interest rate the lender requires?
How about sale and leaseback with a twist. Private lenders are also known to invest in real estate. So your mission is to convince the lender to purchase the home that you want and lease it back to you, with an option to purchase within an agreed upon time frame.
Of course this requires some work. You need to buy right. Find a property where the seller is motivated enough to give you a great price. Off market properties make this more likely.
The key point is that the deal you make will also give an investor a satifactory return to make this investment. Then you work with the investor to create a rent to own transaction that works for both of you.
If you find the right deal, you are well on your way to finding the private lender/investor who will work with you.
Undivided Interests
Here I’m sharing a concept that you need to research further on your own in order to utilize it.
“An undivided interest means that two or more persons have an interest in a property held under the same title . The undivided interest encompasses the whole property, and its holders have equal rights to the entire property. The undivided interest is not separated into parts or shares. Thus, no individual co-owner has exclusive rights to any specific portion of the property.”
“For example, if four persons own under an undivided interest 10 acres of land, each individual owner would have a 25% undivided interest in the entire 10 acres.”
Legal Information Institute-Cornell University
Whether you are an individual fixing and flipping properties, or a larger developer, financing often comes together in partnership with others. These arrangements have many variations and can utilize various legal structures. There will be times that the individuals may not agree on the legal structures to use in a particular investment.
An undivided interest offers an alternative way to acquire, finance, manage and dispose of property. The book “Advanced Creative Real Estate Financing: Breakthrough Success Strategies ” by Chuck Sutherland states the following Key Points:
“Undivided interest can provide a useful alternative to many traditional partnership types of joint ownership. This approach can also provide some valuable 1031 tax-deferred exchange benefits, as well as valuable estate planning benefits.”
“Undivided interests are freely transferable in the absence of any recorded or recordable agreement restricting transfer. That instrument could also be an Agreement for the Ownership, Operation, and Management of the property, or a provision in a mortgage document, or a Restrictive Covenant.”
“The Undivided Interest form of ownership also allows greater flexibility in defining your long-term freedom to to change with whom you own property, what kind of property you own, and even where you own property.”
Any profits that result from the property are divided based on the percentage of ownership. LIkewise expenses are shared.
For more information you may wish to review What is an Undivided Interest? at superfastCPA.
Is A Deferred Sales Trust A Good Solution?
This is an interesting topic because it ties together a number of concepts previously covered here at NoteSolutions. Whether you are selling a business, real property, personal property or land, how do you facilitate the sale and while doing so minimize taxes?
One option is a Deferred Sales Trust (DST). A Deferred Sales Trust is a legal agreement between the seller of an asset which has increased in value during ownership, and a trustee who takes ownership of the asset. The trustee sells the asset, invests the proceeds and makes periodic payments to the asset seller.
The DST is allowed by Internal Revenue Code 453 as an Installment Sale. Provided that it is properly structured., this permits the asset seller to defer capital gains taxes until payments are received.
Procedurally the asset seller finds a buyer, but can not complete the sale and take possession of the funds for this process to work. The seller with legal assistance structures the trust document and an installment payment agreement between the seller and the trustee. The trustee then completes the sale to the end buyer.
IRS code 453 covers the Installment Method which is the IRS approved way of reporting income from an Installment Sale. While IRS code 453 goes back to 1954 a DST is a more recent strategy that uses the capital gains tax deferral allowed by IRS code 453.
For tax purposes seller financing is referred to as an installment sale. An installment sale is a sale of property where you receive at least one payment after the tax year of the sale.
Because of the tax benefits it is desirable to defer capital gains. For example if you seller finance an asset sale, the proceeds come back to you in three forms. The interest you receive is taxable as ordinary income. Gain beyond your basis is taxed as capital gains. Return of basis is not taxable.
By comparison if you receive the full purchase price of your asset in one lump sum, all capital gains are subject to tax in the year of sale. Deferring capital gains by an installment sale spreads out capital gains tax through the years you are paid installments. The additional benefit is minimizing the actual tax rate by keeping you in a lower tax bracket.
While the details will vary based on your personal situation, What Are The Tax Implications Of Seller Financing? will help you understand the tax benefits of an installment sale.
When you are selling a business or a property seller financing offers these tax benefits in addition to others illustrated at NoteSolutions.com. The key benefit is to facilitate the sale.
A 1031 Exchange is another method to defer taxes. A 1031 Exchange is based on Section 1031 of the Internal Revenue Code. It allows businesses and investors to sell a property and reinvest the proceeds in a like-kind property of equal or greater value, while deferring taxes indefinitely.
If you are selling a business you might not want to offer seller financing. If you are selling real estate you may no longer desire to acquire more property to take advantage of a 1031 Exchange. So you could choose a Deferred Sales Trust (DST) as another way to defer taxes.
Keep in mind that by choosing a DST you are not offering seller financing. As I and others have pointed out, most small businesses are sold using seller financing. Likewise many real estate deals will not take place without seller financing. The better you understand seller financing the more usage you will find in it.
As you consider a DST be aware that this is a relatively new tax strategy. Exeter 1031 Exchange Services advises:
“However, contrary to popular belief and what you may have read in various articles published in hard copy or on the internet, there is no guidance from the IRS or Treasury regarding the Deferred Sales Trust. There was a Private Letter Ruling, but it was rescinded by the Internal Revenue Service.
And, although its promoters claim there have been numerous IRS audits and reviews, Investors can not rely upon this for guidance or support in the event they are audited.”
To implement a DST, the asset seller is the grantor of the trust. In order to meet IRS regulations, the grantor can not have actual or constructive receipt of any sales proceeds from an asset’s disposition.
So as the grantor of the trust you must utilize an independent trustee. You can not use a related party or someone you know well to handle your funds. The trustee must be independent of the asset seller.
What about the costs involved? Here’s one view from Sera Capital:
“On average, setup fees and maintenance fees may be higher than other tax deferral strategies. An attorney usually charges a fee to set up the trust, often 1.5% of the asset’s value of the first $1 million and 1.25% of anything over $1 million. Additionally, the independent trustee’s fee may be 0.5%, and an additional investment advisor’s fee may range from 0.5% to 1% of assets under management, although these fees may be negotiable. Lastly, because of the nature of DSTs, there's usually an annuity component to guarantee the principal. This is a full-commission product, and due to insurance regulations, there is no way to reduce or credit commissions to clients.”
As the seller of the asset which becomes the basis of the trust, you become a creditor of the trust, not a beneficiary. So if the trustee mismanaged the funds what is your recourse?. On the other hand if there are additional investment returns beyond the installment payment agreement, those funds go to the trustee.
Be careful based on what other knowledgeable sources advise, and how sales materials can be worded to sway facts in their favor. While you are doing an internet search for information, will you understand the difference? Also recognize that some of the advertised benefits actually come from other estate planning tools. And beware of inaccurate answers from AI.
Here is a concluding thought from the Forbes’ article “Consider All The Implications Before Using A Deferred Sales Trust”:
“In summary, the independence requirement for trustees and wealth managers can pose significant challenges, while the costs involved may severely affect overall returns. Moreover, you need to have a good understanding of your promissory note’s tax implications. You must plan accordingly for these tax responsibilities alongside any form of payment that may be involved.”
Trade Property For Notes Or The Reverse
Are you an investor who both owns property and also buys mortgage notes? Or have you just started to take an interest in the benefits of owning first lien notes?
You can trade a property to acquire notes. Depending on the details, this may require the addition of cash to the property to purchase the notes.
This example can become more desirable if you have a property that you want to sell, but still have an interest in owning real estate. Owning notes can be considered owning real estate without tenants.
The notes can provide an excellent return on your investment. A preferred approach is to have the notes handled for you by a note servicing company, which makes the notes an even more passive investment.
Here are two companies that provide such services:
There is additional benefit in this example if you want to sell a property, but the timing is less than ideal to receive the highest value from the sale. The property involved could be residential, commercial or land. To sell the property you will add cash to what you are offering for sale.
The purchaser might be in a situation where they need cash for some immediate purpose. So you can solve both problems by offering your property plus cash in return for a promissory note or notes.
Timing can make this scenario more realistic for you. Let’s say that you are the purchaser in this example and you need cash to make a balloon payment. Banks are not lending on the type of property that you own. But you do own notes secured by other real estate. So you trade your note or notes for the property for sale plus cash.
This is a creative way for the purchaser to get the money needed to pay off the balloon.
Frequently Asked Questions
What are notes in real estate?
Notes in real estate are secured promissory notes. They are a promise to pay for real estate based on the terms of the note. The note is a document that corresponds with a mortgage or deed of trust. The mortgage or deed of trust is the security agreement which provides collateral for the note. The note includes terms such as the amount of the note, interest rate and payment schedule.
Is a security agreement the same as a lien?
A lien is a claim by one party against the property held by another. If you have a mortgage with a bank, the bank has a claim against the property until the mortgage is paid in full. The mortgage document is a security agreement. The holder of the mortgage such as a bank has a security interest in the property as collateral to secure a debt. So a security interest not a security agreement is the same as lien.
Do security agreements need to be recorded?
While recording a security agreement is preferred, whether it needs to be recorded will depend on the type of security agreement. Mortgages are required to be recorded in most states in the U.S. One benefit is showing the order of a security interest such as a first mortgage versus a second mortgage. The recording process secures the lien against the mortgaged property. The other key benefit is to provide public awareness which protects potential new buyers and lenders.
Conclusion
Whether you are an investor doing many transactions or looking for your first home, seller financing and other creative financing concepts will help you make a deal. The other party to the deal may not be offering what you want, but if you understand what’s possible you can create solutions.
As a note broker I am pleased to offer these insights. When the time is right for you to sell a note or to do a partial sale, please submit a worksheet to NoteSolutions.us so I can provide the cash you need.
References
- Photo by Dominic Kurniawan Suryaputra at Unsplash
- Internal Revenue Code 453
- Why “Deferred Sales Trusts” Can Be A Risky Way To Defer Taxes On A Business Sale
- Step-By-Step Guide To Setting Up A Deferred Sales Trust
- Advanced Creative Real Estate Financing