Seller financing provides a viable alternative to parents who would like to transfer their home to a child but can't afford to give it away. Seller financing is also an option when the child doesn't qualify for a conventional mortgage.
Parents want what's best for their children and will often do everything they can to help them. One way many parents end up helping their kids is by transferring to them the family home. But this is often easier said than done.
This is because many parents don't have enough financial wealth to give the house to their child or sell it at a significant discount. Then there's the fact that many kids don't have the money to purchase their parent's home with cash, so some form of financing is necessary.
The need to purchase a home through financing is by far the most common way of buying a house:
| Home Purchase Method | Percentage of Buyers |
|---|---|
| Financing | 86% |
| Cash | 14% |
But some kids can't qualify for a conventional mortgage. Luckily, there are seller financing options that allow the parents to get reasonable financial compensation for the home that their kids can afford.
What is seller financing?
Seller financing within the context of a home sale is basically a special purchase contract between two private parties. There is no bank or other financial institution involved as is with a conventional mortgage or loan.
When it comes to selling a home to a family member, there are two primary forms of seller financing: the land contract and the all-inclusive mortgage.
The land contract
A land contract is a contract that governs the sale of real estate from the seller to a buyer. With a land contract, the buyer will purchase the property over an extended period, all the while making regular payments. These payments will continue until the house is fully paid for. At that point, legal title will transfer to the buyer and the house will legally belong to them.
While the buyer is making payments, they will only have “equitable title” to the home. This essentially means they have a right to the property such that the seller can't sell it to someone else or do anything to interfere with the buyer's purchase of the property. For example, the seller can't use it as collateral for a loan as this would risk the buyer's right to the property if the seller were to default on the loan.
Some advantages of a land contract:
- The parents and their kids have the freedom to structure the terms of the land contract almost any way they want.
- Allows children to purchase a home they wouldn't otherwise be able to afford.
- Often cheaper to set up a land contract as opposed to a conventional mortgage.
- If the children default, the parents have the option to keep the money and sell the house to someone else.
- If appreciation in the home would be subject to taxes, a land contract can spread out the parents' tax liability over a longer time period.
Some disadvantages of a land contract:
- If the children fail to make payments, they can potentially lose any interest in the property. Unlike a conventional mortgage in which the homeowner builds up equity in the home, there is no such equity accumulation in a land contract.
- It can take a long time for parents to receive full compensation for the home. It might take decades for a child to fully pay for the house.
- If the parents' home is still subject to a mortgage, the sale of the house to a child might trigger the due-on-sale clause. In a conventional home sale with a mortgage, this isn't a problem because the seller gets the full value of the home in a lump sum. With a land contract, that's not the case.
A land contract is ideal for situations where the parents own the house outright and do not need to receive the full value of the home in a lump sum payment. In situations where the parents need some cash, they can always require their child-buyer to make a modest down payment as part of the land contract.
The all-inclusive mortgage
The all-inclusive mortgage, or AIM, is similar to a land contract in that the parents and children can decide their own contractual terms, such as down payment, interest rate, monthly payment size and so on. However unlike a land contract, following the sale of the home, the children will have legal ownership of the home, with the parents holding a security interest, or mortgage, in the home in case the child defaults.
AIMs have similar advantages as land contracts, but one of the biggest differences from land contracts in terms of its benefit is the creation of a formal security interest. This can protect the parents in case of default and the security interest gets recorded, making it known to the public that the home is subject to a security interest. This also means that as the child makes payments, they will begin to accrue equity in the home, just like they would with a conventional mortgage from a bank.
The disadvantages of an AIM include:
- Higher cost and hassle, due to the increased formalities from a mortgage.
- Potentially subject to a due-on-sale clause, just like with the land contract.
- If there is a default, a foreclosure process may be necessary.
The AIM is tailored for transactions where the risk of default is greater and/or both parties want protection if the sale can't take place. The parents will have the ability to foreclose and the child will have the ability to create equity in the home. This equity will mean that all those prior house payments won't be for nothing.
What happens if the parents die before the child pays off the house?
When using either of the above seller financing methods, things can get a little tricky if the parents die before the house is fully paid for. In both the land contract and the AIM, a promissory note is created, which the parents will hold. This is an asset that is usually subject to the probate process.
Upon the parents' deaths (or the last surviving parent's death), the executor will be tasked with collecting remaining payments or otherwise carrying out the terms of the seller financing.
When creating the terms of the land contract or AIM, the parents will have several options.
First, they can require the child to pay the remaining balance in full. An estate may remain open until any outstanding loans or debts settle.
Second, the parents can have any remaining balance forgiven. The problem with this solution is that if the parents' estate is insolvent, the probate court may refuse to enforce the forgiveness provision. That's because the debtors to the parents' estate have a right to have their debts paid by the parents' assets and the promissory note is such an asset.
Third, the outstanding balance can reduce any inheritance the child was to receive.
As you can see, there are plenty of advantages of parents using seller financing to sell a house to a child. However, there are some tax and legal considerations to keep in mind and plan for.