Posted by: admin, in Documentation, Title
From time to time, I like to review real estate instruments as a refresher on the fundamentals of the real estate game. From a legal standpoint, a debt comes into being as a result of an agreement between a payor who borrows money and incurs and obligation to repay it. The Note itself is merely legal evidence of that agreement.
As we continue on down the legal definition, an agreement can only come into existence when two or more parties agree to something; in this case a scheme for repaying the debt obligation. Where this should be pretty straightforward, and where it once was, in recent years commencing when interest rates began to go up and loan underwriting criteria began to tighten, a spate of complex repayment terms have come into being. Here are two:
A couple of creative terms in Notes that buyer/borrowers can try to insert into seller carry back financing are “substitution of collateral” and “built in discounting for early payment. Being able to substitute property that has been mortgaged to secure a note for other property enables the borrower to do a couple of things.
First, he can effectively sell the property and keep all the sale proceeds without having to use any of the money to repay his loan. And, if he wants to carry back financing himself, once the old debt has been removed, he can devise totally different terms to make a property more attractive to buyers.
Last, but not least, by transferring debt to property for which conventional financing is very difficult to obtain, such as raw land, he can make it much more attractive to would-be buyers.
What about self-discounted Notes? Property basis is determined largely by the amount paid in cash, and the amount of original debt used to purchase it, including any existing debt that is taken over by the buyer. When a property is re-sold, the adjusted cost basis determines the taxable profit to the seller. So, a person could induce a buyer to buy the property for a higher price, with lower taxes at point of sale, and shortly thereafter the buyer could re-finance it and pay off the old loan at a discount that would pass along tax-free profit to him in the form of loan money that wasn’t needed to pay off the old debt. The seller is usually induced to provide these terms when there is the prospect that he will be paid off earlier if he offers a discount.
Another wrinkle is that, if the original buyer pays of a conventional note at discount, the difference between what he owes and what he has to actually pay to have the debt removed is taxed as “discount earned” at ordinary income tax rates. On the other hand, when an original borrower and an original seller agree to reduce the original debt, no discount earned tax applies; instead the seller reduces the gains tax he might have had to pay, and the buyer reduces his basis by the amount of the discount.
