Owner financing offers buyers and sellers more opportunities with real estate transactions. 

Before entering this type of transaction, it’s important to know what owner financing is, how it works, who benefits, and who pays property taxes on owner financing.

Owner Financing Basics

Owner financing gives homebuyers more options when looking for financing. 

Also known as seller financing, it often has higher interest rates and different terms than traditional financing, but may be a viable option for some buyers. In addition to knowing who pays taxes on owner financing, it’s important to understand the basics.

What is owner financing?

Owner financing is a loan from the seller of the property (the current owner) rather than a bank or mortgage lender. Sellers often charge higher interest rates than traditional lenders, and they typically want a large down payment and require a balloon payment within a few years of borrowing the funds.

How does owner financing work?

Owner financing works a lot like traditional financing, meaning the buyer needs a down payment and then makes monthly payments as agreed upon. However, there is often more leeway in how your payments are structured if you need less frequent payments, such as quarterly.

Your payments help reduce the principal balance, but you will likely owe the remaining balance as a balloon payment, usually in five years or less. If you plan to keep the property long term, you can either pay the full amount in cash or refinance the loan.

Because there isn’t a traditional lender involved, it’s up to the owner if they want to check your credit history or do a background check. You also won’t have to worry about appraisals or title work, as traditional lenders would require. 

However, it may be in your best interest to take these precautions to ensure you don’t overpay for the property, or the owner will be unable to transfer the title to you.

Who holds the deed in owner financing?

When a buyer and seller use owner financing, the buyer signs a promissory note promising to make the payments as stated in the agreement. They will also sign a deed of trust giving the seller the right to foreclose on the property (take back possession). 

In exchange, the seller signs over the title and transfers it to the buyer. Buyers can refinance and/or sell the property, but they are always required to make their payments.

In less common situations, the seller can remain on title. This requires an executed contract for the deed. This allows the seller to keep the title and only transfer the property when the final payment is made or when the buyer refinances the owner-financing with traditional lender financing.

Benefits and Risks of Owner Financing

Like any real estate transaction, owner financing has benefits and risks for buyers and sellers. Understanding both sides can help you determine if it’s the right choice.

What are the benefits of owner financing for buyers?

Buyers realize many benefits from owner financing, including:

• More flexible qualifying requirements, especially if the seller doesn’t check credit.
• May have fewer closing costs because there aren’t bank processing fees, inspections, and potential appraisals.
• Seller financing usually closes faster, sometimes within a matter of days, versus traditional financing.
• Buyers and sellers can negotiate the terms, including the down payment, monthly payment requirements, and interest costs.
• In a seller’s market, owner financing can help buyers win the property they want without a lender’s red tape.

What are the benefits of owner financing for sellers?

Sellers also realize many benefits of owner financing, including:

• Sellers don’t have to worry about lender property requirements; they may sell the property as-is.
• Sellers have recourse and, even if they transferred the title, can repossess the property if the buyer doesn’t satisfy the loan agreement.
• Owner financing may provide sellers with higher returns than they might earn on any other investment opportunity in the market.
• Allows sellers to sell the property faster with less red tape and no lender requirements.
• In a buyer’s market, sellers can look advantageous to buyers by offering owner financing for faster and less restrictive closings.

What are the risks of owner financing for buyers?

Buyers benefit from owner financing in many ways, but there are risks or downsides, too. Most notably, buyers often need a larger down payment than with traditional financing options. 

They may also have a large balloon payment that requires them to pay off the mortgage within a few years. This can be troublesome if they don’t have the cash and/or can’t get approved for traditional financing.

In addition, some sellers have strict requirements, including credit or background checks. If the buyer’s qualifying factors don’t meet their criteria, they can refuse to offer financing.

What are the risks of owner financing for sellers?

Sellers have the obvious risk of nonpayment from borrowers. While the deed of trust gives sellers the right to repossess the property, that’s not why they entered the agreement, so it can be a downside for sellers.

Sellers in some states may also be limited to what they can offer for owner financing (if they can offer any). State regulations may determine the amount of balloon payments they can require and the terms they offer, or they may require them to use a loan originator as a mediator in the process.

Owner Financing Structure, Terms, and Negotiations

Understanding the financing structure, terms, and what you should and shouldn’t allow as a buyer or seller is important when considering owner financing.

How do you structure an owner-financing deal?

Owner-financing deals can have one of three structures. The most common denominator is that the agreement is in writing, and both parties ensure it’s legally binding.

The options for structuring an owner-financing deal include:

• Promissory note and deed of trust: This is the most common way to structure an owner-financing deal, similar to what you’d see if you used traditional financing. First, both the buyer and seller sign the promissory note, which includes the payment schedule, interest rates, and other details. Next, a mortgage or deed of trust is executed that uses the property as collateral. The buyer receives title to the house in their name, and the county records the new mortgage on the property.
• Contract for deed: This is a less common way to structure an owner-financing deal because the buyer doesn’t take the property title. Instead, it remains in the seller’s name while the buyer makes payments. Once the buyer makes the final payment, either by following the payment schedule or refinancing the debt, they receive title to the property.
• Lease-purchase agreement: In the rent-to-own scenario, tenants enter an agreement to purchase the property after a certain amount of time. They remain living in the property as tenants and paying rent. They can execute their right to buy the house at the predetermined time. If so, a portion of the rent, as agreed upon in the lease-purchase agreement, goes toward the down payment.

What are the typical terms of owner financing?

Many details go into owner financing, including the following:

• Purchase price: This is the amount agreed upon by both buyer and seller for the transaction. This is what the loan amount is based on and how the entire transaction is structured.
• Interest rate: This is the fee the seller charges for providing the financing. It may be higher or lower than traditional mortgage financing rates.
• Down payment: Most sellers require an upfront investment or cash toward the property’s purchase price. This decreases the loan amount.
• Loan amount: Buyers borrow the difference between the purchase price and the down payment. This is the amount they pay interest on and must repay to release the lien on the property.
• Term: Sellers and buyers can negotiate a term, or the time they have to repay the loan. It may be a few months or years, with a balloon payment to finalize the loan.
• Monthly payments: The amount buyers must pay monthly to satisfy the loan agreement is the monthly payment. This is the minimum amount required at each payment interval to satisfy the loan agreement.
• Balloon payment: You may have monthly payments based on a 30-year loan agreement, but the owner financing terms can require a balloon payment after a couple of years. This gives buyers time to secure traditional financing while taking possession of the house faster.

Is a down payment required in owner financing?

The down payment requirements vary because owner financing terms are up to each seller. 

Some states have requirements or restrictions on what they allow for down payments, so be sure you know the state’s laws before entering an agreement. In most cases, though, a down payment is necessary.

Can the interest rate in owner financing be negotiated?

Yes, like the interest rates on traditional mortgage financing, buyers and sellers can negotiate the rate until they reach a deal. Sellers have the upper hand in this situation because they are the ones offering the financing.

Is there a minimum interest rate for owner financing?

Each month, there is a minimum interest rate for federal income tax purposes that you must meet when creating a loan agreement. While the rates are often well below what owners charge for owner financing, it’s important to know the guidelines before creating an agreement to avoid unnecessary tax penalties.

Owner Financing Nuances and Scenarios

Knowing the details involved in owner financing is important as you consider entering an agreement as a buyer or seller.

Can the owner-financed property be sold before the loan is paid off?

If you enter a traditional transaction with a promissory note and deed of trust, the buyer can sell the property, but they must pay off any remaining loan balance with the sale proceeds. Other types of transactions, such as a land contract or rent-to-own situation, do not allow the buyer to sell the property until they hold the title.

Who pays property taxes on owner financing?

Buyers and sellers must work it into the owner financing agreement to decide how to handle property taxes. Typically, buyers pay the property taxes, but you can work out a different plan if the seller is on board.

Are there closing costs with owner financing?

Owner financing does incur some closing costs, but not as many as you might incur with traditional financing. For example, if you bypass the appraisal or inspection, you avoid those costs. Since no bank is involved in the transaction, closing costs can be even lower.

Is a title search and title insurance necessary in owner financing?

Sellers typically don’t require a title search or title insurance, but both can protect buyers, so it’s something to consider. 

A title search ensures the property can legally be transferred to the buyer, and title insurance protects buyers financially against any claims against the property ownership after the title search.

What are the disclosure requirements in owner financing?

Each state has different requirements regarding the disclosures that must accompany owner financing. Work with a local real estate attorney or title company to determine your state’s requirements to ensure you don’t miss any important details.

What happens in an owner-financing deal if the property has an existing mortgage?

If the owner has a current mortgage on the property, they may be able to create a wraparound note.

This is a junior lien that consists of an agreement between the buyer and seller for owner financing. The buyer makes payments to the seller as agreed, and the seller uses the funds to pay the existing mortgage on the property.

The seller must have permission from the first lien holder to enter into a wraparound note, since it puts another lien on the property.

Is owner financing the same as rent to own?

Rent-to-own is one way to conduct an owner-financing deal. A traditional owner financing deal is more straightforward, with buyers making down payments and regular monthly payments on the loan. 

In a rent-to-own agreement, potential buyers rent the property, paying a premium on their rent that goes toward the down payment if they execute their right to buy the property within the allowed time frame.

How does owner financing work for land?

Owner financing for land is similar to owner financing for a house. The seller extends the financing, and both parties sign a promissory note and mortgage deed. The seller hands over title to the land, but retains the right to foreclose on it if the buyer doesn’t satisfy the loan agreement terms.

Can owner financing be used for commercial real estate transactions?

Like residential financing, owner financing can be used in commercial real estate transactions. Because commercial real estate usually costs much more than residential properties, the terms can be different, but can provide tax advantages for both parties.

Income and Credit

As with any mortgage financing or real estate investment, it’s important to understand how the IRS considers owner financing income and how it affects a buyer’s credit.

Does owner financing count as income?

Yes, like rental income, money from owner financing must be claimed on your tax returns as income. This can increase your tax liability, so keep that in mind as you determine how to structure the deal.

How do you report owner financing to credit bureaus?

To report owner financing to the credit bureaus, you must operate as a business and meet certain compliance measures. In most cases, owner financing isn’t reported to the credit bureaus, so it doesn’t help or hurt a buyer’s credit.

Final Thoughts

Owner financing can help both buyers and sellers in the right situation. 

The key is having the proper support and ensuring you meet all state regulations. It is essential to understand who pays property taxes on owner financing, how it affects your income taxes, and what protections sellers have should buyers default.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.