Buying and Selling Real Estate on Land Contract
Buyers and sellers of real estate have the option of using a unique financing mechanism that can, in certain situations, provide a superior means of structuring a property sale. This mechanism, known as a land contract, is a popular form of seller financing used in real estate transactions (often residential) that serves an alternative to traditional forms of financing, such as through a mortgage.
During times of high interest rates (unlike the current climate) and when the borrower does not want to go into the regular borrowing market place for reasons of either lack of a down payment or some other issue, land contracts are popular sales tools. They allow a seller and a buyer to be more creative on financial terms and address a buyer’s shortage of funds available for the transaction.
This article is intended to provide a brief overview of how land contracts work and discuss some of the pros and cons of using this form of financing to buy or sell real estate.
What is a Land Contract?
A land contract is an agreement that provides for both the conveyance of real property and the financing in the transaction. In a land contract, the seller provides the financing for the buyer to purchase the property—essentially in the form of an installment sale. The seller determines down payment, interest rate, installments, and requires payment of taxes and insurance premiums. Although the buyer takes possession at the outset, the seller continues to own the property, pay the mortgage and taxes, and hold the deed until all terms of the contract are met.
As part of the contract, the seller agrees to provide a deed (usually a warranty deed) to the buyer after all of the contractual obligations are satisfied. Under this arrangement, the buyer does not receive the legal title until the debt has been satisfied. For this reason, a land contract is not an instrument of conveyance, but rather is an agreement to convey land.
Once the agreement is signed, the buyer has material use of the property according to the contract. Typically, buyers will need to maintain and repair the property as if they are outright owners. Damaging or neglecting the property will violate terms of the contract. This and any other stipulations in the contract not met are grounds for terminating the contract.
Benefits of a Land Contract
There are several reasons someone may choose to buy or sell real estate using a land contract. Many buyers prefer land contracts because they are a low cost way to obtain financing. Sellers like them because they make it easier to sell property, and the seller can set his or her own terms. If done right, a buyer is able to take possession of a property while making payments towards ownership. Sellers retain title and can turn their real estate investment into a profitable venture.
Land contracts can be used for sales of either residential or commercial property. In residential transactions, buyers who do not have sufficient funds for an equity payment on a house to qualify for a loan or who seek lower interest rates than those available from commercial lenders are likely to pursue a land contract arrangement. A commercial buyer, by contrast, may favor a land contract acquisition to reduce the initial amount of capital that must be invested to acquire real estate, to wait for a later date to obtain an traditional loan to pay off the land contract (e.g., if interest rates are expected to decrease or the buyer’s credit will improve in the future), or to hold out for a date when it expects to have more liquidity.
Within the contract, a seller establishes financing, terms and conditions of ownership, and how the title will pass once the buyer fulfills the contract. In this capacity, a seller can charge a higher interest rate and negotiate a “balloon payment” at a certain point where the buyer pays the final balance or they re-negotiate the terms of the loan. Except for several statutory constraints (such as usury limitations), land contracts are wholly subject to the negotiation of the parties. They are outside the regulations and policies that bind financial institutions in issuing mortgages. As such, land contracts provide more flexibility to parties in negotiating and structuring transactions.
For a seller who finances a real estate transaction personally, a land contract offers more protection and alternatives in the event of a default than a deed with a purchase-money mortgage given to the buyer for the amount owed. Unlike a mortgage, a land contract stipulates that if a buyer does not fulfill his financial obligations in the agreed upon terms of the contract, then the seller regains possession of the property and keeps whatever money the buyer has remitted.
Risks of a Land Contract
A land contract can be a risky transaction. Even though Michigan law makes land contracts legally binding, they are essentially unregulated. And prospective sellers considering selling their property on land contract should carefully consider the fact that they will become the financing entity. Although individuals commonly sell under the presumption that payments will consistently be made and that no further action will be necessary, this is certainly not always the case.
As a result, a seller must make a judgment as to whether he or she feels that the buyer will be able to make all the payments. In a land contract sale, the seller has effectively taken the place of a financial institution. He or she has loaned money and expects to make a return. Just like a bank, the seller must perform due diligence efforts to ensure that the buyer is financially capable and is maintaining the property after closing.
Furthermore, sellers must be prepared to take remedial action if payments are not made. This can be a costly and time-consuming endeavor. In addition, the seller oftentimes takes an inadequate down payment, only to discover that the costs of the forfeiture or foreclosure to take back the property exceed the amount of the down payment. By the time he or she gets the property back, the transaction is a net negative. These considerations should be part of a prospective seller’s analysis in deciding whether to use a land contract. To protect yourself, you should not only do your due diligence on the buyer’s ability to pay, but also make sure the down payment is at least 10% of the purchase price, preferably 15-20%.
While there are so-called standard form land contracts available on the internet, a seller should think carefully before using one. Every deal is different and the terms of the contract should reflect that uniqueness. An experienced real estate attorney can help explain the various terms and ensure that you are properly protected.