In the last year, many Minneapolis and St Paul duplex and investment property owners told me they would sell if not for one thing: taxes.
I suggest a 1031 exchange to all of them. Many, however, realize they will have a difficult time during a time of little inventory finding a replacement property. And others want nothing more to do with rental property whatsoever, so they are in a bind.
There is another solution. While it doesn’t always spring immediately to mind, a contract for deed can help reduce tax obligations. Capital gains tax and depreciation recapture are only levied when you touch the money from a sale. Therefore, if a seller carries a contract on a property, there is time to tax plan and offset any gain realized on an annual basis.
Other benefits of a contract for deed for a seller include:
- Income – Sellers who don’t have a mortgage on their duplex can use the monthly payments as income. Contracts for deed are often at an interest rate that’s a higher return than other investment options generally return.
- More Buyers – While we’re currently in a seller’s market, in times when either the market favors buyers or banks are reluctant to lend money, sellers can broaden their pool of potential buyers by offering more competitive interest rates than a traditional lender or extending credit to buyers who otherwise are not able to qualify for a loan.
- Cancel the contract and resell the property. If a buyer misses two payments, the seller can reclaim the property without having either a foreclosure sale or going to court. The seller may keep everything the buyer has paid to date and resell the property to another buyer.
Of course, there are also some potential pitfalls of selling a property on a contract for deed. They include:
- Due on sale clauses in mortgages – If you have a mortgage on your property, selling it on a contract for deed may trigger what’s known as a due on sale clause. Most mortgages have it. Basically, if the lender learns you have sold the property, they can accelerate the repayment schedule and demand to be paid in full.
- Buyer is unable to make the balloon payment. Real estate and job markets change. If the buyer is unable to refinance either by using the equity accrued over the time of the contract or as a result of a job loss, the seller is left holding the contract. In this case, the seller can choose either to extend the contract and continue to receive monthly payments or to cancel the contract and evict the buyer.
- Buyer fails to make monthly payments. If the buyer fails to make payments, the seller will have to formally cancel the contract in a manner consistent with what the law dictates.
While not terribly common in today’s hot duplex and investment property market, contracts for deed can be an excellent way to sell property.