Some real estate investors love selling their property in an installment sale. They can often negotiate an above -market price. They get a cash deposit up front. The investor takes back a note that earns an above market rate of interest. They lock in an income stream for the life of the note. Taxes are deferred. If the buyer happens to default on the note, the seller can take back the property and sell it again, while keeping the payments already made to date. Sounds terrific, right?
My brother bought a house in a Phoenix suburb in 2005, for $450,000. It was a new house in a planned community of 300 homes.
In 2008, he got an attractive job offer in Seattle, but by then, the housing market had softened. There were dozens of homes for sale in his neighborhood, and all were competing on price. Rather than sell for a loss, he entered into an installment sale for a slight profit. He received $50,000 upfront, and took back a five -year note at 10% interest. It was anticipated that the housing market would rebound, and the buyer could then refinance the remaining note balance with a new mortgage, and cash my brother out.
The buyer stopped making payments after a year, as the market kept plummeting. It took my brother another 18 months to evict the occupants. Once he was in possession of the house, he discovered about $75,000 worth of damage. He finally sold the house outright in 2010 for $175,000.
Points to ponder when considering an installment sale (as the seller):
- Sellers are most inclined to consider an installment sale in a weak market, when they can’t quite get the price they want in an outright sale. However, an installment sale is most vulnerable in a weak market. Weak markets produce weak buyers, who tend to engage in an installment sale to purchase a property they could not otherwise afford. After all, why pay an above market price, or an above market interest rate, if they can get better terms in an outright purchase.
- An installment sale is most likely to fail in a weak market. A weak buyer may be unable to maintain the payment schedule in a weak economy. It may behoove the buyer to walk away, if property values are falling faster than expected, and it makes sense to stop throwing good money after bad. The buyer may not be able to ultimately refinance, regardless of market conditions.
- An installment sale does not eliminate or even defer taxes. It merely spreads them over the payment period. And recapture of depreciation is not deferred at all. It must all be recognized at the close of the sale.
- Installment sellers place great value in their ability to foreclose on a defaulted property and re-sell it, keeping the payments that have already been made. As you can see in our example, my brother derived scant comfort from this feature.
How about an installment sale if you are the buyer? It depends on the terms. If you can buy at the market price or better, and pay the note at market rates or better, it may be a valid tool to expand your options. Using an installment sale to over-leverage yourself may seem attractive in a bull market, but disastrous when the market turns.