Navigating Regulations with Owner Financing

Last month I did a presentation in Minnesota teaching investors how to purchase property using the subject-to method. This method is simply taking title to a house without paying off the current loan. You are essentially informally taking over the loan. There are a lot of advantages to this method, which we talked about in the class, including no bank qualifying and little to no money down. We have posted several articles on our blog about this buying method. 

Something that came up in the class that I wanted to address is the new Dodd-Frank rules, along with the SAFE Act that passed a few years ago. I want to first point out that neither of these regulate non-owner occupied transactions, so assuming you are buying property with owner financing, you will not need to worry about these rules. Where it gets tricky, is once you own the house and want to sell it using owner financing terms to a buyer that will be living in the home.

SAFE Act

This is an acronym for Secure And Fair Enforcement for mortgage brokers and other lenders. This is the law that created the national licensing system that all loan originators are part of, and is what required lender licensing in all states. The SAFE Act was implemented several years ago and part of this limited selling properties with owner carry terms. There was some confusion around this, but writing an owner carry deal, is originating a loan for your buyer. When this first came out I was reading articles about the world for investors ending. Well it turns out that investors did not go out of business. An easy way around this is to work with an attorney or licensed loan originator, pay them a fair fee and let them structure the deal for you. (Many states have an exemption to this licensing requirement for a limited number of deals)

Dodd-Frank

The Dodd-Frank Financial Reform came into play recently. In fact, much of it took effect in January 2014. While the SAFE Act allows states to regulate, Dodd-Frank is national regulation. It is very long and cumbersome. From what I have read, the creators of it do not even understand it. Under the Dodd-Frank, if you are selling a piece of property to a non-owner occupied user, you will be exempt from the regulation. If you are selling a house that you have not lived in to someone who will live there, and you are carrying the financing, you will fall under this regulation with one exception. If you are a person or a trust, you are exempt for one deal per year with pretty much no guidelines or restrictions. If you are a corporate entity, you can do three deals per year as long as: there is no balloon or maturity date, the interest rate is fixed for five or more years, and you “qualify” your buyer. Of course, in this huge document with a bunch of stuff that people don’t understand, there is no definition of what it takes to “qualify” your buyer. As long as you use a reasonable effort, I think you should be fine. The balloon piece is what bothers me. As an investor, I typically want to get my profit sooner than later so I can roll that into another deal. In the past, we could do a three or five year balloon and demand that our buyer pay us off. Now we can only do one balloon deal a year, but for the other deals we are doing, we can increase the interest rate after five years so our buyer wants to pay us off.

So what if you want to do more deals?

You can do one as an individual and or trust, so I guess it could be possible to set up multiple trusts. I am sure this could work, but my guess is if you are 100% owner of each trust, regulators would count all of them as one person. So although this is possible, I am not sure I would do this. You can do three deals under an LLC, so I guess it is possible to set up separate LLCs with you as the owner. Or you can set up LLCs with different owners. For example if you own an LLC and your wife owns an LLC, together you can do 8 deals; three each for the LLCs and one each individually. Also, if you have an IRA, it is a separate entity and could potentially do four more deals. Here are some other things to think about:

Licensing - If you are serious about this and doing multiple deals a year, it probably makes since to use a mortgage broker to do these deals for you for a small fee (maybe $400 to $500) or go get a license yourself. This is not a difficult license to get.

Rent to Own or Lease Options - I know many investors that prefer to do a lease option to avoid all the red tape. If you decide to play it safe and stick with a lease option, I suggest you keep your leases at two years or less. There is a chance that a long term lease could be viewed as financing.

Remember the SAFE Act could trump Dodd-Frank, so if there is not an exemption in your state under the SAFE Act, you might need a license to do one of these even if you are exempt from Dodd-Frank.

So what happens if you violate the SAFE Act or Dodd-Frank?

I would not be too worried about the SAFE Act. This is regulatory, meaning that it is handled by the state regulatory agency. So chances are you are under the radar. If you are caught, you will most likely go under investigation and then be issued a cease and desist, giving you the ability to correct what you are doing with no penalty.

Violating Dodd-Frank, that can be a bit harsher. In this case, you will not go to jail, but you could be held liable through a civil action. This would really only come into play if your buyer defaults and you start some type of action to reposes the property. The chances are high you can work it out without a foreclosure, but if not, your buyer would need to hire an attorney that understands this law and they will have to sue you. If they do and win, you could be liable for all their down payment and interest they paid. Again, I suggest you just follow the rules, but if not you might consider setting up separate entities to limit your exposure.

This is just a brief summary of Dodd-Frank and the SAFE Act. I am not an attorney and am not giving legal advice. Because much of this is state specific, I highly recommend you consult with an attorney in your market before doing any owner carry transactions.