Seller-Financed Loans

How it works

The buyer signs a promissory note for some or all of the purchase price, and the seller records a mortgage or deed of trust against the property to secure it. Title normally transfers at closing exactly as it would in a cash sale, with the seller's security interest recorded against the property. That is the key difference from a land contract, where legal title stays with the seller until the final payment is made, changing both the remedies available on default and the protections the buyer has, and treated differently from state to state.

A wraparound note has the buyer pay the seller on a new, larger note, while the seller keeps paying the existing underlying mortgage out of what comes in. This works only as long as the underlying lender does not call the loan, and most conventional mortgages contain a due-on-sale clause that gives them the right to do exactly that once the property changes hands.

Business sales use the same structure under a different name: a seller note, often subordinated to a bank or SBA lender, sometimes with an earn-out that ties part of the payment to the business's future performance. Terms across both real estate and business deals are commonly interest-only or lightly amortising, with a balloon payment due after a few years on the assumption that the buyer will refinance elsewhere by then.

What it pays

The seller collects a negotiated interest rate on the outstanding note balance, on top of whatever down payment was collected at closing. Pricing follows what the buyer's alternative financing would cost and why that alternative was not available — thin credit history, an unusual property type, or a business with uneven earnings all push the negotiated rate up.

The down payment matters more than the rate. It sets the buyer's initial equity cushion and is the strongest single predictor of whether payments continue, because a buyer with real equity at stake has more to lose by walking away.

Balloon structures front-load the seller's income relative to a fully amortising loan and concentrate repayment risk on a single refinancing date years out. The IRS applicable federal rate acts as a floor under all of this: price a note below it and the imputed-interest and unstated-interest rules recharacterise part of each payment as interest for tax purposes regardless of what the note says.

A seller note can later be sold to a note buyer, converting the income stream back into a lump sum — but only at a discount to its face value, since the buyer of the note is pricing in the same default and refinancing risks the original seller took on.

Costs and taxes

Closing involves legal drafting, title insurance, escrow, and recording fees, and an ongoing third-party servicer is commonly used to collect payments and produce the paperwork needed for tax filing. The installment method under Internal Revenue Code Section 453 lets the seller recognize gain proportionally as principal is received, rather than all at once in the year of sale.

Each payment received is split three ways for tax purposes: interest, taxed as ordinary income; return of basis, which is not taxable; and gain, taxed as capital gain. Depreciation recapture on rental property is generally due in the year of sale, not spread across the installment period, which surprises sellers who expect their entire tax bill to arrive gradually alongside the cash.

Interest income must be reported as ordinary income, and the appropriate 1098 or 1099 documentation is issued or received depending on the type of property involved. For residential property sold to an owner-occupant, Dodd-Frank and the SAFE Act impose loan-originator obligations on the seller, with narrow exclusions for sellers who do only a small number of these transactions in a year — whether the exclusion applies turns on property type, owner-occupancy, and transaction volume.

Liquidity and time commitment

The seller's capital — really the equity left in the deal rather than new cash — is tied up for the life of the note. That illiquidity is the trade made in exchange for the income stream and the tax deferral the installment method provides.

The note can be sold to a note buyer before maturity, but only at a discount, and that discount widens for notes that are new and unseasoned, carry small down payments, or lack clean documentation. The balloon date functions as the practical time horizon for most seller notes, since they are written expecting the buyer to refinance within a few years rather than to pay to term.

Ongoing effort centers on servicing: collecting payments, tracking the amortization schedule, and confirming that the buyer is keeping property taxes and hazard insurance current. This last point matters because unpaid property taxes create a lien that outranks the seller's recorded mortgage. A default turns what was a passive note into an active foreclosure project, and the timelines and costs involved vary widely between judicial and non-judicial foreclosure states.

How it goes wrong

The buyer stops paying and the seller has to foreclose, often reclaiming a property that has been neglected, with back taxes and deferred maintenance to absorb before it can be resold. The balloon comes due and the buyer cannot refinance, forcing the seller into an extension on their own terms, a negotiated workout, or foreclosure.

A lapse in hazard insurance or unpaid property taxes lets a tax lien jump ahead of the seller's recorded mortgage in priority. On a wraparound, the due-on-sale clause in the underlying mortgage is triggered, and the original lender can accelerate that loan, leaving the seller exposed on debt they no longer control the collateral for.

Consumer-protection rules on residential seller financing get breached — no ability-to-repay assessment performed, a balloon structured where one is not permitted on an owner-occupied deal — creating rescission rights and liability for the seller. Electing out of, or misapplying, the installment method turns a planned multi-year tax spread into one large tax bill in the year of sale.

On a business sale, the seller note commonly sits behind a bank or SBA loan. If the business falters, the seller is subordinated, often receiving nothing while contractually blocked from enforcing the note until the senior lender is satisfied.