The Difference Between “Seller Financing” and “Rent-to-Own”
Chapter Five of HUD Handbook 4350.3, Chg. 4 outlines various requirements relative to the determination of value and income for assets. One of the more unusual assets managers of affordable housing developments may encounter is a mortgage or deed of trust. Also known as “seller financing,” this situation occurs when an individual sells a piece of real estate, but instead of the purchaser obtaining a mortgage from a bank, the seller loans money to the purchaser through a mortgage or deed of trust. This may also be referred to as a “contract sale.”
A mortgage or deed of trust held by a family member is included as an asset. Payments on this type of asset are often received on a monthly basis and include both interest and principal. As stated by HUD, the value of the asset is the unpaid principal as of the effective date of the certification. Each year this balance will decline as more principal is paid off. The interest portion of the payment is counted as actual income from the asset.
But, what about a “rent-to-own” situation? How does this differ from a contract sale for purposes of determining income?
In a seller financing situation, the purchaser legally owns the home and the seller and purchaser sign a legal mortgage agreement that specifies the term of the loan, interest rate, monthly payments, and additional clauses – just like a traditional mortgage. The purchaser is responsible for upkeep and taxes, unlike a rent-to-own, where the landlord is responsible for both. When a seller finances the sale of a home, the asset for the seller is the deed of trust – the home is an asset for the purchaser.
In a rent-to-own situation, also known as a “lease-purchase,” the owner retains ownership of the home and acts as a landlord. This is a legally documented transaction under which the property is leased in exchange for a weekly or monthly payment, with the option to purchase at some point during the agreement. A major difference between this and seller financing is that the lessee can terminate the agreement by simply returning the property.
Structure of a Rent-to-Own
The tenant lives on the property and pays toward purchasing at a fixed price within a specific period of time, usually one to five years. As part of the contract, the renter may be required to make a nonrefundable deposit, often included as part of a downpayment at the end of the lease term. At the end of the lease term, the tenant has a right of first refusal to purchase the property at an agreed upon sales price, or walk away and forfeit the deposit.
In a true lease-option, there is a clear line between a lease and a purchase. First, a tenant has a written lease and a written sales agreement, and the lease specifies a termination date. A lease-option rent amount is expected to reflect market value rents for the neighborhood. Also, the tenant acquires no equity or interest in the property during the lease term, nor are they responsible for investing their own money in improvements or repairs.
When faced with a situation where it is unclear whether it is seller financing or a lease-purchase, managers should examine the structure of the arrangement. Is there a lease? Who is responsible for upkeep and repairs? Examining the structure of the arrangement will assist management in determining whether to treat the situation as a contract sale or a rental. If it is clearly a sale, the value of the deed of trust (the asset) should be determined as noted above, and the income from the asset is the interest that the purchaser will pay during the 12-month period following the effective date of the certification. If it is a lease, the asset is the property, and the cash value of the property is the value of the asset. The rent paid is income to the asset (verified operating expenses may be deducted from the rental income in order to determine net income to the asset).
In summary, a key to understanding whether there is seller financing or a rent-to-own arrangement is a determination regarding who owns the property. Once this is known, management can easily judge whether to treat the real estate or the deed of trust as an asset.