Contracts for Deed: Seller-Financed Real Estate Closings

An overlooked method of completing the sale of property in Virginia without involving a third-party lender is a “Contract for Deed.” It is an alternative for buyers who cannot or may not want to obtain bank financing due to demanding qualification standards, and for sellers who wish to avoid the formalities and red-tape of third-party financing.

Nature of a Contract for Deed

A Contract for Deed, also known as a Land Sales Contract, is a private transaction for the transfer of property in which the seller remains the property owner, and the buyer has a contractual interest in the property. Although the buyer takes possession of the property, the property title does not transfer until the buyer has satisfied all payment terms.

Here’s How it Works:

Contracts for Deed are similar to regular property settlements, in that the seller executes the Deed to the buyer, the buyer executes a Note payable to the seller and takes immediate possession of the property. Unlike regular settlements, the Contract for Deed is a private transaction between the buyer and seller, where the buyer usually makes payments directly to the seller. If there is an existing mortgage held by the Seller, the seller typically uses the buyer's payments to pay the existing loan (called a “wrap-around contract”). The Deed and Note are held in escrow, usually by the settlement attorney, pending payoff of the loan. The Deed is recorded and title transfers to the buyer at the end of the contract.

Pros and Cons of Contracts for Deed

In the Pros column, because Contracts for Deeds do not involve lender approval, the buyer does not qualify for a loan and can benefit from a low down payment and flexible interest rates. The buyer also gets immediate possession and all rights of quiet enjoyment of the property. Both parties benefit from lower closing costs and a quicker settlement, as there are no lender fees and a property survey is not required. Also the term of a Contract for Deed is usually much shorter than in a traditional property settlement, translating to lower interest payments for the buyer and quicker repayment for the seller. Often the biggest benefit to the seller is that the capital gains taxes can be distributed over the entire contract period, and not just in the year the property was sold. The seller is protected in the event of buyer default, as the property automatically reverts to the seller should the buyer fail to fulfill the provisions in the contract.

As for Cons, there is enough risk for both the buyer and the seller that a Contract for Deed should not be entered lightly. The seller is still responsible for paying the underlying mortgage until the loan is satisfied, in situations where the seller still has a mortgage on the property.Because of the risk of buyer default, which may be heightened because the buyer does not submit to a formal loan application process, Contracts for Deed generally contain the provision that, upon default, the buyer's interest terminates, the buyer is treated as a tenant, and all sums paid up to the date of default are considered rent, meaning the buyer risks losing his investment in the property. With the interest paid converted to rent in the event of default, the seller may evict the buyer and repossess the property.

A Contract for Deed can be a great alternative for parties looking to enter a property transaction. But because of the risks facing both parties, buyers need to make sure they can cover the contract terms or risk losing their investment, and sellers should be counseled to insist on current credit reports and several years worth of tax returns from the buyer as a prerequisite to entering the Contract for Deed.