There are fewer farm acquisition arrangements more attractive for new farmers than the owner-financed sale. It can be a win-win situation for both the farmer-buyer and owner-seller, as long as both parties are well aware of the risks before entering into an agreement.
In an owner-financed sale, title is passed to the farmer-buyer, and the owner-seller basically acts as the bank. Land, the farm house(s) and existing infrastructure are subject to a mortgage from the owner-seller. This is distinct from a ‘land contract’ where the farmer-buyer does not assume title until 100% of the installments to meet the purchase price are paid.
Owner financing is advantageous for farmer-buyers who have trouble meeting the credit history or collateral requirements of traditional lending institutions. Owner-sellers are often willing to set lower interest rates due to the fact that there are no “points” on the loan or no spread (difference between the interest rate the bank is charged for obtaining its money and interest charged on loans made to customers, which goes towards paying bank employees or overhead).
Owner-sellers can benefit from an owner-financed sale in two primary ways: first, the owner seller can generate income over many years into the future by charging the farmer-buyer an interest rate on top of principal (an interest payment is actually required by the IRS). This is especially advantageous for owner sellers at or nearing retirement, during which time income is hard to come by. Secondly, the owner-seller can spread out taxes paid on capital gains over many years, instead of getting hit with one lump sum payment to the feds.
The drawbacks for using the owner financed sale are related to the level of risk that the seller must take on. The owner seller should understand that a farmer-buyer might not have good credit, and there is always the risk that he/she might not be able to keep up with the installment purchase payments.
Farmer-buyers should understand that if they are not able to keep up with payments and breech the terms of the owner-financed sale promissory note agreement, the owner seller then has the right to foreclose and repossess the property in a manner according to state and federal laws.
To mitigate these risks, owner financing arrangements are often set as balloon payments, where the farmer-buyer would, for example, make payments according to a 30 year amortization schedule, but be required to hand over a lump sum of the remaining balance balloon payment at the 5-year mark. At this point, a conventional lender would step in and enable the farmer-buyer to pay off the owner-seller in full. In this scenario, the owner seller would not have to worry about collecting payments for the entire 30 years.
The time period leading up to the balloon payment might give the farmer-buyer a cushion to be able to build enough equity in the land or in the farm operation to obtain a loan from a conventional agricultural lender, such as FSA, VACC, or Farm Credit. The loan from the conventional lender would enable the farmer to pay off the full balance of the purchase price to the owner-seller.
Other strategies an owner seller might want to use to lessen risk include desiring a higher than market interest rate or a hefty down payment. If the arrangement calls for a balloon payment only after a few years, the high interest rate might be agreeable considering the chance that interest rates during refinancing to pay the balloon payment might be lower than the rate paid to the owner-seller in the short time leading up to the balloon payment.
Owner-sellers can either be the primary financer or they can team up with another lender to offer financing that enables the farmer to meet the total purchase price. This can be especially beneficial to new farmers in cases where conventional lenders are willing to write a loan for only a portion of the purchase price. The landowner provides financing for the balance, based on terms that are defined by the landowner and the farmer-buyer. The farmer-buyer makes two separate regular loan re-payments– one to the conventional lender and the other to the owner-seller.
When setting the terms of the promissory note that is the backbone of the owner-financed sale agreement, one important consideration comes into play. The IRS requires that a minimum annual interest be paid on top of principal that goes towards paying off the loan amount. Owner Financed Sales are treated as “installment sales” for federal tax purposes. See IRS “Tax Topic 705: Installment Sales” for basic information or IRS Publication 537 for full details about accounting for installment sales. If you do not state interest, the IRS will state it for you, based on the rules outlined in Publication 537!
There are many other details that should be worked out before entering into an owner-financed sale agreement, such as requirements for taxes and insurance. It is highly recommended that farmer-buyers consult with a real estate agent, an accountant, and it is practically necessary that they be represented by a licensed attorney when signing any agreement related to owner-financed arrangements.
The owner-financed sale is not, however, complicated. It has been used in conventional real estate transactions for decades. With the risks clearly understood by both buyers and sellers, owner financing can make sense for the farm as well. And remember, it can’t hurt for farmer-buyers to, at least, stimulate conversations or make inquiries about the potential for owner financing. You might be surprised to learn, like the signs say, that, “Owner Financing is Available!”
Thanks for this, Ben, and for all of your other work.
Would you consider doing a similar piece about the use of the vehicle know as “Lifetime Estate”? We’ve used this once, and we are currently looking at another opportunity. It feels like a very civilized form of property succession.