Owner- Financed Sales and Land Contracts

Chapter

Owner-

Financed

Sales and

Land

Contracts

by Anthony Iarrapino, Esq.,

Staff Attorney, Conservation Law

Foundation, and Elizabeth Spellman,

Law Clerk, Conservation

Law Foundation

Top image used with permission of Ben Waterman, Center image used with permis-

sion of Rachel Schattman, Bottom image used with permission of Corie Pierce.

This section explores two options—owner-ﬁnanced sales and installment contracts—that farmers should be aware of

when they seek to buy or sell farmland without relying solely (or at all) on traditional lenders like banks. By cutting out the

“middle man,” owner-ﬁnanced sales and installment contracts can enable buyers and sellers to be more creative in setting

terms tailored to the realities of a farm start-up, lowering hurdles for new farmers and potentially increasing a seller’s overall

gain. A brief explanation of the basics of buying and selling land illustrates how these two options differ from the traditional

mortgage scenarios, and should help you understand whether one of them might be right for you.

In the normal property sale, the average buyer cannot, on the date of sale (known as the “closing”), pay the seller’s full

asking price for the property. Instead, the parties contract for the sale with a “purchase and sales agreement” pursuant to

which the buyer typically makes a down-payment toward the overall sale price and takes out a mortgage loan from the bank

for the rest using the property as loan collateral. The bank then pays the seller a lump sum on behalf of the buyer who took out

the mortgage. In exchange, the seller signs over a deed to the buyer conveying ownership of the property. At the same time, the

bank requires the buyer to sign a promissory note, a contract reﬂecting the buyer’s promise to repay the loan, and a mortgage

deed creating a lien on the property. The mortgage entitles the bank to take the property from the buyer, through foreclosure,

in the event that the buyer defaults on the loan. The bank records the mortgage in the land records giving notice to all of its

interests in the property.

There are several reasons why a

new farmer seeking to buy land and a

seller seeking to help a new farmer get

started may not have the desire or the

ability to work with a traditional lender.

A bank typically requires the buyer to

“qualify” for the loan by demonstrating

good credit history and a steady source of

existing income that is sufﬁcient to cover

repayment of the loan principal with

interest. Yet for someone just starting up

in farming, it may be difﬁcult to convince

a loan ofﬁcer that future revenues from

the start-up farm operation will meet

a bank’s rigid income requirements,

especially if the future farmer’s credit

score is not high enough.

A buyer’s up-front and overall costs in a bank loan scenario may be increased by administrative fees that banks charge

for processing the loan. Banks set interest rates at a level necessary to help recoup overhead for bank operations while also

earning a proﬁt for the bank. Time is money, too, and your deal may be one of many that a bank is working on, thus the process

can move slower than the buyer and seller would like.

The Basic Owner-Financed Farm Sale

With an owner-ﬁnanced sale, the process of transferring ownership (purchase and sales agreement, promissory note,

mortgage deed) is the same, but there is no third-party lender involved. Instead, the buyer and seller directly negotiate the

amount of time—the loan term—that the buyer will have to pay the seller the full sale price and the interest rate that the

buyer will pay on the outstanding balance over that time.

Thus, on the closing date, instead of getting a lump sum for the

entire sale price from the bank the buyer is borrowing from, the seller signs the deed over to the buyer in exchange for a

promissory note and mortgage that the seller then records in the land records. Before entering any deal, a buyer needs to be

sure that the seller actually owns the property and that it is not subject to another mortgage already. An attorney can provide

this information to the buyer by conducting a title search in the land records where the property is located.

17 IRS regulations classify owner-ﬁnanced situations as “installment sales” and require that the seller charge the buyer some amount of interest in an owner-

ﬁnanced sale, though the actual interest rate remains subject to negotiation between the buyer and seller. 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. State law sets a maximum limitation on the interest rate that an owner-ﬁnancer may charge. In Vermont, those limitations are set forth

at 9 V.S.A. § 41a.

The Risk of Foreclosure

Just like in a traditional bank mortgage, farmer-buyers should understand that if

they are not able to keep up with mortgage payments owed to the seller, the seller

then has the legal right to foreclose and repossess the property. After receiving a

foreclosure notice, the buyer typically has a six-month redemption period during

which the buyer can avoid foreclosure by making good on delinquent payments (and

in some cases repaying the seller’s costs of foreclosure).

Foreclosure is no picnic for the seller. During the redemption period an owner-

seller could have a buyer living on his “sold” property for half a year where the owner-

seller neither can use the property, nor be paid by the buyer. Unlike a bank, however,

a seller offering owner ﬁnancing may be willing to seek a creative resolution to avoid

foreclosure. Even though both parties hope that the buyer will pay the loan on time

without problems, it is best for the parties to discuss and agree upon these creative

alternatives up front and to include them in the agreements they make.

In an owner-ﬁnanced sale, the buyer and the

seller have tremendous ﬂexibility when it comes to key

elements of the deal. The parties can tailor their ﬁnancing

plan; for example, owner-ﬁnancing arrangements are

often set as “balloon payments,” where the farmer-buyer

makes payments according to a 30-year amortization

schedule and is required to hand over a lump sum of the

remaining balance balloon payment at some point prior to

the full thirty year term (often at the ﬁve-year mark). This

assumes that the buyer will build up enough equity in the

property, good credit, and a solid income stream from farm

operations to attract a conventional lender to 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.

Other lower-risk strategies an owner seller might

want to use include an above-market interest rate or

a hefty down payment. A seller can require an offer of

personal liability from the buyer, a third-party guarantee

or co-signature on the agreement. Depending on a seller’s

individual circumstances, the heightened risk to the

seller may be offset by the tax advantages the seller could

realize. In an owner-ﬁnanced sale, the seller pays capital gains on the principal and income tax on the interest over time as the

seller receives annual installments from the buyer, rather than having all state and federal taxes taken in one big chunk in the

year of the closing—as is the case in a traditional

sale.

Buyers and sellers in the owner-ﬁnanced

transaction can be creative and ﬂexible when it

comes to dealing with situations where the buyer

has temporary problems making payments.

Consider the opportunities where, for example,

the property has a woodlot. The parties can agree

that the owner-ﬁnancer is allowed to log the

property in the event that the buyer falls behind

on payments, taking enough timber to cover

the amount of the delinquent payments until

the buyer catches up with cash payments. The

same arrangement could work with other farm

products. This is just one example of the ﬂexibility

buyers and sellers can enjoy when ﬁnancing

a property transfer without a bank. The key is

making sure that the parties clearly spell out any special terms like this to avoid misunderstandings after the deal is done. The

parties should be able to negotiate without the aid of lawyers, but once you come to terms, it is wise for each party to consult

a lawyer with experience in real estate to ensure that the terms of the ﬁnal agreement are enforceable and clearly reﬂected in

writing.

Sellers can either be the primary ﬁnancer or they can team up with another lender to offer ﬁnancing that enables the

farmer-buyer 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 owner-seller provides ﬁnancing for the balance,

based on terms that are deﬁned by the owner-seller and the farmer-buyer. The farmer-buyer makes two separate regular loan

repayments; one to the conventional lender and the other to the owner-seller, each of which would record a mortgage lien on

the property.

18 Farmers can also get creative to ﬁnance land where the property is not entirely owner or bank-ﬁnanced. For example, farms can ﬁnance part of their land by partnering

with their future customers through the various ﬁnancing mechanisms outlined in this guide. Farmers can consider giving several seasons’ worth of CSA shares (see Chapter

9: The Multi-year CSA) or specifying an amount of food to be used to pay back part of the principal and/or interest on a loan from a community member over several years (see

Chapter 5: The Promissory Note). Farmers should be aware of the implications of the ﬁnancing arrangement for triggering securities regulations (see Chapters 1 and 2, Federal

Securities Laws and State Securities Laws), especially in cases where the farmer solicits ﬁnancing for the land purchase from the general public.

Tax Implications of Owner-Financed Sales

Owner-ﬁnanced sales can involve complicated tax ramiﬁcations,

and it is advisable to consult with a qualiﬁed tax accountant to

understand clearly how the IRS will interpret the terms of the

arrangement. For example, in many cases, unless the arrangement

falls under speciﬁc exemptions, the IRS expects that some portion

of the loan will be paid back in interest and taxed accordingly. If

interest is not stated in the agreement, it will be imputed or implied

according to IRS regulations and the going IRS’ Applicable Federal

Rate (AFR). Read IRS Publication 537, “Installment Sales,” for more

information on the AFR and tax treatment of owner-ﬁnanced

sales. AFR rates are based on federal short, medium and long-term

interest rates, and are published monthly in the Internal Revenue

Bulletins (IRBs), available at local IRS ofﬁces or online at http://

www.IRS.gov. The rules for including interest hold true even when

sympathetic sellers desire to make zero or low-interest loans. For

tax purposes, if these transactions are to be considered loans (vs.

taxable gifts or capital contributions), they must follow IRS “Below-

market Loan Rules.” For more information about below-market

loans, see IRS Publication 550, “Investment Income,” available

online at http://www.IRS.gov.

Is the Land Encumbered?

Real estate is encumbered when a legal claim exists against a property

that restricts its transferability. Any farmer entering into an installment

contract (conventional owner-ﬁnanced sale or land contract) should

make sure to ask the all-important question: is the seller’s land or farm

encumbered in any way? In Vermont, buyers can access public records at

the town ofﬁce to research whether or not any mortgages or liens have

been recorded speciﬁc to the property in question. The buyer should also

consult with his/her attorney reviewing the agreement to conﬁrm that the

owner-seller will be able to transfer free and clear title to the buyer at the

end of the payment period. Buyers should also be aware if the owner-seller

is using the installment contract as a “wrap-around” to pay off a mortgage

from another lender while seller is slowly selling to the buyer under the

installment contract (which can be a dicey situation for both owner-seller

and farmer-buyer).

An owner-seller will not generally need a license from the state to sell and ﬁnance the property as long as the loan is

primarily for an agricultural property, and personal, family, or household use does not supersede agricultural use (e.g., a hobby

farm where the buyer is purchasing the land to serve primarily as a residence). Otherwise, the seller may need a mortgage loan

originator license.

Another Variation of an Owner-Financed Farm Sale: The Land Contract

In cases where a seller is reluctant to fully ﬁnance a start-up farmer with a low credit score and/or little track record in

the business of farming, a land contract with what amounts to a lease-to-own arrangement, aka an “installment contract”

may provide the seller with more comfort in taking a risk. Unlike an owner-ﬁnanced sale, the seller in a land contract does

not give the buyer a deed conveying an ownership interest in the property to the buyer until the full price is paid. Thus, unless

the land contract agreement speciﬁes otherwise, the buyer will not be allowed to borrow against the property by taking out a

second mortgage to ﬁnance farm operations, and the buyer will not be able to sell the property to a third party. Owner-sellers

might feel more comfortable knowing that they retain legal ownership while the land is “under contract” and the buyer is

making payments.

Land contracts allow for a great deal of ﬂexibility and creativity in setting the terms of payment. They allow both the

farmer-buyer and owner-seller to avoid the hassle and expense of most closing costs common in conventional mortgage

transactions. As noted above, land contracts give sellers more control than normal owner-ﬁnanced sales. For all these reasons,

land contracts are often the preferred mechanism for transferring ownership of agricultural property from senior to junior

generation within the farm family.

Land contracts can be considered as conventional purchase and sales agreements with a greatly extended time period

before closing—instead of signing a purchase and sales contract and then taking 30-45 days to close the deal, land contract

deals can take as long as 30 years. Five to ten years is a more common time frame, with a regular payment schedule concluded

by a balloon payment. The assumption is that in ﬁve to ten years, the farmer-buyer will have enough time to improve his/her

balance sheet and credit to come up with traditional ﬁnancing to make the lump-sum payment that ﬁnishes the deal with

the seller.

Lower risk for the seller, in some cases, means higher risk for the buyer. In traditional land contract arrangements, when

a buyer defaults, there is typically a forfeiture provision whereby the buyer loses the property and all the payments they have

made. He or she is not likely to be entitled to the legal protections of the foreclosure process. If the buyer resides on the

premises, the seller will have to use eviction procedures pursuant to state law. If the buyer does not reside at the premises, the

seller can likely pursue an ejection action against the tenant. The seller can take back the property without going through the

foreclosure process because there is no mortgage involved, and under the terms of the contract, the buyer loses possession

of the property. A buyer generally cannot recover principal paid to the seller, unless the contract speciﬁes otherwise. Instead,

the buyer may forfeit past principal payments upon breach of the contract (essentially, those past payments may be viewed

19 8 V.S.A. § 2201(a)(3) describes these licenses, and subpart (e) of the same section outlines exemptions for the license requirement. A Vermont Superior Court case in 2011

elucidated the terminology of “in the business of.” Based on the statute and the recent case, it would be rare for an owner-seller to need a lender license when selling to a

farmer-buyer, assuming the seller is not involved with money-lending aside from the owner-ﬁnanced deal.

20 The USDA Farm Service Agency’s deﬁnition of a land contract is “an installment contract drawn between a buyer and a seller for the sale of real property, in which

complete fee title ownership of the property is not transferred until all payments under the contract have been made.” From the January 2012 FSA Fact Sheet on the Land

Contract Guarantee Program. Accessed online 2/14/12 at http://www.fsa.usda.gov/Internet/FSA_File/lc_guarantee_program.pdf .

Image used with permission of Rachel Schattman.

as lease payments compensating the owner for the buyer’s past use of

the property as a farm and residence).

Here again, it is up to the parties

to anticipate these possibilities and to tailor the agreement to their

expectations and needs before signing on the dotted line.

Farmer-buyers often intend to make changes or improvements

to the property as the farm gets up and running, before making all the

required payments under an owner-ﬁnanced sale or a land contract. It

is important for the parties to determine the fate of these improvements

in case the agreement goes sour, either from the buyer’s default or the

seller’s breach of contract. For example, the contract can include a

formula that indicates how much the owner-seller should pay the buyer

for improvements made prior to default. In other cases, the seller might

not want to be responsible for compensating the buyer for improvements,

justiﬁcation being that the seller assumes risk by permitting the farmer to

access and alter the land while the seller still owns it, still pays the taxes,

still is ultimately responsible for environmental laws breached, etc. In

any case, it is common practice in crafting land contract agreements for

parties to agree that the buyer must seek the seller’s permission before

making any major improvements to the land or buildings on the property

during the contract period. Remember: the buyer does not actually own

the property until the seller receives all payments required under the

land contract!

Payment of property taxes and insurance are key considerations

for both parties. The buyer will want to be sure that the seller is not

behind on taxes. A buyer can obtain tax status information at the town

ofﬁce where the property is located. Insurance is another important

issue; the farmer-buyer should ask the owner-seller or his/her agent

about the seller’s insurance policies on the property. This information

will give the farmer-buyer a sense of what kinds of prominent risks

might exist in owning the property and how and at what cost insurance

might mitigate these risks. The parties will also want to agree on

who will pay insurance and taxes during the payment period of the

installment contract.

There are many templates found and sold online for developing

installment sale agreements. While the parties can do much of the

preliminary work on their own, including negotiating key terms, there is

no substitute for the expertise of an attorney or an accountant familiar

with these types of transactions.

Buyers and sellers have been using owner-ﬁnanced sales and

land contract sales to transfer property without third-party lenders

for decades. With creativity, careful attention, and timely assistance

of professionals such as attorneys and accountants, these alternative

ﬁnancing agreements can help a start-up farmer clear the biggest

barrier to entry in agriculture: access to farmland.

21 Some courts have imposed a more equitable parting of the ways, and have ordered the

return of some of the buyers payments. Dow, Heikkila v. Carver, 378 N.W.2d 214 (S.D.1985),

and Prentice v. Classen, 355 N.W.2d 352 (S.D.1984).

22 USDA FSA opened nationally in 2012 the Land Contract Guarantee Program. According

to FSA, “guarantees will be offered to the owner of a farm who wishes to sell real estate

through a land contract to a beginning farmer or a farmer who is a member of a socially

disadvantaged group.” For more information, contact your local USDA service center FSA

ofﬁce or see the FSA one-page fact sheet on the program online at: http://www.fsa.usda.gov/

Internet/FSA_File/lc_guarantee_program.pdf Accessed online 1/26/2012.

Image used with permission of Steve Mease.