There's a common misconception I hear from land investors who are selling their properties with owner financing.

I hear it so often that it warrants my time to write this blog post, so I can explain it once and not re-hash it every time I hear this.

Here's the issue…

A lot of people think that if they sell a property with owner financing (like a land contract, where the deed isn't recorded until the loan is paid in full) and if the borrower defaults (i.e., stops making their loan payments), the land investor can simply re-list the property and sell it to another buyer all over again.

“I never recorded the loan documents and I haven't signed a deed to the buyer yet. The county doesn't know about the transaction and the borrower doesn't have the deed, so it's like the deal never happened!”

Wrong.

Just because you haven't signed a deed over to the buyer and haven't recorded any loan documents doesn't mean you have the right to re-sell the property.

Understanding a Buyer's Equitable Interest

There's a reason you can't just re-sell a property when your borrower stops paying.

When both parties have signed loan documents, and after the borrower has made even a single payment to the seller, that borrower now has an equitable interest in the property.

Even if the loan documents haven't been recorded at the county, and even if the borrower doesn't have legal title yet (with their name on a recorded deed), the equitable title gives the borrower the right to obtain legal title in the future and to access the property in the meantime.

Even worse, it gives the borrower the right to grant recorded mortgages against the property and incur liens, which will take precedence over your unrecorded loan documents. If this happens and you try to recover the property, the net value could be zero.

Let me repeat that.

Even if you never record the loan documents for your sale of the property, it's not as simple as walking away from the borrower and re-selling the property. You must still go through the proper channels to eliminate their equitable interest.

Granted, if those loan documents aren't recorded, it would certainly leave title insurance companies and title searchers blind to the issue, but that doesn't mean the issue is actually gone. As long as your original buyer has copies of the loan documents they signed, along with purchase and sale documents (which the closing agent is required to give them) and can provide proof that they've substantially performed their payment obligations, all they would have to do is bring those documents to a judge, and they would still technically have an equitable interest in the property.

Now, practically speaking, most defaulting borrowers aren't going to come back and give the lender trouble when they know they've defaulted and they're in the wrong, but the only way to be 100% certain and eliminate any possibility of future problems is to properly remove their interest in the property.

But if the defaulting buyer does try to contest the default, there could be big consequences for failing to record documents. Consider what could happen if the defaulting buyer files for bankruptcy protection. The Trustee can take over the defaulting buyer's entire equitable interest and cram your unrecorded loan documents down into an unsecured position. You end up with an unsecured claim and possibly no net value.

RELATED: Land Contract or Deed of Trust: Which is Better for Seller Financing?

How Easy Is It To Remove a Borrower's Equitable Interest?

Now that we've beat that issue to death, you're probably wondering,

“Okay, Seth. How do I remove the borrower's equitable interest in my property?”

The “ease” of getting rid of the defaulting borrower's equitable title depends on a few things,

• What kind of loan instrument you use.
• Whether your loan documents contained the correct language in the state where the property is located.
• Whether you're in a judicial or non-judicial foreclosure state (judicial foreclosures involve a lot more time and red tape than non-judicial foreclosures).
• If you can work out a solution directly with the defaulting borrower.
• Whether the documents were recorded correctly in the first place.

In the ideal scenario (if your borrower is responsive), it's much easier to communicate directly with the borrower and get them to voluntarily surrender their interest in the property.

Even if you have to pay them for their trouble, it's much cleaner and easier to get their cooperation than forcing them out through your state's judicial foreclosure process (which is kind of like the nuclear option when all else has failed… it will work, but it's more like the last resort).

Getting a defaulting borrower to simply sign over a quit claim deed to you will effectively wipe out their equitable interest in the property… but again, this will only be an option if the borrower is willing to pick up the phone when you call and/or respond to your emails and texts.

If they've changed their number, moved away, and disappeared off the face of the earth, you'll have no other option than to go through the proper legal channels, which vary from state to state (some states make it much harder than others).

Choose Your Battles Wisely

Is it a pain to deal with all of this? Absolutely.

Especially if the property was only sold for $5,000 and you're getting a measly $100/mo.

When a past due borrower isn't responsive or willing to sign a quit claim deed back to you, it's hard to justify going through the “proper legal channels” to remove their equitable interest.

For this reason, it's a smart move to only offer seller financing on properties that are worth fighting for.

If you don't want to spend months clearing the borrower's interest in a super-cheap property, then don't offer seller financing on super-cheap properties. Sell them for cash!

Seller financing is an incredible selling tool, but that doesn't mean you should automatically offer it on every property you're selling. Look at the numbers and make sure that in the worst-case scenario, if the borrower decides to put you in a bad position, you won't be forced to fight a battle where you're guaranteed to lose.

The Purpose of Borrower Screening

And don't forget; there's no reason you need to walk into a lending relationship blind.

The whole idea behind borrower screening is to build confidence that your borrower won't default in the first place. When you have confidence that the borrower will do what they agree to, you won't have to deal with getting your property back or getting rid of their interest in the property.

Every serious lender does this kind of underwriting upfront because there's a lot more money on the line, with a much higher LTV, and they want to know who they're dealing with before they commit to a financial relationship.

That being said, if you're in a non-judicial foreclosure state and/or if you have a good system for repossessing properties without going through foreclosure and/or if you're dealing with a super-simple type of property (like land) and you're comfortable with the inherent risk of not knowing your borrower very well, I can see why some people would rather forego tenant screening and deal with the risk. But the point is, you don't have to go into a lending relationship blind (and institutional lenders simply won't do it).

Expect Defaults (And Know How to Deal With Them)

All this to say, if you're serious about getting into seller financing, expect some borrowers to default.

It will happen, and if you aren't willing to spend time investigating your borrowers beforehand, you should expect it to happen more frequently.

And when these defaults inevitably happen, don't just “wing it” and assume it's fine to re-sell the property just because the transaction hasn't been recorded at the county.

If evidence exists anywhere that you have a loan agreement with a borrower and that they've paid any amount of money to you, they can absolutely come back to haunt you in the future.

Before you get too deep into seller financing, understand precisely how to handle a defaulting borrower in your state (remember, every state has different rules), and figure this out before you close on the deal and start taking payments (yes, even if that means paying a local attorney to help you understand how it works).

Seller financing is an excellent tool for selling properties faster and often at a higher price. It's also a great strategy for real estate investors who want to build sources of recurring income. But even with all of its advantages, it's still important to do the hard work of dealing with loan defaults properly.

Know how to repossess properties in your state and follow the rules! You'll sleep much better at night.

Reviewed by Mark H. Zietlow, Innovative Law Group