Frequently Asked Questions About Sub2

There are many ways to buy property. In the almost 3 decades that I have been investing, I have bought with cash, bank loans, via sandwich lease options and my personal favorite, "Subject-To".

In my opinion, subject-to is the easiest, fastest, cheapest, least complicated way to acquire property, although contrary to what some will tell you, it is not without risk. Although in a lot of cases you CAN buy without having cash, I would not recommend doing so without cash or access to it. Agreeing to make payments on someone's loan is a huge responsibility, and I think everyone that utilizes this way of buying should look at each loan as if he himself had personally signed the mortgage.

Below are a few of the questions I have been asked in the past about this method of buying property. I hope these questions and answers help you in understanding this method.

What is buying a house "Subject-To"?

When you buy a property "subject-to", you are purchasing it subject to the existing financing. Simply, this means that the loan already on the property stays there without any formal assumption on your part. The owner deeds the property to you, and you take the payment book and start sending in the payments just as the former owner did. Simple, huh?

The seller deeds you the property and remains liable for the debt? Why would any seller agree to that?

There are as many reasons as there are houses. In the 2 1/2 years that I have been a full-time investor, I have had over 60 houses deeded to me from sellers in a wide variety of situations.

There was the seller with perfect credit who was being downsized and wanted to stay, as he put it, "ahead of the 8 ball". He deeded me a beautiful 3/2, 2 story, only 7 years old with over 25k in equity. He just needed a fast sale.

There was the lady who deeded me her house for the loan balance of 14k. She had owned the house for 25 years and her mother had recently died and left her another house free and clear. Although the house she deeded me needed 10k in work, it was still worth 70k or so. When I asked what she wanted for it, she said she just wanted to be rid of it. I was happy I could assist her.

There have been many sellers who have deeded me properties days and even hours away from the auction block, some with substantial equity, some with little equity but 6% loans.

Not all sellers who deed you their property are "unsophisticated" or "down and out". Some just realize that they have a problem that needs an immediate solution. You just need to know how to provide it.

Isn't buying this way illegal? What about the "due on sale" clause?

There is absolutely NOTHING illegal, immoral or unethical about buying property subject to. Banks began using "due on sale" clauses in their mortgages in the 80's when interest rates rose significantly and homebuyers were assuming lower rate mortgages instead of obtaining the higher rate, new loans. The due on sale clause gives banks the right, at their option, to call the loan due upon transfer of title or beneficial interest in the property with a few exceptions such as transferring title into a land trust for estate planning purposes. With today's interest rates, the likelihood of any bank calling a performing loan due would be in my opinion miniscule.

I heard that if I buy this way, I am not liable for the loan. If I can't make the payments, I can just give the house back to the seller. Is this true?

Sorry, but I don't go along with that baloney some gurus will tell you about how you should "not make any promises" to your sellers.

In my opinion, from a moral standpoint, you are totally responsible for this loan once the paperwork is signed. A seller needed your help and you offered him a solution. He trusted you and now it is up to you to keep your word and do what you have to keep that loan in good standing.

From a legal standpoint, you might be responsible. I have heard of a couple of lawsuits in the past few months regarding investors who failed to make payments on loans they had taken over with this method.

My best advice would be, don't do the deal if you can't follow through.

I have heard "Subject-To" is a good way to get started without cash or credit. Would you recommend this?

Absolutely not. Although it is touted by some investors as a good "no money down" way to buy, I recommend having at least 3 months reserves to cover payments until you can either sell this property or get a tenant/buyer in it. What happens if you can't get it rented quick enough? What happens if your tenant doesn't pay and you have to evict? Things like this happen (ask me how I know) and you have to be ready.

There is also the DOS to think about. What would happen if the bank DID call it due? Granted, the chance is small, but that has to be a consideration. What would you do? Could you refinance it? Do you know another investor who had good credit who would partner with you?

Subject to is a great way to buy property. It is cheap (no closing costs to pay), fast, (no qualifying with the bank), easy, (you can close on a kitchen table) but it is not without risk.

Learn to use this method properly and it will be very good to your balance sheet.

Subject To Investing for the Beginner

Where the term “Subject To” came from is a mystery to me. Whoever thought of this method of investing should be immortalized in the Real Estate Investing Hall of Fame, should there ever be one.

When you purchase a property "Subject To" the existing loan stays in your seller's name. In other words, the seller leaves his current loan on his property in place and makes it available for you and then your buyers' use. You become the owner of the property when the seller signs the Grant Bargain & Sale Deed or other State specific device to transfer property.

You usually give the seller of the property at least token money, what I refer to as “U-Haul” money or moving out money for their equity. When you sell the property, you can offer No Qualifying Loans to your buyers. This makes the house attractive in your prospective buyer's eyes. Selling “No Qualifying” to someone does not necessarily mean your buyer has bad credit. It could mean he/she is new to the area and some lenders want two years residency before granting a loan. Because you are selling to Non Qualifying buyers you should get $6K to $12K down on houses worth $100K to $150K. Remember you are the owner so you can even advertise Owner Financing. You can raise the interest rate; let's say it is 7%, make it 9% this will add an additional $200 per month in your pocket. Then you might increase the value of the house 10% to 20% so when the time comes for your buyer to refinance, usually in approximately 2 years, this could give you an additional $10K, $20K, $30K etc. once the house is actually refinanced. The average profit on one deal of this kind would be close to $28K for your investment of around $1K.

Before 1988, 1989 there were loans, FHA, VA, that were fully assumable with out qualifying; no credit check required. Today almost all loans include a Due on Sale (DOS) clause whereby the lender can call the note due and payable upon transfer of the property to someone else.

However, it is my belief that if the loan is kept current then no ”flag” is thrown to trigger this clause. I have personally never had a loan called on my properties nor known anyone else that has. It is not illegal to take over or, I should say, become responsible for someone else's loan. I felt this area of "Subject To" should be covered, as it is a risk inherent with "Subject To" investing, but certainly one that has not concerned me. However, you should be prepared to address this situation should the need arise by re-financing or building your Trust Account up, which I will discuss below. There are risks in all forms of real estate investing if not done properly. "Subject To" is no different.

I use a Loan Servicing Company (LSC) to collect my buyers' payments and to disperse these funds to the lenders. This is also an excellent way to address the objection from a seller, “how do I know my payments will be made, so my credit is not affected.” Set up a trust account at the LSC where you leave extra money to make payments should your buyer or buyers fail to do so; usually one to three months of mortgage payments taken out of what you get as a down payment on the property. The LSC sends out year-end statements to your buyers that they use for interest deductions on their income tax. The LSC eliminates your having to take care of accounting and mailings that take away from your productive time of buying and selling houses. The LSC also keeps a record of how your buyer is timely paying the mortgage, this plays an important role when the time comes for him to refinance. Lenders rely heavily upon this record in making a decision to loan money. I stress to my buyers how important it is to make their payment on time. Even buyers that have had credit problems in the past have been able to get a new loan because they have made their payments on time to the LSC.

When you first start doing "Subject To" investing, you will be "Subject To" receiving large amounts of money. If you are not accustomed to this type of money being available to you, then my advice would be, instead of buying the new Mercedes, let your Trust Account build up to a comfortable level then budget your money on a monthly basis. Then buy the Mercedes or “Beamer” for the younger set.

You may possess all the knowledge in the world about real estate investing, which is absolutely useless unless you “apply” the knowledge learned.

This is a small effort on my part to give you a better understanding of "Subject To" investing.

They Told Me I Wouldn’t Need Cash When Buying Subject-To!

Alright, here is the bad news. Forget about what the GURUs told you about how you don't need cash or credit to do this business. Although buying sub2 is essentially buying with owner financing, sometimes these houses will need payments brought current or minor to major repair. This takes cash. There WILL be times when you will need cash or credit or a combination of the two. Don’t get me wrong, you CAN do some deals without either but if you are thinking about holding property without having at least the ability to get cash if needed, I just have one word for you..DON’T!

Holding property without the means to take care of the unexpected is foolish and extremely risky. Since we want to be successful real estate investors, we don’t want to be foolish or risky. If your bank account is sitting at -0- and a tenant doesn’t pay, what happens then? What if they move out and trash the place, who pays to repair it? In GURU world, tenants always pay and never skip out. In my world, and yes, yours too, it happens more often than you would like to think. Be ready for it.

Here are a few things to do to have money ready when you need it.

Credit Cards

When I first got started I was fortunate enough to have both a little cash and great credit. While you don’t need both, it does help to have one or the other. I knew I wanted to leave my job ASAP and I also know that as soon as I was unemployed, the banks might not look as favorable on me. Knowing that the banks might not lend me money while unemployed, I started sending in every pre-approved application that came in the mail. I soon had over 300k available to me in cash advances that I could use to make up payments or buy and rehab properties. While I have never had to use this source to actually buy property, it was nice knowing it was there if I did need it.

As most major credit cards allow you to get cash advances or write checks to access the credit limit, it can be a source of fast cash. The fees to do this are usually small and certainly less than the typical points, survey, title insurance and appraisal costs of banks which you won’t have using this method. In addition, once you have several cards, you will be bombarded with cash access checks with promotional 0% interest rates for 6 to 12 months. I once knew a lady investor who would actually buy junker houses with cash access checks at 0% interest rates and rehab them. If they hadn’t sold by the time the promotional rate was up, she would just do a balance transfer to another card and another 0% interest card. She bought dozens of houses with no finance charge! Pretty creative, huh?

Bank or Other Institutional Financing

If you already have a relationship with a bank, you may be able to get a credit line. These come in two flavors, secured and unsecured. Secured credit lines typically are secured by the real estate you buy with them. They may be good for one year and have to be renewed at that time meaning that the bank can call them due at renewal time in they want. The unsecured works like a checkbook. The bank gives you a credit limit and a checkbook and you can spend as you wish. These lines are great for down payments or to bring payments current on a pre-foreclosure or to make repairs to property or for whatever else you may need. Getting a sizable one is generally difficult and something that you have to establish yourself with the bank before they will consider it.

Friends & Relatives

These can be sources of borrowed money but I would only consider it as a last resort. Nothing wrecks relationships faster than not being able to pay back a personal loan. Give them a little time and let them start to see you making cash and doing well before you approach them. They might even approach you first!

Partners

While I have never used partners, most every other investor I know has. Partners can be anyone from other investors who have the cash to help you fund arrears or fix-up in exchange for a share of cash flow or back-end profit to folks who have no interest in real estate investing who are just looking for a return on their money. Be sure if you do use partners to spell out very clearly exactly who has what job in the agreement.

Hard Money/Private Money

Look for private individuals who make loans on real estate. You can find them through your local real estate club or research at the courthouse for individuals who are making private loans on real estate. Hard money lenders are usually equity based lenders meaning that they are lending purely on the value of the property not on your credit score. They generally loan up to 70% of value at higher than bank rates, usually 12 to 18%. This is just a general guide as some of them may lend less and some more. Some may want to check your credit and some may not. Most will only lend as a first mortgage but a few (like mine) will lend me cash for a second mortgage which comes in handy on sub2 deals where there are arrears or that need repairs. These are good lenders to have as you will need cash from time to time to bring loans current so you can take over payments. Get to know a couple of these lenders if you can. They are just people like you and me who have cash that they want to get a good return on.

I met my primary private lender when I called him on a home he was trying to sell. We chatted a few times, developed a rapport and he agreed to lease option it to me. I paid him like clockwork every month for two years and when the tenant/buyers finally cashed me out, I asked him what he was going to do with the cash. I proposed him lending to me to buy real estate on the short-term and we agreed at 8%. It is much better than CDs for him, much better than hard money for me. Truly win/win. Now when I need money for a cash deal I call him up, drive out and have a cup of coffee with him and leave with a check. No appraisals, fees, credit applications, balance sheets or hoops to jump through.

Don’t get me wrong, there are deals out there that you can buy sub2 that will not need cash to close the deal. Pretty houses where you have buyers ready to go into them, even fixer’s in nice neighborhoods if you have a ready buyer may not need any cash from you, however, you are going to be missing many, many opportunities by not having a source for cash WHEN you need it.

This week, for example, I bought a pre-foreclosure sub2. This house is a 3/2 on 1 acre in a great suburban area of our town and will sell fast. It needs very little in repair (maybe $1500) and it is all cosmetic. The owners are divorcing and had abandoned the house. They have owned the house for 10 years and it has a 7% VA loan in place with payments of $640 PITI. They owe 76k on this house worth 115k and they gave it to me for the loan balance but I had to make up the 7k in arrears. Had I not had access to the cash to do this, I would have had to pass on this deal.

Take the time to line up sources for cash. There really are many sources out there and you don’t have to have perfect credit to use them. Once you have these sources in place, you will find many more potential deals in your area.

Tax Issues on a Subject 2 Deal

You buy a property "subject to" an existing loan. You sell the property on an installment land contract or lease/option. What are the tax ramifications?

Part One - Determining Your Basis

Your tax basis is basically what you paid for a property. If you have a seller $2,000 and took a deed subject an existing loan of $189,000, your basis is $191,000. Basically, your basis in a subject to is cash paid to the seller, plus existing loan you are taking over. If you also paid money for back taxes and mortgage payments, that would also be part of your basis. So, if in the above example you paid $3,000 to the lender to cure the back payments, your tax basis is $194,000.

Part Two - Figuring Out Your Gain

If you resell the property for cash, the gain is easy to figure out; sales prices less your basis, less your sales costs (broker fees, closing costs, etc). If you resell the property on a lease/option, you haven't really sold it at all, since a lease/option is generally not considered a sale until the tenant exercises the option to purchase. During the period of the lease, you would be taking depreciation, so there's a recapture of that depreciation when you sell at 25%.

If you resell on an installment land contract (aka "contract for deed"), it IS a sale, even though title does not pass to the buyer. Thus, your gain is the sales price on the contract, less your tax basis. This is considered an "installment sale", so your taxable gain is based on the cash received, plus any principal received in the year of sale. When the buyer pays off the balance of the contract, you have a gain in that tax year for the balance of principal received.

Part Three - The Interest

This part of the equation always gets people confused. In our example above, you bought a property from Sally Seller subject to the existing loan. You then sold it on a land contract to Barney Buyer. Who "owns" the property? For federal income tax purposes, there were two sales - from Sally to you, then from you to Barney. So Barney would be deducting the interest he is paying on schedule "A" of his federal income tax return as the "equitable owner".

This appears confusing because you have the deed and Barney does not. It is also even more weird because Sally Seller's lender is sending a form 1098 for the annual mortgage interest to the IRS in Sally's name! Don't let that fool you... the basic rule of the interest deduction is that the person who has an ownership interest in the property, uses it as his principal residence, and actually makes the interest payments is the one who is entitled to the deduction. So, in this case, Sally Seller neither owns the house nor makes the payments - she does nothing. Barney Buyer is the "equitable owner", which give him an ownership interest. And, Barney is also actually making the interest payments, which he can deduct.

One last part of the equation - the interest you are paying on the underlying loan. If you buy subject to and sell on a wraparound, you are collecting payments from Barney Buyer and continuing to make payments on Sally's underlying loan. The interest you pay is deductible as an offset (business interest) against the interest income you are collecting from Barney Buyer.

Yes, the Seller Can Get a New Loan

One of the questions I see asked over and over on the REI newsgroups is "Can the seller get another loan?" This is a great question because it so often is one of the objections raised by a seller when a creative offer is being discussed.

The short answer is "yes". Only in rare situations would a seller not be able to qualify for another loan. This, of course, assumes the seller would typically qualify if they were not going to leave their loan behind. Let's explore explanations that can be used with the seller.

Straight Rental

If the seller doesn't sell the house and plans to move anyway, the seller will be forced to either lose the property to foreclosure or lease the property out soon.

Yes, there are other solutions, but this is what the typical motivated seller sees as their options by the time they jump on the phone and start contacting real estate investors. The above responses seem to be the two most common answers to the "What will you do if it doesn't sell?" question.

So, let's assume for discussion purposes that we are not involved at this point. If the seller finds someone to lease their property, the seller's loan will still be in place. The seller may or may not have landlording experience and may or may not have a decent tenant. Those arguments come in handy for other objections, but don't really affect the "new loan" scenario. Most lenders will give the seller a 75% income credit toward their debt ratios. For an example, assume the seller has an underlying payment of $750 and a tenant who's paying $1,000. The lender will include 75% of the rental amount, or $750, as income which will help offset the underlying debt payment of $750. It's not really a "wash", but it's pretty darn close.

Even if the rent were only $750, the 75% rental income credit would equate to $562.50, against the monthly payment of $750. In my experience the $187.50 is usually not enough to disqualify the seller for the loan.

So, to summarize, regardless of whether you plan on acquiring the property through a lease option, Sub2, or some other form of creative financing where the existing loan stays in place, the worst case scenario should be that the new lender treats the property as if it's a rental.

Lease Option

If you've entered into a lease option agreement with the seller, this may work favorably for the seller in qualifying for a new loan. Again, worst case should be that the property is treated as a straight rental. Best case would be that the lender gives the seller full credit for the debt payment.

Sometimes the lenders may have different requirements to "prove" the payments are actually being made by the investor. In the past I've been asked to supply a letter confirming my agreement to be responsible for the payment. Sometimes having the seller
show the lease option agreement may be enough. Other times I've had to actually round-up copies (front and back) of the cancelled checks and mail those off.

As far as I know, I've never had a seller not receive full credit for payments that I'm making
and the sellers will typically contact me when applying for a new loan. I invite them to do so when having the initial discussion about the Due-on-Sale (DOS) clause and the "How do I get another loan?" concern.

Owner Financing

Generally, this will be a no-brainer if the transaction is done in a "traditional" manner. By this, I mean that a document exists that can be shown to the lender as evidence of the transaction and agreement. It could be a promissory note and deed of trust (mortgage in some states), contract for deed, or similar document.

I think that some investors become more concerned when purchasing the property subject to the existing financing (Sub2). Since many Sub2 transactions do not have a "traditional" type document that proves the purchase, a bit more effort may be needed here.

Depending on the language in the purchase agreement, this may or may not be an issue. More often than not my sellers are able to prove the sale by providing the lender a copy of the agreement. Since my agreement states that I'm responsible for the payments, this will frequently satisfy the new lender.

If it doesn't do the job by itself, adding a copy of the completed HUD-1 Settlement Statement will boost the argument. Regardless of the fact that I filled the HUD-1 out myself, it does evidence the fact that a sale took place. Until you know what you're doing, I would recommend allowing the title company or closing attorney to complete the form for you. If you're buying title insurance on the deal, it will most likely be done for you anyway.

If you do decide to do it yourself, you can get a fillable PDF copy on the Real Estate Forms page on this site. Use a copy of a prior transaction to use as a guide and/or have someone who is knowledgeable review your work.

Time for a quick side note here. Some loan officers and real estate investors will offer up the suggestion that you either create a "contingency" document at the time of purchase or backdate one at the time of the loan application. Utilizing a document (typically a Contract for Deed) that really plays no part in the substance of the transaction just for the purposes of making it easier for your seller to get another loan is not only unnecessary, but potentially fraudulent.

So, even on a Sub2 transaction which typically involves less documentation and is unfamiliar to almost every party who will be involved in the seller's loan process, proving the payments are being made shouldn't be a big issue. It may require some additional effort by the investor if the purchase agreement and HUD-1 are not sufficient proof, but the seller can qualify for a new loan and will typically receive full credit for their prior debt payments on the property.

One potential risk that I have not run across personally might be if the seller somehow ended up at the same lender who holds and/or services the first loan. Perhaps that would cause some problems, but again, this is easily addressed when having the initial DOS discussion.

To summarize, the seller can get another loan even after leaving the prior one in place and this objection should be a non-issue when discussing the acquisition of their property, regardless of which creative technique is used.