Learn about wraps and structure better deals
A “wrap-around” mortgage (also referred to as a “wrap”) is a subsequent and subordinate mortgage secured by real property where a first mortgage remains outstanding and unsatisfied. A wrap differs from a conventional second mortgage in that it requires an agreement between the parties for payment of the first mortgage obligation by the lender. Consequently, the principal of the wrap-around loan is the sum of the outstanding indebtedness on the first mortgage and new funds advanced.
The wrap technique is typically employed in transactions involving large commercial loans. However the same financing technique is used in single family real estate investments.
Here’s an example:
Joe owns a commercial property with a $500,000 value and a mortgage of $150,000. He enters into a contract to sell the real property to Jane for $500,000. The contract consists of a note for the entire $500,000 payable to Joe.
Jane will make payments on the $500,000 loan directly to Joe.
Joe will in turn continue to make payments on the $150,000 underlying mortgage and retain the excess, if any.
Wraps and installment sales
Frequently in the sale of real estate, the seller may elect to receive payment in installments, providing the purchaser a convenient financing option while generating desirable tax benefits to the seller. As described in more detail in How to Defer Taxes on Capital Gains, installment payments can defer taxes on capital gains if the seller receives at least one payment after the year of a disposition. Use of an installment sale permits a seller to spread the recognition of taxable income over time and avoid recognizing the entire gain before actual payment is received.
Generally, if a buyer assumes a mortgage or purchases the property subject to an existing mortgage, the excess of that debt over the seller’s basis is treated as a payment received in the year of sale (triggering gain recognition). In addition, the assumed mortgage is not included in the contract price, resulting in a higher gross profit percentage, accelerating recognition of taxable income.
If a wrap mortgage is used, the contract price is the entire sales price, resulting in a lower gross profit percentage (and correspondingly less gain recognized in each year’s collections). Also, since the property is not taken subject to the seller’s mortgage, there is no tax on a phantom payment in the year of sale, even if the mortgage exceeds the seller’s basis.
Beware the due on sale clause
The due on sale (or acceleration clause) is a provision in most mortgage documents that allows the lender the right to demand payment of the unpaid loan balance when the property is sold. This is a right provided by the contract, not by law. This means if title to the property is transferred, the bank has the right, but not the obligation, to demand payment.
Benefits to buyers and sellers
Wrap-around mortgages can offer flexibility and tax benefits to both buyer and seller. The wrap also includes credit risk if the purchaser defaults or if the underlying mortgage lender calls the loan.
We’ve got your back
Are you considering using the wrap-around technique on your real estate transaction? You’ll need to consider both the tax and legal ramifications. At KRS, we’re pros at real estate taxes, so contact us to discuss your plans at 201.655.7411 or [email protected].