Full Disclosure Finance

By Justin

I have recently put my rental property up for sale, which I have held for a few months now. In the process of potential buyers walking through and seeing the place, the feedback has varied wildy. I have heard “the place is in below average condition”, and then 2 weeks later heard it was “in very good shape”. I guess the residents must have had a huge cleaning spree spontaneously…hmm.

Some buyers clearly looked at it and asked themselves if they would live there, which is not the point. The important question to ask is “would residents live here at the rate I would like to charge?” I could tell when experienced investors went through because their questions were related more to financing and confirming details of operating expenses. One question I was asked yesterday was “would you do a vendor take-back mortgage for 10% of the price at 12% over 5 years?”

My answer was a clear NO, because I didn’t know anything about them. This was a group of experienced investors that own multiple properties in the area and are always looking for the option of a vendor take back. The advantage is that they have to borrow less from a lending institution, which allows them to devote capital to another deal.

But you’re saying, hold up, what’s a vendor take back?

Good question, I had to find out for myself.

The Canada Mortgage and Housing Corporation (CMHC) describes a Vendor Take Back Mortgage (VTB) as when the seller or vendor rather than a financial institution finances a portion of the mortgage. An agreement is made between the two parties independent of much of the administrative hassle associated with obtaining one through a financial institution. This can be helpful when the buyer cannot (or it does not provide decent leverage) finance the entire property from a down payment and conventional first mortgage.

Advantages for the Vendor (Seller of the Property):

Firstly, it provides steady cash flow over time, rather than dumping a pile of money and forcing you to go out and get a return on it somewhere else. There is also the ability to defer some payment of capital gains taxes if you elect to do a VTB. The amount you can defer varies with the amount you took back. The link to Real Estate Investing in Canada.com contains more details.

Key Data:

Purchase Price is $ 100,000
Selling Price is $ 250,000
Capital Gain is $ 150,000
Initial Proceeds are $ 100,000
Vendor Take Back $ 150,000
1/5 of Capital Gain is $ 30,000
Annual Payment is $ 15,000
In this case the VTB amount is equal to the amount of capital gains. This is an easy scenario for calculation purposes.

You can spread the capital gains over a maximum of 5 years. The amount that can be deducted each year is the LOWER of the following calculations:

#1
Total Capital Gain ($150,000) x (100% -(Years Since Sale) x 20%)
e.g Year of Sale $150,000 x 80% = $120,000

#2
Amount of VTB Outstanding ($150,000 – any payments made) / Sale Price ($250,000)
x Total Capital Gain ($150,000)
e.g Year of Sale $150,000 (no payments made yet) / $250,000 x $150,000 = $90,000

The lower amount of $90,000 is deferred from the capital gain of $150,000. Therefore one will report a gain of $60,000 on their tax return (only half is taxable at your personal income tax rate) instead of $150,000.

The savings for someone earning the 2005 median Canadian household income of $48,800 in Ontario would be as follows:

Marginal Tax Rate: 31.15%
Tax Paid on Full Gain = $150,000 x 50% x 31.15% = $23362
Tax Paid with Deferral = $60,000 x 50% x 31.15% = $9345
Savings for Year = $14017

You will eventually pay capital gains tax amounting to the total of $23,362 , but deferring it over 5 years means that the present value of tax paid is lower (due to the deflation of money over time).

Disadvantages for the Vendor (Seller of the Property):

In my case, I would have less capital to use for the purchase of another property. I would also be required to draft an agreement between both parties and obtain some collateral for the VTB amount, which may be difficult.

After drafting an agreement, it is difficult to modify it if something has been missed because the changes must be agreed upon by both parties.

The primary disadvantage then is that you are entering into a legal agreement with someone who is not guaranteed to pay you. The risk is on my end to ensure I draft a solid agreement that ensures I will be protected. At this time, I am not confident that I can do that and therefore have chosen to pass on the option.

If you are financing the entire property then you have it secured. In the event of a default, the title would return to you. In the case when you are acting as a second mortgage for the buyer, the institution holding the primary mortgage will generally have secured the property. In the event of default, where would I stand? With nothing secured, I would have to proceed through the courts to obtain a settlement, which is time consuming and costly.

According to British Columbia Law (Hey, it’s still Canadian!) there are 3 critical clauses that a vendor should seek to have in their VTB agreement.

1) A ‘due on sale’ clause stating that upon sale of the property, the purchaser of the VTB must repay the full amount of the VTB, at the option of the vendor (me).
2) Give the vendor the right to cure any defaults under a prior mortgage in order to increase the principal secured under the current VTB.
3) A ‘prior mortgage’ clause giving the vendor the right to foreclose if payments are in default even if payments for the first mortgage are in good standing.

I’m sure you can now see the need for a great real estate lawyer if you’re going to get into this game!

Conclusion:

This move has tax advantages that make it worthwhile if you do not need the capital to make another purchase. It is currently over my head, so I took a pass. I would be interested to hear your experiences with VTBs and any advice.