Want to sell your house at a nice price?

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Seller financing may help–if you know what you’re doing.

In early October, when Dorte and Houschang Pakpour put their Mediterranean-style villa in Laguna Beach, Calif. on the market, they put a little extra bait on the hook. In the glossy sales brochure touting the ocean and canyon views, European gardens and cathedral ceilings, the Pakpours noted that seller financing was available. “I’m willing to work with a serious buyer,” says Houschang Pakpour, 62, a piano restorer and antique dealer. “I figured I would just be putting the money in an interest-bearing account at a bank anyway. This way I can make a little bit more.”

With credit markets in a grand funk, Pakpour may have also shortened his odds on finding a buyer and of getting his asking price of $2.8 million for the 2,700-square-foot, three-bedroom house. Realtors have said for years that the three most important terms are “location, location, location,” says Tucker Watkins, a certified financial planner with Ameriprise Financial (nyse: AMP – news – people ) in Irvine, Calif. “These days it’s location, price and terms.”

Nowadays buyers find it harder to qualify for jumbo mortgages, those in excess of $1 million. That is true even for borrowers who have pristine credit, says Lloyd Streisand, a senior loan officer with Sterling National Mortgage in Great Neck, N.Y. Watkins observes that high-end home deals “are collapsing at the last minute because lenders are balking at the price or appraisals. And many lenders are no longer making jumbo loans.”

The Pakpours are willing to finance up to $500,000 of the purchase price of their house as a second note. The buyer will have to pay the remainder in cash or proceeds from a first mortgage. In five years the buyer will have to pay off the second note in full, though there are no prepayment penalties. In the event of a default the Pakpours can take back the property, provided they are willing to pay off the first mortgage (or persuade that lender to let them assume responsibility for it).

Seller financing doesn’t always work out. Alex N. Feick, a fee-only financial adviser at Paragon Capital Management in Denver, recalls one client who offered seller financing on his $1.3 million home in Mesa, Ariz. Prospective buyers had $75,000 in cash for a down payment but could get no more than a $1.1 million mortgage. “My client was nervous about property values declining, so he offered to hold the second mortgage for $125,000,” says Feick.

The seller’s contract, which was to be two years in length, spelled out that if the monthly payment of $1,500 was late, a penalty of $3,000 would be tacked on to the principal, and if a payment was missed, the seller could initiate foreclosure. Nonetheless, the buyers were consistently late with their payments. After 30 months the $125,000 10% note had become a $185,000 debt. The seller had neglected to include a clause in the contract to let him run a credit check on the buyers. “He couldn’t find out if they were current on their primary mortgage,” adds Feick. It turned out the buyers were good on that, just consistently late with the seller’s note. “My client probably should have just accepted less on the sale price and not hassled with it,” Feick says.

To avoid a similar situation, a seller should do everything a traditional lender does before approving a mortgage. Lisa Osofsky, a certified public accountant at Weiser LLP, a New York City accounting firm, offers this checklist: Review the buyer’s credit history, to see if he has a record of late payments, bankruptcies and/or outstanding obligations. Require personal financial statements, so you can determine if the buyer has adequate income or assets to support the loan. Work with a real estate attorney to make sure the documents are drafted properly and with an escrow company to create the note and deed of trust. Ask for references from prior lenders, recommendation letters from landlords and proof that the buyer is in good standing with his employer. Set the interest rate on the loan within a few percentage points of the going bank rate. If interest is not charged or the interest rate is too low, the IRS will assign an “imputed” interest rate to the transaction; interest is taxable as ordinary income.

The best protection against default is a hefty down payment. “A borrower probably won’t walk away from a six-figure, nonrefundable down payment,” says Kevin Carey, an agent with Prudential California Realty in Laguna Beach. Weiser’s Osofsky also recommends that you include clauses in the contract that do these five things: impose a penalty if payments are late; require proof of homeowners insurance covering fire and other perils; give the seller a right to do annual inspections; require the buyer to confess if he’s delinquent with the first mortgage; and give the seller periodic access to credit reports.

For a buyer, seller financing is easier to qualify for than a traditional loan. Plus, the interest rate might be better, and if the seller is the only lender, closing costs will be lower, since there will be no bank application fees or mortgage insurance required. Buyers should get several appraisals of the property to make sure they are not overpaying, as well as an inspection of the home and (as with any home purchase) a title search. The mortgage should be recorded with the county clerk’s office, even though this may mean paying a mortgage tax, typically 1% to 2% of the loan. The mortgage must be secured by the home in order for the buyer to deduct the interest.

The taxman considers seller financing as an installment sale if the sale of a property is at a gain where at least one payment is to be received after the tax year in which the sale occurs. In this case the seller should first figure out how much of his profit is taxable (after the exemption of up to $500,000, if he’s eligible) and then include as a capital gain each year an appropriate fraction of his principal payments. Do think about the possibility that capital gain tax rates will go up before the note is paid off, warns Osofsky.

Protect Thyself

–Verify buyer’s income with his employer.

–Ask for signed personal financial statements and copies of signed tax returns. Require that documents be sent to you directly from the buyer’s certified public accountant.

–Be named as “loss payee” on the buyer’s homeowners insurance policy, so if there’s a catastrophic loss, your financial interest is protected.

–Require verification that real estate taxes are paid each year.

By Carrie Coolidge, FORBES.com

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