Note Holders Handbook

Whenever any person, partnership, trust, corporation or any other entity becomes a lender on a piece of real property, a promissory note is created. You became a lender when you sold your real estate and carried back a note.

A promissory note is a written promise to pay a certain amount of money, and its payment is secured by some type of security instrument that becomes a lien on the real property.

The note specifies: (1) the amount of the loan (principal); (2) the interest rate (interest); (3) the amount and frequency of payments (debt service); (4) when the borrower must repay the principal (due date); and (5) the penalties imposed if the borrower fails to timely pay or tender a payment (late charge) or decides to pay a portion or all of the principal prior to the due date (prepayment penalty). The promissory note identifies the person who makes the payments to you (the buyer of your property—the borrower) and the person who receives the payments (you).

The security instrument is the document that provides for the alternate repayment of the debt to you in the case of default by the borrower. The security instrument is recorded in the county recorder's office as a lien against the title of the property you sold.

There are three kinds of instruments used to make real estate security for a debt: (1) mortgage, with or without the power of sale; (2) deed of trust; and (3) land contract. In California, deeds of trust are by far the most common. People often call them mortgages. They account for well over 99% of the security devices used for real estate. The land contract—known by many names such as installment contract, contract for deed, contract of sale, conditional sales contract, and the like—is used on occasion. A true mortgage is extremely rare in California. However, a discussion of mortgages helps with the understanding of other security device.

The mortgage gives the lender a lien on the real estate and hypothecates it as security for the note. The borrower, who is the buyer of the property, is called the mortgagor. The lender is called the mortgagee.

If the borrower does not pay, the lender may go to court through a procedure called a judicial foreclosure, that is, foreclosure through the courts. In this procedure, he has the court sell the property and, out of the money obtained from the sale, take enough to pay the expenses of the foreclosure and pay off the debt.

When a deed of trust is used, an additional party called a trustee is brought into the transaction. The borrower, called the trustor, transfers "bare legal title" but nothing more to the trustee. The trustee holds this title for the benefit of the lender, who is called the beneficiary.

If the borrower does not pay, the lender directs the trustee to start a foreclosure. This non-judicial foreclosure involves the process of selling the Property to a third-party bidder or, in the absence of a sufficient third-party bid, the beneficiary acquires title to the Property. The foreclosure sale, in most cases, satisfies the debt.

If you need to direct the trustee to start a non-judicial foreclosure, you may or may not be able to recover the entire loan balance. For example, if a third party bids at a non-judicial foreclosure sale an amount equal to or greater than the amount which you are owed (including fees, costs, and expenses of the foreclosure) you would be fully paid.

On the other hand, if you bid the full amount that is owed to you, including all foreclosure fees, costs, and expenses (full credit bid) and there are no third-party bids, you will generally be limited to the Property and its value as the source of repayment of the outstanding balance of the note.

A land contract comes about in a situation similar to the purchase money deed of trust. Instead of giving a deed and taking back a promissory note secured by a deed of trust, the seller enters into a land contract with the buyer in which the buyer promises to pay for the land. Ordinarily the buyer promises to pay in installments over a period of time. In the same contract, the seller promises to deed the property to the buyer when the purchase price is fully paid.

The following discussion also applies to first and second position liens with minor modifications. This type of transaction usually occurs because there are not enough prospective buyers who can qualify for institutional financing. If there were, there would be no need for the seller to take back a note. Even when the buyer can qualify for a loan, the buyer may not have enough for the entire down payment. In this case, the buyer gets a first loan from the institution, and the seller takes back a second note and deed of trust because the buyer is able to buy a property that he or she would not otherwise have been able to buy, and because the value of the $90,000 face value note in the secondary mortgage money market is only about

$70,000, assuming yields in that market are 15% at the time of this sale, the buyer may be willing to pay more than the current appraised market value of the property. This is true because with a seller carry back note the buyer doesn't have to pay points, fees and other costs usually associated with an institutional loan.

The seller carry back note can be structured in an almost limitless variety of ways. The note can be fully amortized with no balloon payment (as in this example), amortized over a number of years, say 30 years, with a balloon payment at say 5 or 10 years. The note could be interest only with a balloon.

It can even have stepped interest payments (for example, 8% in year 1,9% in year 2 and 10%. in year U 3 through the end of the term), or graduated payments (for example, $500 per month for the first 12 months, $600 per month in year 2, $700 in year 3, etc.) The value of the note in the secondary mortgage money market depends on all of these parameters and more, See Section 6 of this report for a discussion of note value.

Here Is A Typical Example:

A free and clear property (with no existing loans) was sold for $100,000. BUYER gave SELLER

a $10,000 cash down payment and SELLER carried back a purchase money Note and Deed of

Trust for $90,000. SELLER was getting no action on the property when trying to sell it for

$90,000 cash (the appraised value). Potential buyers would have had to pay all cash or qualify for

a loan.

SELLER offered to sell the property for $100,000 with 10% cash down payment to attract more buyers.

This sale is equivalent to selling the property for $80,000 cash because the SELLER would get about $70,000 for the note if he sold it immediately, assuming the market yield for these types of notes was 15% in the secondary mortgage money market.

Section 3

Note Safety

During the years after the creation of the note when you are receiving your monthly payments, there are several things you should do to keep your note safe and to maximize its value in the event you want to sell all or part of it in the future. You also need to know the best way to handle problems when they occur.

A low loan-to-value ratio makes your note safer and increases its resale value. The loan-to-value ratio for your note is the sum of the current loan balance for your loan and all senior loans divided by the current market value of the property securing the note.

Loan-to-value ratio for a second loan having a current balance of $30,000, an underlying first deed of trust with a loan balance of $100,000 and a current property value of $200,000 is 65% (130,000÷ 200,000).

The priority of your note and deed of trust on the property (first position, second position, etc.) is critical to the note's value and should be verified by going to the county recorder's office and researching the title if you have any doubt about its priority.

This can be done by finding the document numbers of the liens filed against the property in the grantor/grantee index at the recorder's office and then reviewing the time stamp on each document to see which one was filed first, second, etc. You must

know the priority of your note and the loan balances on any senior liens to be able to accurately calculate loan-to-value ratio.

If the loan-to-value ratio for your note is too high, there may not be enough equity in the property to pay off your note plus back payments, late charges and foreclosures costs in the event of a default and resulting foreclosure.

The loan-to-value ratio of your note should improve over time because the loan balances are being reduced. If the property appreciates, this also improves loan-to-value ratio (makes it lower).

The same low loan-to-value ratio that improves the safety of your note also makes it more valuable because the risk of ownership is reduced.

It is important to keep your original note in a safe place such as a safe deposit box or a fireproof safe in your home. Make a photocopy to keep with your trust deed and other escrow papers.

There are two reasons for this precaution. First, the note is not recorded in the county recorder's office. The deed of trust is. If you lost your deed of trust, you could simply get another copy at the recorder's office.

Second, your note is a negotiable instrument that means it can be endorsed on the back like a check. You wouldn't keep an uncashed check lying around, so think of your note like check and take good care of it.

Many people guard their original grant deed on a property with their life. The fact is anyone can get another copy of their grant deed from the county recorder's office, just like they can a trust deed.

Keeping a detailed, well-organized and legible payment record showing the date each payment was received, and a breakdown of the principal, interest and late charge for each amount received is important to maintaining the value of your note.

If you ever decide to sell your note, you will be required to show the payment history to a prospective note buyer so the note buyer can verify the payment patterns of the note payor.

f the payments on a "seasoned" note, which is a note with a payment history over an extended period, have been made consistently on time, the value of the note will be greater than if the payments have been late or delinquent because the perceived risk of the note is lower.

If the payments on your note are late, it is important to call the note payor and find out why the payment is late and when it will be sent. Most note payors don't like to receive these kinds of phone calls, and just by calling you will improve your chances of receiving future payments on time. Be courteous but firm about the need to receive the payments on time.

If your note calls for a late payment charge, be sure to collect it. Many note holders have a late payment charge built into their note but do not collect it. There are two reasons to collect the late charge besides the obvious one that it is more money in your pocket.

First, you will again improve your chances of receiving future payments on time if you collect the late charge.

Second, if you don't collect the late charges regularly, you may not be able to collect them later in the event of a foreclosure because you demonstrated that you do not enforce that part of the note contract.

If a payment is more than a month overdue, it ceases to be late and becomes delinquent. If you have talked to the note payor when the payment was merely late, you have taken the first step toward solving the delinquency problem because you have established communication with the payor.

The worst thinking you can do when the payments stop is to break off communications with the payor and start a foreclosure. Foreclosure may eventually be necessary, but it should definitely not be your first option.

A non-judicial foreclosure takes approximately four months if there are not postponements of the trustee's sale. In many cases, there are multiple postponements that could further prolong the process. Usually one or two months have passed without payments before the notice of default is filed, which means that six or more payments may be in arrears before the foreclosure sale takes place.

In order for you to recoup your investment in your note, someone must bid high enough for the property at the trustee's sale to cover the remaining principal balance on your note (and any underlying notes), all the back payments and late charges, and the trustee's fees and attorney's fees.

The amounts bid by the bidders at a trustee's sale will be well below the market value of the property. If the loan-to-value ratio of your loan is not low enough, no one will bid high enough at the trustee's sale to purchase the property. In this case, you will end up with the property back and may not be able to sell it for enough to get your money back out of your note.

If the note payor declares bankruptcy, this could incur further delays and costs. Even though the court may eventually rule that the foreclosure may proceed, these additional costs could mean you might end up with the property and not be able to sell for enough to recoup your investment in the note.

Another problem with foreclosure occurs when you have to take the property back. You must report the remainder of the realized gain that has not yet been reported (see the section on Tax Reporting For Notes, pages 16 — 18). In other words, you must complete the tax reporting of the installment gain from when the property was sold. If you are not able to sell the property in the same year that you receive it in a foreclosure, then you must pay taxes on the gain even though you have received no cash. Then if you sell the property in a subsequent year and take a loss you can only deduct $3000 of the loss per year.

It is best if you can get the note payor to make up the delinquent payments, but sometimes this is not possible because the delinquency may have been caused by the payor's loss of a job and other loss of income during a period of several months.

Many times a payor can resume making payments but cannot make up the missed payments. If this is the case, it is an excellent opportunity to restructure the note so that you have a more valuable note. The payor will usually go along with a restructuring because it solves his problem also. In other words, you agree not to foreclose if the payor agrees to restructure the note.

Restructuring a note requires some special expertise and you should only do this yourself if you feel confident you know what you are doing. If you want help restructuring a note, call (Ruth Maldonado) or at EXPEDIENT FUNDING (626-294-0344)

If the payor is not able to resume payments, you have two options—start foreclosure or sell the note. Sometimes you can still work with the note payor to restructure the note after the foreclosure has been started.

To start a foreclosure, notify the trustee of the default and request a foreclosure. The process will proceed according to the process described in Appendix B.

If you sell the note when payments are delinquent, but before a foreclosure is initiated, you will not receive as much cash for the note as you would if payments were not delinquent, but probably more cash than you would if the foreclosure is already in process. This is because if you sell the note before the foreclosure process is started, the new buyer of the note has the time to try to work with the note payor to restructure or refinance.

If you want to sell a delinquent note before the foreclosure process has started, call Ruth Maldonado (626-294-0344.)

A secured real estate note can be sold at any time from the day it was created until the day of the last payment. What is actually being sold is the stream of monthly payments. A note holder can sell all the payments (a full sale) or part of the payments (a-partial sale).

There are so many options available to the note holder for full and partial sales; they are too numerous to mention. If the note holder is working with a knowledgeable note buyer, the note buyer can structure options designed specifically for the cash needs of the note holder.

It is important to know that all of these sales are equivalent. In other words, a note buyer would be equally happy with any of these purchases from a note holder.

Some Of The Options Available To The Note Holder

1. DO NOTHING. Continue receiving the remaining 156 monthly payments of $967.14.

3. PARTIAL SALE-FRONT END PAYMENTS. Sell the next 5 years of payments (60 payments). Then receive the last 96 payments.

5. PARTIAL SALE - ONE HALF OF EACH MONTHLY PAYMENT. Sell one half of each monthly payment and continue to receive the other half.

Many other options are available. Options can be designed specifically for the cash needs of the Note Holder.

When the entire note is sold, it is always sold at a "discount" off the current principal balance of the note. The reason for this is that the face interest rate of the note is seldom as high as the market yield required in the secondary mortgage money market. In the example, the discount is $18,027.90 ($84,257.33 minus $66,229.43) assuming the secondary mortgage money market yield is 15%. The discount could be more or less depending on the current yield requirements in the secondary mortgage money market.

Partial sales are very attractive from the point of view of a note holder because the note holder does not have to take a big discount. The main reason for the discount being so large ($18,027.90 in the example) is that the payments due in the distant future are worth much less in today's dollars than the payments that are due soon.

In a full sale, the note holder is selling all the payments, and not getting much for the ones at the end of the 15-year term—thus the large discount. In a partial sale where the front-end or near term payments are sold, most of the payment is interest. This means that the note holder gets a sizable amount of cash now ($40,653.34 in the example) and when the note holder gets the note back after 60 payments, the balance of the note is still fairly high ($63,736.86 in the example). The note holder then gets the remaining 96 payments of $967.14.

A partial sale of the front-end payments is like having your cake and eating it, too. You get a sizablechunk of cash now, and when you get the note back, it has a high remaining principal balance and payment left to collect.In the example, the cash the note holder receives now plus the remaining loan balance the note holder receivesi n 5 years is more than $20,000 higher than the current principal balance of the note. In many cases, note holders prefer this type of an arrangement rather than selling the entire note for a large discount off the current principa balance.

Full Sale-Split Funding In the split-funded sale, the note holder is selling all of the payments but is only selling part of the ___ payments now and part of the payments in the future. This type of sale is really a hybrid between a full sale and a partial sale.

In the example, one half of the note (the next 78 payments) is sold now and the other half of the note (the last 78 payments) is sold after the first 78 payments are paid. $48,010.47 is paid in cash now and an equal amount in 6 ½ years.

This is only one variation of a split-funded sale. The note could be split into three, four or more equal or unequal parts.

In this type of a sale, the note holder sells on half of each monthly payment and continues to receive the other half. This is a particularly attractive way to sell a note if you need some cash now but also want to keep part of the monthly cash flow. The example shows that one half of each of the 156 remaining payments can be sold for $33,114.72 and $483.57 keeps coming in every month.

Again, this is only one variation of this type of sale. Many different variations are available to suit your needs as a note holder.

When real property is sold, and a purchase money note and deed of trust are carried back by the seller as part or all of the purchase price of the property, the gain on the sale is reported on the seller's tax return as an installment sale.

The amount of interest received each year by the seller or note holder must be reported on Schedule B of Form 1040. This is a very simple process if the note holder has an amortization schedule for the loan, which summarizes the interest portion of each payment received.

A portion of the principal received each year must also h~ reported on Schedule D of Form 1040 (and supporting Form 6251 for Installment Sales). This is not as simple as the tax reporting for interest.

The total amount of the gain on the sale is called the realized gain. Realized gain is the net sales price less the cost. The amount of the realized gain that is reported each year on the note holder's tax return is called recognized gain.

Refer to Appendix C—AMORTIZATION SCHEDULE—$90,000 NOTE. The amortization schedule shows the amount of interest and principal reduction for each payment, and the yearly totals.

For this example, we will assume that the cost of the property (cost basis) was $40,000. The realized gain is the sales price ($100,000) less the cost ($40,000) or $60,000.

A simple technique for properly computing the recognized gain for each year's tax return, and thus avoiding tax problems, is to first compute the gross profit percentage which is the realized gain divided by the sales price. In the example, this percentage is $60,000 divided by $100,000 or 60%.

In the example, the property was sold in December 1988. The cash down payment was $10,000 and no payments were received on the note in 1988 because payments did not start until January 1989.

The amount of the gain to report on Schedule Din the first year (1988) is 60% of the $10,000 down payment of $6,000. For 1989, the amount to report on Schedule D is 60% of principal received in 1989 ($2,728.49 from appendix C) or $1,637.09.

For the next year, 1990, the amount to report on Schedule D is 60% of principal received in 1990

($3,014.18) or $1,808.51. In our example, we assumed that the note holder sold the note after two

years. Therefore, he also has to report the net amount he receives on the sale of the note in 1990.

The additional amount to report in 1990 is 60% of the remaining note balance of $84,257.33 or

$50,554.40. Notice that the total of the four amounts reported ($6,000 + $1,637.09 + $1,808.51 +

$50,554.40) is equal to the $60,000 realized gain that must be reported over the life of the note.

However, what about the discount? The note holder did not receive the entire remaining balance of $84,257.33 when he or she sold the note. The note holder received $66,229.43 in our example.

In this case, the note holder takes the entire discount of $84,257.33 less $66,229.43 or $18,027.90 as a tax deduction thus reducing the amount to report on Schedule D in 1990 from $50,554.40 to $32,526.50.

Tax reporting for partial sales and split funded sales are somewhat more complicated than this example for a full sale. You should consult your tax advisor for the tax reporting method for these types of sales.

As you can see from this example, it is very important to have an amortization schedule for your

note. If you don't have an amortization schedule, you can get one like the example shown in Appendix C by following the instructions in Appendix E —Low Cost Amortization Schedule For Note Holders.

Another important reason to have an amortization schedule is that California law requires you, as the holder of a real estate note, to provide an annual statement to the payor of the note within 60 days after the end of each year. This statement itemizes and accounts for the entire principal and all the interest received during the year.

If you have an amortization schedule for your note, the yearly principal paid the yearly interest paid are simple taken from the yearly totals shown on the amortization schedule.

Another way of asking this question is "How much of a discount must I take if I sell my note?" All notes are purchased at less than the remaining balance of the note if the whole note is purchased. This difference between the remaining balance and the purchase price of the note is the "discount."

There is no standard discount because there are no standard notes or standard properties. Each note is different and each note must be individually researched in order to determine its highest value.

If you do not need all the cash from your note immediately, it is possible to receive 100% or more of the remaining balance of your note by selling only a part of the payments on our note now. This is illustrated in section 4 of this report.

The best way to find out how much your note is worth is to get a quotation from a professional note buyer. Be wary of some people who may approach you offering to buy your note for cash. Many of these buyers will attempt to give you a low-ball offer, whereas a professional note buyer will be more competitive with current secondary mortgage money market rates.

Also, many amateur note buyers don't know how to structure partial offers tailored to your needs as a note holder and many don't know how to close the transaction properly so both the note holder and the note buyer are protected.

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