AN INTRODUCTION TO VENDOR FINANCE FOR REAL ESTATE IN AUSTRALIA

By Anthony J Cordato © Copyright Sydney 2007

Contents

This commentary has been prepared to assist those who wish to vendor finance real estate. It is intended to provide a general guide, but is not intended to be relied upon. Professional advice should for use for particular purposes.

These topics are covered:

• What is Vendor Finance?
  
• Why Vendor Finance is used for Real Estate
  
• A Century of use for the sale of Real Estate in Australia
  
• The three kinds of Vendor Finance
  
• Illustrations of Vendor Finance
  
• Vendor Finance as an investment method
  
• Legislation which applies to Vendor Finance for Real Estate
  
• Documentation for Vendor Finance
  

What is Vendor Finance?

Vendor Finance is finance offered by a seller (a Vendor) to finance the sale of goods, services or real estate to a buyer (a Purchaser).

Most commonly, sellers offer “terms” to Purchasers to allow Purchasers to pay the price by weekly, fortnightly or monthly payments over time. The purchaser pays a deposit, with the balance of the price paid by an agreed number of payments. It is the fact that these payments are made, rather than a lump sum being paid, that makes the arrangement a Vendor Finance arrangement.

Sellers offering Vendor Finance use time as well as price in selling the property. By offering time to pay they make a sale where the buyer does not have the full price in their pocket. They sell at the price they desire because they provide time to pay. Sellers offering Vendor Finance are the opposite of sellers who discount the price for a quick sale because they offer terms.

Vendor Finance is often referred to as alternative housing finance. It encompasses terms sales, rent to buy and sales with a carry back mortgage.

It is recognised officially in Australia. In the 2006 Australian Census, question 56 was Is this dwelling: Being purchased under a rent/buy scheme?

Why Vendor Finance is used for Real Estate

The high price of real estate means that most purchasers must borrow money to purchase real estate. Saving the money to purchase real estate without borrowing has been uncommon since the 1950s because of the high cost of real estate.

Because borrowing money is necessary for a purchase, the difficulties many people have in obtaining finance for the purchase of real estate makes real estate a very attractive proposition for the use of Vendor Finance.

The advantages of Vendor Finance for both Vendors and Purchasers of real estate are that the sale is not dependent on the Purchaser qualifying for external finance.

Advantages for Vendors in providing Vendor Finance are that the Vendor secures a sale, at their desired price, on terms for payment of the price.

Disadvantages for Vendors in providing Vendor Finance are that it ties the Vendor to the property, potentially for a long time, and that the Vendor must retain satisfactory security for payment of the price.

Advantages for Purchasers in using Vendor Finance are that the Purchaser can purchase immediately at an agreed price rather than deferring purchase, and receive immediate enjoyment of the property (i.e. the Purchaser can move into occupation).

Disadvantages for Purchasers in using Vendor Finance are that Purchaser cannot sell or mortgage the property without first making full payment to the Vendor. Also, the money the Purchaser pays may be at risk if the Vendor defaults under its mortgage over the property.

A Century of use for the sale of Real Estate in Australia

Vendor Finance for real estate has a long history in Australia.

In the land boom years of the 1870s and 1880s, property developers subdivided land and sold the land to purchasers to build homes upon and to property speculators who purchased the land for re-sale. Property developers offered terms to sell the land, typically ¼ of the price as a deposit, ¼ after six months, ¼ after 12 months and ¼ after 18 months, with interest payable at 6% p.a. on the outstanding amounts.

By the early 1900s, the practice was widely used and accepted, with land in suburban locations such as North Sydney and Chatswood advertised for sale on terms.

In 1927, the High Court of Australia considered the tax consequences of Vendor Finance, in the case of:

The Federal Commissioner of Taxation -v- Thorogood.

The facts:

James H Thorogood carried on the business of buying land, dividing it into allotments and building houses on them, selling these as house and land packages.

In some sales, a deposit was paid in cash with the balance price payable by instalments over several years. In these sales, Thorogood “funded” the whole price. These sales were documented by a Contract for Sale, which remained uncompleted for several years, with Thorogood retaining the title to the property until the final instalment was paid.

In other sales, the Purchaser paid some deposit, paid some of the price using external finance secured by first mortgage, with the balance of the price funded by Thorogood taking a second mortgage over the property. These sales were documented by a Contract for Sale which was completed in the normal way. Title to the property was transferred immediately to the Purchaser, but with a second mortgage in favour of Thorogood which was registered, ranking after a first mortgage from an external financier, to secure the balance of the price owing to Thorogood.
In both cases, interest was payable on the balance price owing to Thorogood.

The dispute:

The Federal Commissioner of Taxation assessed Thorogood to pay income tax on both the part of the price received and on the balance price payable in future years, in the year the Contract for Sale was entered, even though considerable portions of the balance price were to be paid in future years. Thorogood objected and contended that he should pay tax only on the balance price in the year it was actually received.

The decision:

The High Court did not decide the dispute - it decided only that it was possible to take either view of the tax consequences of the transaction, depending upon the facts (Report found in: (1927) 40 CLR 454). For our purposes, the legality of these two forms of Vendor Finance was accepted.
For the current tax position see below.

The use of Vendor Finance fluctuates according to social and economic conditions.

• In the 1950’s and 1960’s, most land for housing was subdivided and sold on Vendor Finance terms of up to 5 years with instalments paid monthly. The reason Vendor Finance was used was that the banking system did not provide loans for the purchase of blocks of land.
  
• Therefore, in the 1950’s and 1960’s, most young couples looking to build a home would purchase a block of land to build a home upon, from a property developer “off the plan” in a land subdivision, using terms finance. Once the land was paid for, they would borrow the money to build their home from a Bank.
  
• In the 1960’s, 1970’s & early 1980’s, many young couples would purchase house and land packages from builders, using terms finance. In those times, a Purchaser would need to demonstrate a 12 months savings record and have a 25% deposit (the Banks would lend up to 75% only). Generally after one year, the builder would “cash out” the terms finance Contract, by transferring the Contract to their financier, who might then provide normal mortgage finance to the Purchaser.
  
• From the mid 1980’s to date, the deregulation of the banking system has resulted in an increasing availability of mortgage finance from Banks and non-Bank lenders (up to 95% of valuation with minimal savings record). As a result, terms finance has been used relatively rarely for sales of property. However, it is interesting to note that it has been used continuously for sales by the NSW Department of Housing to its tenants since the early 1970’s, with 40 year terms on a 25% deposit being common.
  
• Recently, since 2000, an unsatisfied demand for Vendor Finance has become apparent amongst purchasers with low deposits, purchasers who have their own business or trades and purchasers whose credit rating is impaired, who do not qualify for Bank or non-Bank Loans, even low doc loans.
  
  According to the Australian Statistician, just 0.2% of Australian households surveyed in the 2006 Census of Population and Housing were purchasing dwellings under a rent/buy scheme. This is down from 0.7% in 2001 and 0.5% in 1996. These statistics show that rent/buy is currently under-utilised for the sale of dwellings in Australia.
  
  Therefore, Vendor Financiers have considerable scope to meet the demand for affordable housing.

The three forms of Vendor Finance

The decision of Thorogood describes two kinds of Vendor Finance namely:

1. Instalment Sales Finance or Terms Finance: In this form of Vendor Finance, the property is sold at an agreed price, but instead of the price being paid up front, the price funded from external sources, the Vendor agrees to accept payment of the whole of the price by instalments, over a period of time.
   The key elements are that the Vendor fully funds the price by setting up an instalment payment arrangement or plan in the Contract; the Purchaser takes possession once the Contract is entered into; and the title (i.e. ownership) remains with the Vendor until the final instalment is paid (or the loan is refinanced).
   
   The Contract period is usually 25 or 30 years, but generally the Purchaser will pay out the amount outstanding under the Contract as soon as they are able to refinance with external finance, which is usually after 2 or 3 years. The Purchaser pays interest at a rate of between .5% and 3% above the interest rate the Vendor is paying on their loan.
   
   This form of Vendor Finance is documented by an Instalment Sales Contract.
   
2. Mortgage Back Finance: Traditionally, especially for the sale of farming properties, the Vendor loans the greater part of the price to the purchaser under a mortgage back finance arrangement. The Vendor transfers the title to the property to the Purchaser, and takes a registered first mortgage back as security for the balance price that was due and owing.
   
   This form of Vendor Finance is also used as deposit finance, where the deposit is funded by the Vendor. The key elements of deposit finance are that an external financier funds most of the price (and takes a first mortgage), and title passes to the purchaser immediately. The Vendor funds the shortfall between the price and the external finance (that shortfall is the unpaid price which is often 20%) and takes a second mortgage over the property as security for payment. Usually the Purchaser has a small cash deposit, and so the Vendor Finance is usually less than 20%. The Vendor finance may also cover purchase and loan expenses, such as stamp duty.
   
   Mortgage Back Finance is what solicitors usually have in mind when the expression “vendor finance” is used and deposit finance is therefore the form of Vendor Finance that is closest to their experience.
   
   There is a third form of vendor finance, as follows:
   
3. Rent to Buy (Lease Option) Finance: In this form of Vendor Finance, the Vendor leases the property to a purchaser under a normal residential lease. At the same time, the purchaser makes payments towards the deposit on the purchase of the property, under an option which contains an agreed price for the sale of the property. This form of Vendor Finance is useful where the Purchaser is required to build up a deposit.
   
   The option is an option to enter into a Contract for Sale, at an agreed price, with payments made under that option being credited against the deposit payable under the Contract for Sale. The Purchaser enters the Contract for Sale when the option is exercised, using payment made as the deposit. Until the option is exercised, the Purchaser rents the property under a Residential Tenancy Agreement.
   

Illustrations of Vendor Finance

These three simple illustrations are of the three common forms of Vendor Finance. Assume a house is to be sold for $250,000, and is capable of being rented for $240 per week.

Illustration 1 – an Instalment Sale or Terms Sale

The house is sold on a deposit of $10,000, with the balance price of $240,000 payable by instalments of $425 per week over the next 30 years. For this example, the instalment amount is comprised of both principal and interest, and the interest rate is assumed to be 8.5% per annum. The Purchaser moves in immediately, also paying $35 per week to reimburse all rates and, insurances. The Purchaser is also responsible for maintenance. This example is a terms sale or an instalment sales form of Vendor Finance because the price payable under the Contract is payable by instalments.

Illustration 2 – Rent to Buy or Rent to Own

A Purchaser rents the house at $260 per week for three years, at the same time putting aside a little extra ($125 per week) which is paid to the Owner along with the rent. Over 3 years, the extra paid totals $19,500, which together with an up-front option fee paid of $5,500, adds up to $25,000. The $25,000 represents a deposit of 10% paid towards the price of $250,000. Therefore, at the end of the three years the Purchaser is in a position to use external finance to pay the balance price of $225,000. If the purchaser requires further time, this can be given. This example is a rent to buy or rent to own form of Vendor Finance, documented as a lease / option.

Illustration 3 – mortgage carry back

A Purchaser is given assistance to pay up to a 20% deposit of $50,000, by the Vendor giving deposit finance, with the balance funds (80% of the price) loaned by an external financier. The Purchaser pays interest only of $76.92 per week on the deposit finance, calculated at 8% per annum and repays it all at the end of 3 or 5 years out of savings or external financing. This example is a mortgage carry back form of Vendor Finance, which in this example is used to fund the payment of the deposit, because it is documented by a mortgage.

Vendor Finance as an investment method

Advantages

Vendor Finance is gaining popularity as an investment method for investors because it generates positive cashflow from residential property.

‘Positive cashflow’ means that the income from the property exceeds the outgoings, be they mortgage payments, rates and taxes, maintenance and repairs. It is the opposite of negative gearing, which is where the owner must contribute to the shortfall in the money available to meet the outgoings from their own pocket.

Vendor Finance is successful as an investment method because it meets the demand by Australians who want to purchase their own home, to ‘escape’ from the rental market, but who for some reason are ‘locked out’ of the banking system.

Specifically, the demand by purchasers for Vendor Finance in Australia is to be found in two situations:

1. Where the Purchaser has little or no deposit, or insufficient savings record, or is not creditworthy (cannot obtain bank or other finance) to obtain bank or non-bank Finance. Some Purchasers may be creditworthy, but find it difficult to deal with lenders. Other Purchasers are not creditworthy. They must repair a poor credit rating, or have difficulty proving income because they are self employed or have casual or irregular income.
   
2. Where the property is such that bank or non-bank finance is not easily obtained by anyone. Examples are vacant land (especially outside the Metropolitan Area), acreage, farms, commercial property and unusual property such as boarding houses.
   

Using the Instalment Sales Finance or Terms Finance Method for investing

Instalment Sales Finance or Terms Finance, which is colloquially referred to as a “wrap” is a method used by investors to sell a residential property to generate positive cashflow from the property. The investor purchases the property using external finance, and then privately finances a purchaser to purchase the property, on terms, giving rise to a “wrap around” financing, commonly known as “wrapping”. The term ‘wrap’ was coined by US and US based investors, and has been used extensively in Australia since 1999.

The outstanding advantage for an investor of using the “wrap” method is that the investment return from the property is strongly cashflow positive from day one. This is achieved by setting a level of instalments payable by the Purchaser which is greater than the amount of the investor’s payments to their Bank. In addition, the investor passes responsibility to the Purchaser to pay the outgoings, consisting of rates, taxes, insurance premiums, and the responsibility for repairs and maintenance. Using this technique, investors can achieve returns on residential real estate investment comparable to the returns achieved on commercial real estate investment.

The Documentation for Instalment Sales or Terms Finance

The form of documentation generally used is an Instalment Sales Contract. This Contract is in the form of a normal Contract for the Sale of Land, with four modifications. The first is that the Purchaser enters into possession of the property on exchange of Contracts; the second is that the purchaser pays a low deposit; the third is that the balance price is paid by instalments; and the fourth is that the purchaser pays all outgoings and is responsible for repairs and maintenance. The Purchaser does not take a transfer of legal title until completion, when the whole of the price has been paid.

For further comments on documentation, see below.

Using the Rent to Buy Method for investing

Rent to Buy is similar in terms of objectives to “wrap” financing, in that the objective is to boost the cashflow return from residential property. The boost is in the form of the payments made by the purchaser over and on top of the rent. Usually, the cashflow is not as strong as the cashflow on a “wrap”, because the Purchaser has not committed themself to the same extent as they commit themself under a “wrap”. Purchasers in a rent to buy are equivocal; they are thinking ‘rent now, purchase later’ rather than ‘purchase now’.

The documentation for Rent to Buy

Rent to Buy consists of two documents. The first is the lease, which is technically known as a Residential Tenancy Agreement. Under the law, it must be in a standard form. The rent is paid under the Residential Tenancy Agreement. The second is the option. Under the law, there is no standard form of option. In most states, a cooling off warning must be attached, and in some states, a contract summary or a full Contract for Sale must be attached.

For further comments on documentation, see below.

Refinancing by Purchasers of a Vendor Finance arrangement

Whatever the form of documentation used, Vendor Finance is a means to an end, the end being the Purchaser refinancing using external finance. Vendor Finance is only the “bridge between the Purchaser’s position of being unable to obtain bank finance and the banking system”.

Once the Purchaser has built up equity in the property by home improvements, savings or capital appreciation, and has a track record for payments, then the Purchaser is able to refinance the Vendor Finance on more favourable terms (lower interest rates for example).

Therefore although the Instalment Sales documentation is written for a term of 25 or 30 years, in many cases a Vendor Finance arrangement can be for a term of as little as 1 to 2 years, and generally no more than 2 to 5 years. This reduces risks to both Vendor and Purchaser appreciably.

The period of 2 to 3 years for the Rent to Buy arrangement puts a formal time frame upon the Purchaser to purchase the property. The Purchaser has a deposit and a track record of payments, to enable the Purchaser to obtain external finance, should the purchaser choose to proceed with the purchase of the property. Should the purchaser decide not to proceed, the purchaser moves out and the Vendor keeps the payments.

Joint Ventures

Instalment Sales and Rent to Buy have become popular in Australia with Investors because of the high returns achievable on money invested. But often Investors do not have the time or skill to put Vendor Finance arrangements into place.

Investors often utilise the services of an experienced “wrapper” as a co-investor under a Joint Venture Agreement, to put a Vendor Finance arrangement into place. A separate commentary upon Joint Venture Arrangements appears on this website.

Other investment methods

Other methods have been developed in the USA for property investment, such as purchasing “subject to” an existing mortgage (i.e. taking over the property, subject to the Vendor’s mortgage). These methods are difficult to import easily into Australia, because they work in the absence of a title registration system, in contrast to the situation in Australia, where a title registration system exists. In Australia, the process of taking over a property, ‘subject to’ the existing mortgage is more formal, but possible, using a reverse rent to buy arrangement.

Tenancy in common arrangements, where a vendor and purchaser each take shares in a property also come in and out of fashion in Australia. This investment method starts with an investor who provides a deposit for the purchaser to purchase a home, and at the end of a specified period, the purchaser must refinance or sell to repay the deposit. These tenancy in common arrangements are far less attractive to an investor than other Vendor Finance techniques and will not be examined further.

There are a number of property trading methods, generally using options, which are also not examined in this article.

Legislation which applies to Vendor Finance for Real Estate in Australia

The Title Registration System in Australia

Real estate transactions in Australia are subject to the laws of the State in which the real estate is situated. The laws of each State have one characteristic in common which is that a title registration system applies. Each State maintains a Land Titles Office at which a register of Certificates of Title is kept for (almost) all real estate in that State, and in which transactions applicable to the property are recorded upon the Certificate of Title for that property. A search of the Certificate of Title will reveal the legal owner, any mortgages, easements and the like. The accuracy of the information recorded is effectively guaranteed by the State.

Land Sales Laws applicable to Instalment Sale Contracts (terms contracts)

Land Sales laws were introduced in the 1950s, 1960s and 1970s, to protect purchasers involved in Vendor Finance arrangements. This was the reasoning:

Before the 1920s, subdividers would simply draw up a plan of subdivision, and register the plan at the Land Titles Office, and would issue a separate title for each lot in the plan. Subdividers were not required to build roads, curbs and guttering or connect services such as water, sewerage and electricity. Purchasers would be required to build and connect these items when they wished to build.

Particularly from the 1950s and 1960s, local government authorities began to require subdividers to build roads and connect services to the lots, before the plan of subdivision was allowed to be registered. Subdividers found that by using Instalment Sales Contracts to sell the lots ‘off the plan’ before the plan of subdivision was registered, the instalments received would fund the cost of putting in those services. They also funded their loan payments to their financier using the instalments received. Purchasers were happy to enter into Instalment Sales Contracts, because banks would not finance most Purchasers to purchase land. The use of Instalment Sales Contracts enabled Purchasers to pay off the land without bank finance. Once the Purchaser paid of the land, the banks were willing to lend money to build the house.

Where was the problem? If the subdivider became bankrupt, went into liquidation or receivership because it was unable to meet its commitments before the plan of subdivision was registered, the Purchaser did not have a separate title for the property being purchased to enable it to be transferred into their name. The Purchaser was therefore an unsecured creditor, could not receive title to the property, and the Purchaser lost their deposit and the instalments they had paid.

There are laws specifically applicable to the sale of land by instalments in most States. The laws are specifically directed to the payment of the instalments directly to the Vendor, which are used by the Vendor for payment of their loans, and otherwise. The laws are piecemeal, and in many ways have been superseded by the Uniform Consumer Credit Code, which was introduced in 1994. They are as follows:
[list]
*In NSW, the Land Sales Act 1964 is the applicable legislation. It was introduced after the 1961 recession to quarantine the instalments paid under Instalment Sales Contracts from being used to pay the financiers and other creditors of insolvent subdividers of land.
The Land Sales Act became law in 1964. It applies only to the sale of the land in a subdivision of land which consists of five or more lots, and only to Contracts for Sale where the price is payable by four or more instalments. If the Act applies, the instalments must be paid to a trustee, rather than to the Vendor, until the subdivision is completed.

Needless to say, the Act effectively ended the use of Instalment Sales Contracts for the sale of lots in subdivisions in NSW. Subdividers sold land with 10% or 15% deposits, which was released to the subdivider on signing the Contract for the ‘off the plan’ purchase, and once the plan was registered, finance companies such as ASL, CAGA, FCA, ESANDA stepped in to finance the purchasers.

The Land Sales Act does not restrict, nor does any other Act specifically restrict the sale of any other property under an Instalment Sales Contract.
*In Victoria, the Sale of Land Act 1962 defines a terms contract as being an uncompleted contract for the sale of land which provides for two or more payments before the contract is completed, and where occupation is given prior to completion. The land is not restricted to land in a subdivision, and may apply to any property.

The Act restricts the sale of in a number of ways, including that the property must not further mortgaged, the mortgage must be solely on the land (and not secured by other land as well), the purchaser has the right to call for a transfer of the property at any time and for certain disclosures to be made.
*In Queensland, the Property Law Act 1974 restricts the sale of real estate under Instalment Sales Contracts, by providing amongst other things, (i) that the Vendor cannot mortgage the property further (without the Purchaser’s consent), and (ii) title to the property must be transferred to the Purchaser (if the Purchaser requires) once the Purchaser has paid one third of the price. The Act applies to all property, including vacant land and land with houses or other improvements.
*In South Australia, the Land and Business (Sale and Conveyancing) Act 1994 makes Contract for Sale of Land illegal where the purchase price is payable in part before the date settlement. The exception is the payment of the deposit, which can be payable in a lump sum or by not more than three instalments.
As a consequence, Lease Options (Rent to Buy) are the means adopted for documenting Vendor Finance in that State.
*In Western Australia, the Sale of Land Act 1970 restricts Contracts for Sale (known as terms contracts) where the price is payable by instalments (defined as 2 or more payments) by providing amongst other things, that the property can not be remortgaged by a Vendor after a terms sales contract is entered into (without the Purchaser’s consent), and for certain disclosures.
*In Tasmania, there is no applicable legislation.

The Universal Consumer Credit Code applies to Instalment Sales Contracts

In the early 1990s, the States decided to replace their out-dated money lending laws with a new uniform law for consumer credit transactions. The law was introduced as the Consumer Credit Code 1994 in Queensland, and was then adopted around Australia.

Since 2000, when terms contracts were introduced in their current form in Australia, the State Departments of Fair Trading / Consumer Affairs have examined the contracts and have decided that because Instalment Sales Contracts were essentially contracts under which consumer credit is provided, then regulation under the Consumer Credit Code provided the best protection for the consumer. This view that the Consumer Credit Code applies to Instalment Sales Contracts (or Terms Contracts as they are referred to by the Departments) was confirmed by the Victorian Civil and Administrative Tribunal in the case of Director of Consumer Affairs Victoria v Geeveekay Pty Ltd (Credit) [2006] VCAT 793 (8 May 2006).

For that reason, the Consumer Credit Code is the principal means for regulating Instalment Sales Contracts currently in Australia.

The Consumer Credit Code regulates contracts by providing for certain disclosures and imposing specific obligations upon Vendors, and by providing for the re-writing of unfair contracts.

The specific obligations imposed by the Consumer Credit Code include:

1. Making a full disclosure of the terms of the contract including a proper Credit Code Disclosure Statement
   
2. Not charging unconscionable interest rates
   
3. Allowing for suspension of payments for up to two months on the grounds of hardship.
   
4. Requiring a Statement of Account to be given to the Purchaser every six months.
   

Special care must be taken to avoid Vendor Finance contracts being declared to be unfair, as follows:

1. Proper investigations must be carried out upon the prospective purchaser’s ability to make the payments required under the Instalment Sales Contract. These investigations include verification of income, job status, current commitments, defaults recorded on the credit file; and
   
2. The terms of the Contract must not be unfair, particularly terms relating to default and termination of the Contract, and forfeiture of money paid if the Contract is terminated.
   

The Consumer Credit Code is administered by the Department of Fair Trading / Consumer Affairs in each State.

States adopt different practices when it comes to licensing credit providers under the Consumer Credit Code. All persons carrying on the business of money lending were required to hold a licence under the Money lenders Acts, which applied before the introduction of the Consumer Credit Code. Some States have continued to require licensing as Credit Providers under the Consumer Credit Code – they are Victoria, Western Australia and the ACT. In other States there is no Credit Providers licensing - such as N.S.W, Queensland and Tasmania.

Residential Tenancies Laws apply to Rent to Buy

Since the mid 1980s, the States have harmonised residential tenancy laws throughout Australia.

The applicable Acts are: N.S.W. – Residential Tenancies Act, 1987; Victoria – Residential Tenancies Act 1997; Queensland - Residential Tenancies Act, 1994; Western Australian - Residential Tenancies Act, 1987; South Australia - Residential Tenancies Act, 1995.

The Residential Tenancies Acts expressly do not apply to an Instalment Sales Contract because the Acts exempt arrangements where a purchaser enters into possession of a property under a bona fide Contract for Sale, before completion of the Contract for Sale takes place.

The Residential Tenancies Acts apply to Leases in Rent to Buy arrangements.
Under the Acts rights are given to tenants and obligations are imposed upon landlords. Some of the rights and obligations are:

1. The tenant/purchaser signs a lease in the standard form prescribed under the Acts, with all the rights and obligations it contains unable to be excluded.
   
2. The landlord must pay council rates, water rates, levies, insurance premiums, land tax, maintenance and repairs, and cannot pass on the cost of these to the tenant/purchaser.
   
3. The rules for giving notices to quit and for obtaining possession through the Residential Tenancy Tribunal must be followed.
   

Options for the sale of property are governed in each State by the legislation that applies to Contracts for the sale of land. The requirements are generally extensions of the requirements applicable to the sale of land such as cooling off notices and rights, disclosure statements for the property and in NSW, the requirement to attach a complete copy of the contract for sale to the option and to prohibit the exercise of an option within 42 days of its grant.

Apart from these requirements, the contents of an option are not prescribed.

First Home Owners Grant Acts apply to Vendor Finance Arrangements

Each State has a First Home Owners Grant Act, and in each State the Act is administered by the State Office of State Revenue.
In some States, the First Home Owners Grant is paid on the entry of possession under an Instalment Saes Contract, such as in NSW and Victoria, while in other States it is payable 12 months after the entry, such as in Queensland. The First Home Owners Grant is not payable under a Rent to Buy arrangement until the option is exercised and a Contract for Sale comes into existence.

Land Tax Acts apply to Vendor Finance Arrangements

Each State has a Land Tax Act, and in each State the Act is administered by the State Office of State Revenue.

In some States, the liability of an owner for land tax passes to a purchaser on the entry of a Contract for Sale and the purchaser under that contract taking possession of the property. The purchaser is exempt from land tax in this situation provided that they are owner occupiers. This transfer of liability benefits Vendors under Instalment Sales Contracts, but does not benefit Owners selling under a Rent to Buy arrangement, until the option is exercised and a Contract for Sale comes into existence.

Law Reform proposed to apply to Vendor Finance Arrangements

Victoria appears to have taken the lead amongst the States in terms of reviewing what is described as Alternative housing finance or non-conforming credit. A consumer credit review report was issued in 2006, with a number of recommendations, to which the Victorian Government has responded. Legislation is awaited. The recommendations made relating to vendor finance, which have been supported by the Government, are:

• The Sale of Land Act 1962 (Vic.) should be simplified to make the vendor finance protections it offers more accessible.
  
• Extend the unfair contract terms provisions in Part 2B of the Fair Trading Act 1999 (Vic.) to apply to vendor finance.
  
• Extend specific residential tenancies protections to consumers who enter into ‘rent-to-buy’ contracts.
  

None of these recommendations are for the outlawing vendor finance arrangements. They are directed to making the consumer better informed by re-drafting in plain English the Sale of Land Act and extending protections which are already found n the Credit Code as to unfair terms in contracts.

The Australian Taxation Office and Vendor Finance

There is no specific part of the Income Tax Assessment Act that applies to Vendor Finance. Nor are there any Tax Rulings which provide a definitive statement of the ATO’s views.

However, the ATO has produced several Interpretative Decisions (IDs) in response to requests by taxpayers to the ATO to give guidance on how to treat receipts under Instalment Sales Contracts. These are:

• Treatment of residential properties under instalment sales contracts as trading stock - ATO ID 2004/25
  
  The ATO decision was that the residential properties held by the taxpayer are 'trading stock' for the purposes of section 70-10 of the ITAA 1997, provided they are held for sale in the ordinary course of the business of selling properties under instalment contracts.
  
  This decision was clarified in ATO ID 2004/26 where the ATO decided that The residential properties are 'trading stock on hand' at the end of the income year for the purposes of section 70-35 of the ITAA 1997, as the taxpayer has not lost dispositive power over the properties.
  
  
• Are proceeds of sale under an instalment contract entered in the course of a business a capital gain when the contract is entered or ordinary income when received - ATO ID 2004/27
  
  In this decision, the ATO considered the position of a taxpayer carrying on the business of vendor finance, whether on exchange of an instalment contract, the gain was taxable as a capital gain immediately, or whether the profits (the gain and the interest) were taxable as income in the year of receipt (assuming the properties were trading stock).
  
  The ATO decision was that the payments will not be included in the assessable income of the taxpayer under subsection 6-5(1) of the ITAA 1997 in the income year in which the contract is entered into, as the income has not yet been derived.
  
  
• Are proceeds of sale under an instalment contract not entered in the course of a business a capital gain when the contract is entered or ordinary income when received - ATO ID 2004/407
  
  In this decision, the ATO considered the position of an investor who is not carrying on a business.
  
  The ATO decision was that the profit on the sale of a residential property under an instalment sale contract, will not be included in the assessable income of the taxpayer under section 6-5 of the ITAA 1997 in the income year in which the contract is entered into, as the income has not yet been derived.
  
  
• Treatment of default profits under an instalment contract - ATO ID 2004/28
  
  The ATO decision was that the forfeited deposit and instalments are assessable as ordinary income under subsection 6-5(1) of the ITAA 1997 in the year in which the purchaser defaulted under the contract.
  
  
• Treatment of payments to purchasers to vacate - ATO ID 2004/29
  
  The ATO decision was that the amount paid to the defaulting purchaser to persuade them to vacate a residential property, following their default under an instalment sales contract is an allowable deduction under section 8-1 of the ITAA 1997 as it was incurred in carrying on the business of the taxpayer and it is not a loss or outgoing of a capital nature.
  
  
• Joint Ventures - Derivation of income: residential properties instalment sales contract - ATO ID 2004/406
  
  In this decision, the ATO considered whether the proceeds the joint venturer receives to arrange for the purchase of properties by investors and its share of the proceeds of the sale under instalment contracts, should be included in their assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) in the year in which the proceeds are received.
  
  The ATO decision was that the proceeds received in the tax year in question by the joint venturer are ordinary income and are included in the taxpayer's assessable income.
  
  
• Goods and Services Tax and Instalment Contracts - ATO ID 2005/194
  
  In this decision, the ATO considered whether the instalment payments received on the sale of residential premises were a supply for GST purposes, even though the vendor was registered for GST purposes.
  
  The ATO decision was that the entity is making an input taxed financial supply of a credit arrangement under subsection 40-5(1) of the GST Act when it gives the purchaser time to pay for a property under an instalment contract. Therefore the instalment payments received under the instalment contract for sale of residential premises are not subject to GST.
  

Documentation for Vendor Finance

The Instalment Sales Contract

Where Vendor Finance consists of terms payments or instalment payments then it is known as terms finance and the sales are called terms sales. Terms sales are documented by way of an Instalment Sales Contract.

An Instalment Sales Contract takes the form of a standard Contract for Sale of real estate which has been modified to provide for the payment of the price by instalments, over time.

These are the modifications required to be made to a standard Contract for Sale to convert it into an Instalment Sales Contract:

1. The price set represents a profit over the purchase price. The price is payable by instalments, instead of a lump sum on completion.
   
2. The instalments are payable regularly, either weekly, fortnightly or monthly, and will include interest. The interest rate is usually set at a premium above the interest rate payable on the investor’s loan / mortgage upon the property.
   
3. The time between the date the Contract is entered and is therefore legally binding (called “the exchange of Contracts”) and completion of the Contract (also called “settlement” in Australia and “closure” in the USA) may be as long as 25 or 30 years, rather than the 30 days or 42 days found in a standard Contract.
   
4. The Purchaser enters into possession of the property, under a licence rather than a lease, and will be responsible for all expenses as from the exchange of Contracts (i.e. when the contracts are signed and the deposit is paid).
   
5. During the continuation of the Contract, the Purchaser must reimburse the Vendor for all Council and Water rates, taxes and other outgoings, the insurance premium, and must keep the property in good repair and carry out all repairs and maintenance to do so.
   
6. The deposit is paid by the Purchaser on the entry of the contract. The deposit paid will generally be less than 10% and where applicable, will include the First Home Owner’s Grant. It may itself be paid by instalments, and will be given direct to the Vendor, and not held by a deposit holder until completion.
   
7. The Vendor retains legal title until completion. That is, the Purchaser does not have title to the property transferred into their name (and is therefore not the “owner”) until the final instalment of the price is paid.
   
8. Default under the Contract will result in late payment charges. If the Contract is terminated, the deposit and all instalments paid are non refundable and are kept by the Vendor.
   
9. The Purchaser can pay out the balance price under the Contract before the due date for completion, but must pay all payments due to that date and an early completion charge.
   
10. The Vendor needs to provide a Credit Code Disclosure Statement with the Contract and a Statement every six months to comply with the Consumer Credit Code.
    

There is no standard form of Instalment Sales Contract. The form of the Instalment Sales Contract undergoes continuous amendment as new issues arise and as new ways of looking at old issues are found.

The Lease / Option

Where Vendor Finance consists of payments consisting of a mixture of rent and option fees, then it is known as rent to buy, rent to own or rent now, purchase later. These are documented by way of a Residential Tenancy Agreement and an option for sale, hence the abbreviation, Lease / Option.

The Residential Tenancy Acts in each State have a Schedule which contains the standard form of Residential Tenancy Agreement to be used in that State. In some States, a different form is prescribed for short term leases as compared with longer term leases. The Acts prohibit any amendments to those standard forms.

Therefore, all that needs to be done is for the particulars to be inserted, namely the names and addresses of the landlord and tenant, the address of the property, the rent, and how it is to be payable, the term of the lease, the commencing date and the terminating date. Often the bond requirement is omitted.

The option is a separate document to the Residential Tenancy Agreement. The Sale of Land or Conveyancing Acts in each State provide for certain inclusions, but apart from that, the form of the option is left to the discretion of the drafter of the option. There are many precedents for call options available to assist in drafting the option.

Technically, the option is a ‘call option’. This means that the purchaser takes an option to purchase the property. As a taker of the option, it is up to the purchaser to decide whether or not to proceed with the option, which is technically known as exercising the option. Because options are granted for a fixed period of time, then unless the option is exercised within that period of time, the option will lapse.

The main task of the person who drafts the option is to document the payment of the option fee. It must be documented so that it properly reflects the intention that it be credited as part of the deposit to be paid under the Contract for Sale, which comes into existence when the option is exercised. This credit is colloquially referred to as the ‘rent credit’.

The Second Mortgage

Where Vendor Finance consists of payments consisting of a mixture of principal and interest, then it is known as carry back finance. Because the title to the property goes into the name of the purchaser, the documentation takes the form of a second mortgage, which is to rank after the first mortgage upon the property.

The second mortgage is no different in form from a first mortgage, although some drafters like to add a clause that a default under the first mortgage is to be treated as a default under the second mortgage. Often, but not always, the consent of the first mortgagee to the entry of the second mortgage will be obtained. The consent may be given by letter, or in the form of a Deed of Priority. The second mortgage will either be registered upon the title to the property, or a Caveat will be registered to protect the second mortgage.

Disclaimer: The information and advice contained in this commentary is: (a) general in nature; (b) intended to draw attention to certain items to be discussed with a professional adviser; (c) not intended to provide specific advice; (d) takes no account of particular facts and circumstances; and (e) is not to be relied upon for any purpose.; and (f) is copyright, and must not be used other than for private or educational purposes and is not to be published in any form without the prior written consent of Anthony J Cordato.
Anthony J Cordato and Cordato Partners Lawyers disclaim all liability and responsibility to the fullest extent available at law. Liability limited by a scheme approved under Professional Standards Legislation