Today, I want to take some time to answer wrap around mortgage questions I often receive. First, a legal disclaimer because I am not providing legal advice. Only general information. You need to seek competent legal advice based on your specific circumstances. With that said, let’s take on some tough questions.

Q #1: If you invest in a house by financing it with a wrapped around mortgage and the seller files bankruptcy, can the house be repossessed from you if you are the legal owner?

A #1: You’ll need to get competent legal advice here because circumstances will affect the outcome. Technically, the seller that is going into bankruptcy does not own a legal right to the property. If the original mortgage is current, you will probably prevail in court but it could be ugly. The bankruptcy trustee is going to at least want any money the seller has coming from the wrap around mortgage.

Q #2: What happens to the seller if the buyer in a wrap around mortgage declares bankruptcy?

A #2: The seller has a few options. Some better than others. As the holder of the wrap around mortgage, you are holding a second mortgage. The original lender has the senior loan. You can foreclose on the property but the original loan must be kept current. That could require you to make the original loan payments until the foreclosure is complete. If the original loan is in default, the original lender has the right to foreclose. If the property sells for more than what is owed on the original loan you will receive the balance. Another option is contacting the buyer and asking them to deed the property back using a deed-in-lieu of foreclosure. The advantage for the buyer is this can preserve their credit rating.

Q #3: Will a wrap around mortgage work when the seller has multiple loans against the property?

A: #3: A wrap around can still work here if the total of the loans is equal to or less than the purchase price the buyer agrees to. The multiple loans can be consolidated and assigned to the buyer.

Q #4: What happens with the interest deduction and the 1098 form the original lender sends every tax year?

A #4: The lender will likely continue sending the 1098 form to the seller with their name on it because technically the original loan is still in the seller’s name. However, the seller is no longer the owner of the property. The buyer is now the owner of the property and the one making the mortgage payments. The seller or seller’s accountant will need to issue a new 1098 form to the buyer covering both the interest on the original loan and any interest payments made to the seller as part of the wrap around mortgage.

Q #5: What happens if the buyer cannot obtain refinancing when a balloon payment comes due?

A #5: The seller has a few options but ideally this should be addressed in the original wrap around contract. If the buyer is current with the payments the most common way this is addressed is for the wrap around payments to continue until refinancing can be obtained. However, the buyer has to be motivated to obtain new financing. Typically, a payment escalation clause is used to motivate the buyer. The monthly payments on the wrap mortgage go up. This can be from a higher interest rate or a shortening of the amortization schedule or both. A word of caution, you don’t want to escalate the payments to the point that the buyer finds it to be a better financial decision to walk away after years of steady payments.