What A Wrap Actually Is
A wrap-around mortgage (or "wrap") is a seller-financed note where the seller continues to make payments on an existing underlying mortgage from the proceeds of your note payment.
The mechanics:
- Seller has an existing first mortgage with a balance of $X at rate R1
- You buy the property with a seller-financed wrap note of $Y at rate R2 (where Y is larger than X and R2 is higher than R1)
- Your monthly payment on $Y goes to the seller
- The seller continues making the underlying mortgage payment on $X
- The seller pockets the spread
The seller earns:
- Interest spread (R2 minus R1) on the underlying balance
- Full interest at R2 on the equity portion (Y minus X)
- Plus their tax-advantaged installment-sale treatment on the gain
When Wraps Make Sense
Wraps are useful when:
The seller has an existing low-rate loan they want to keep alive. Same logic as subject-to but with a layer of seller-equity wrapped on top. If the seller has a 4 percent mortgage in a 7 percent environment, that low-rate loan is valuable.
The seller wants ongoing income beyond just the equity. A pure seller carry on $200,000 produces less income than a wrap of $400,000 with a $200,000 underlying loan inside. The seller's payment received is larger.
The buyer needs more flexibility than a sub2 allows. A wrap is more clearly the buyer's loan because the buyer is contracting directly with the seller. Sub2 deals can have ambiguous tax treatment.
The seller has equity but wants to maximize yield. A typical seller carry might pay 5 percent. A wrap might pay 6.5 percent because the seller can spread the rate over a larger principal.
When Wraps Do Not Make Sense
Wraps are problematic when:
The underlying loan has a strict due-on-sale clause and an active servicer. Same risk as subject-to. Wraps technically trigger due-on-sale because the buyer is paying on the seller's mortgage through the wrap mechanism.
The underlying loan rate is not below market. If the underlying loan is at 6.5 percent and current rates are 7 percent, the spread does not justify the complexity. Use straight seller financing instead.
The buyer plans to refinance within 2 to 3 years. Wraps add complexity that does not pay off if the underlying loan is going to be paid off soon anyway.
Either party lacks the servicing infrastructure. Wraps require a professional loan servicer to handle the payment split. DIY wraps end in tears.
Worked Example
Setup:
- Property value: $400,000
- Existing first mortgage: $180,000 at 4.0 percent, payment $860/month
- Seller equity: $220,000
Standard seller financing alternative:
- Sale price: $400,000
- Down payment: $40,000
- Seller carry: $360,000 at 5.5 percent, payment $2,217/month
- Seller would have to first pay off existing mortgage (uses $180,000 of down payment proceeds, leaving only $220,000 for the carry)
- Actually: down payment $40,000 - too small to pay off $180,000 - cannot do straight carry without payoff
Wrap alternative:
- Sale price: $400,000
- Down payment: $40,000
- Wrap note: $360,000 at 6.5 percent, payment $2,448/month
- Seller continues paying underlying $860/month
- Seller's net monthly inflow: $2,448 minus $860 equals $1,588
Seller's effective yield:
- Cash to seller at close: $40,000
- Annual net income from wrap (Year 1): $1,588 x 12 equals $19,056
- Plus principal pay-down on underlying loan (around $4,300/year): seller's equity grows
- Plus installment sale tax treatment
The wrap lets the seller monetize the embedded value of the low-rate underlying loan. A straight seller carry would have required paying off the underlying loan, losing that value.
The Servicing Setup
A wrap requires a professional loan servicer to handle the payment split. The servicer:
- Receives the buyer's monthly payment
- Forwards the underlying mortgage payment to the original lender
- Forwards the spread to the seller
- Maintains separate amortization for both
- Handles escrow, 1098/1099 issuance, year-end reconciliation
Without professional servicing, the seller could pocket the buyer's payment and let the underlying mortgage default. The buyer's title is then at risk. Professional servicing protects both parties.
Cost: $20 to $40 per month, paid typically by the buyer or split. Cheap insurance.
Due-On-Sale Risk
The wrap technically triggers the due-on-sale clause on the underlying loan. The lender could call the loan due immediately. In practice:
- Lenders rarely call performing loans. They got paid every month. Why disrupt that?
- Lenders typically discover ownership changes through escrow inquiries, refi attempts, or insurance changes. Wraps that keep the underlying lender invisible are usually safe.
- Doing the wrap into a trust (Garn-St. Germain trust transfer) can technically protect against due-on-sale enforcement. Talk to your attorney.
Risk mitigation:
- Make underlying payments on time, every time
- Do not change insurance to the buyer's name (keep it in the seller's name, or use a complicated three-party arrangement)
- Do not ping the lender unnecessarily
- Have a "Plan B" if the underlying loan gets called
Tax Treatment Considerations
Wraps create tax complexity because the seller is essentially running a two-sided lending operation. Their installment sale treatment under IRC Section 453 applies, but the gross profit ratio calculation gets technical.
Engage a CPA who has done wrap deals before. The math is doable but the documentation matters at IRS time.
When To Use Wraps Versus Straight Seller Financing
Use wraps when:
- Underlying loan is below market rate
- Underlying balance is significant (over $100,000)
- Both parties can use a professional servicer
- Buyer plans to hold for 5-plus years
Use straight seller financing when:
- Property is free and clear
- Underlying loan is at or above market rate
- Either party is uncomfortable with the complexity
- Buyer plans to refinance within 2 years
In most situations, straight seller financing wins on simplicity. Wraps are a specialized tool for specific situations where the underlying loan has real value.
Documentation Required
A clean wrap requires:
- Wrap promissory note (your note to the seller)
- Wrap deed of trust or mortgage (security for the wrap note)
- Servicing agreement (3-party: buyer, seller, servicer)
- Title insurance policy with wrap endorsement
- Side agreement covering due-on-sale risk allocation
- Tax disclosures for both parties
This is not a DIY transaction. Use a real estate attorney who has closed wraps before. Most general practitioners have not.