The concept of "deemed interest" - does it exist in the U.S.A?

[Roy N.]

Good morning BP!

I was over in the blogs this morning reading Brandon Turner's latest essay, "The Definitive Guide to Using Seller Financing to Buy Real Estate" and, in the comments following the article there are two references to seller carried notes at 0% interest - one including an inflated sale price as an offset for no interest.

These references started me wondering and I have a few questions:

1) Does the IRS wield the concept of "deemed interest"? Here on the north side of the 49th, creating a note (taking a mortgage) at 0% interest would most probably initiate sirens and red flashing lights at taxman central, who, in-turn, might very well deem the lender to have written the note at the prevailing bank rate and tax her/him accordingly.

2) If zero interest notes/mortgages are legal in the U.S.A, are there any special considerations in structuring one to keep it legal?

I expect @Bill Gulley or @Dion DePaoli or @Jeff S could quickly and succinctly {maybe not Bill} clarify my confusion.

[@Joshua Dorkin ... I'm back to the @mention only working for your name]

[Bill Gulley]

Dawn, what you found was the applicable rates for credits allowed in government subsidized units/properties.

Section 42 is a tax credit program that allows credits to be sold as a means to raise capital for subsidized projects. Nothing to do with our topic.

The IRS and courts consider the economic impact of no or very low interest as a financing concession. Why would any prudent person in a business transaction loan money for nothing? The IRS and courts do not view lending under biblical teachings and they recognize that the financing wasn't out of the good of someone's heart.

One issue. Failing to charge a reasonable rate of interest is assumed to be charged, if not for the use of funds then in a price. No one would sell an asset at its fair market value and another party loan money to buy it at no or at a very low interest. You have two transactions here. So, it can be viewed as an increased price to compensate for the lack of interest. As Steve mentioned.

Shortly after a sale, we all know, lenders look at the sale price and the appraised value. You have tainted the sale price with a seller concession. For a seller, profit was claimed on the sale. but there is no value to the interest income. It brings into question the true value and the transaction being at arm's length. In secondary markets this issue may disqualify a refi within one year, depends on who is buying it.

If a transaction is seen as failing to meet the arm's length test, your note and transaction may then be unraveled.

While you basically made an unmarketable note, you also destroyed the seller's financial statement as to assets, People die, estates are settled, state and federal taxes , may be due based on assets, administrators in your county receive fees based on assets.

A trust is required to value assets annually, what's a zero interest note worth (?), laws require values to be set at market, there is no market, the value in some cases is zero!

Yes, you can assess a value from the annuity income by assigning a market rate for similar investments, but that is not reaching a market value of a real estate note. The other consideration is in the overvalued collateral secured. So you can't prove a market value.

Valuations come up in bankruptcy as well, for buyer or seller, you clog that aspect up and your deal gets look at under a microscope.

What real economic value is there for a buyer? None really, as you're probably paying too much and getting a perceived better loan. Probably not, as you'll be doing some slick talk to sell the deal with no interest and you could use that effort in getting a lower price and paying interest and be in the same position or better off, especially if you refinanced it! I'd rather have a discounted price and finance it two points over that discount rate, that give me a high rate loan but a lower price that I can refinance, making the loan irrelevant. It's not even a good tactic to go to 0 interest loans.

There can be more issues as well.

Creative financing isn't just anything some imagination can dream up and turned into some guru transaction, there are reasons that financing is structured in certain ways so that the transaction meshes with other financial aspects of business and life. In other words, your deals need to fit into the world of business practices and other financial requirements. There is plenty of room to be creative, but this isn't an area to mess with. :)