Rental Property Investor · Fredericton, New Brunswick · Member since 2013 · 7k+ posts · 4k+ votes
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 D. ... I'm back to the @mention only working for your name]
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
12y
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. :)
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
12y
WHAT??????
I'm going to have to read that!
Zero interest is a really bad idea, it's guru stuff, it causes imputed rates to be applied each year, it brings into question the valuation and arm's length transaction issues and it's something that should be wiped out of the minds of all real estate operators.
BiggerPockets Founder · HI · Member since 2008 · 16k+ posts · 5k+ votes
12y
@Roy N. & @Wayne Brooks - Thanks for the head's up . . . we're back investigating again. Can you guys let me know your browser type and the version you're running? Feel free to take this to PM.
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 D. ... I'm back to the @mention only working for your name]
Sorry but there needs to be a reasonable interest. I too recommend the federal rates.
I don't understand why it's bad to sell or buy with 0% interest, and why the gov't cares with regard to taxation. I mean, if there's interest, they're gonna allow a write-off on the buyer, and tax the seller on the interest income. Maybe they make more on the taxation side? I don't claim to know much about tax law...I still get a refund.
Rental Property Investor · Fredericton, New Brunswick · Member since 2013 · 7k+ posts · 4k+ votes
12y
Thanks all,
So things work basically the same down there as they do up here.
If someone writes a note/loan at 0% - or even an unreasonably low rate of interest (like 1%), the IRS, like the CRA, will impute the published federal rate to be used.
I presume that in addition to taxing the interest earned at the imputed rate, there are also fines/penalties assessed as there are/can be here.
I figured something didn't smell right about seller financing at 0% interest.
I don't understand why it's bad to sell or buy with 0% interest, and why the gov't cares with regard to taxation. I mean, if there's interest, they're gonna allow a write-off on the buyer, and tax the seller on the interest income. Maybe they make more on the taxation side? I don't claim to know much about tax law...I still get a refund.
Please forgive my ignorance on this one.
From our perspective (loans between parents & kids) the entire loan could be 'deemed' a gift.
@Pat L. what is the definition of "short-term", "mid-term" and "long-term"?
As per the IRS....
The federal "short-term rate" is determined from a one-month average of the market yields from marketable obligations of the United States with maturities of 3 years or less. The "mid-term rate" is determined from obligations with maturities of more than 3 years but not more than 9 years, and the "long-term rate" is determined from obligations with maturities of more than 9 years.
I'm with @Dawn Anastasi ...
I don't understand why it's bad to sell or buy with 0% interest, and why the gov't cares with regard to taxation. I mean, if there's interest, they're gonna allow a write-off on the buyer, and tax the seller on the interest income. Maybe they make more on the taxation side? I don't claim to know much about tax law...I still get a refund.
The interest is an expense for the buyer and income for the seller. Income taxed at their marginal rate. That means someone is paying on it. That someone also has an increased income due to capital gain.
Real Estate Agent · Weatherford, TX · Member since 2011 · 726 posts · 284 votes
12y
Hey @Steven, thanks for chiming in! That part I understand pretty well. What I don't understand is why the IRS cares if a transaction is done with 0% interest, and what they actually "do" when they deem an interest rate.
Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
12y
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. :)
Hey @Steven, thanks for chiming in! That part I understand pretty well. What I don't understand is why the IRS cares if a transaction is done with 0% interest, and what they actually "do" when they deem an interest rate.
They send the seller a bill for an imputed interest. ~2%. At a tax rate of 39.6% that would be a tax bill of: 792 on a 100k note.
Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes
12y
Nice to see @Bill Gulley ,and @Steven Hamilton II on. I am not hijacking the thread but it brings up a question, I bought a house using creative financing a year ago and 5 years ago where the Seller financed part of the price at 2% interest a year for 5 years with monthly payments and a balloon at the end. Would that rate trigger imputed interest? The 2% was picked because it was 2X as high as the bank was paying on CDs and lower than what I could borrow at, so we both did well. Nice to see you all btw.
Nice to see @Bill Gulley ,and @Steven Hamilton II on. I am not hijacking the thread but it brings up a question, I bought a house using creative financing a year ago and 5 years ago where the Seller financed part of the price at 2% interest a year for 5 years with monthly payments and a balloon at the end. Would that rate trigger imputed interest? The 2% was picked because it was 2X as high as the bank was paying on CDs and lower than what I could borrow at, so we both did well. Nice to see you all btw.
No, you should be fine as there was at least an interest rate. And it was about prime rate. If you were to go back to the IRS and say he accepted that as it was higher than CDs; however, lower than you could borrow at you might have a case. Look at the IRS imputed rate.
Hi Jerry, you're up late....well, not as late as me...
I'd say you're pre SAFE Act, no issue. As to the rate I don't know what the assessment is currently, @Steven Hamilton II just computed it above.
If rates were that's what a 5yr CD was at that time I'd think you'd be safe as it would be above fed rate.
Hi Jerry, you're up late....well, not as late as me...
I'd say you're pre SAFE Act, no issue. As to the rate I don't know what the assessment is currently, @Steven Hamilton II just computed it above.
If rates were that's what a 5yr CD was at that time I'd think you'd be safe as it would be above fed rate.
And, that makes sense too. :)
It is actually a bit higher than I said above. Applicable Federal Rates (AFR) for November 2013
Federal Rates by Month
Great Steve, I just looked back to 3-11, the 2% appears to be close, what we'd have is a mid term I believe but I don't know as the table give three chapters ?
I know it's not Sec 42.
They go by the date the note was made, but we use to have a different table, you know which is applicable to Jerry? :)
Investor · Thermopolis, WY · Member since 2012 · 4k+ posts · 4k+ votes
12y
Thanks for the expert advice. I remember when the imputed rate was about 6%, seems strange how much things change. None of my homes were for owner occupied, and all were financed by the home owner so we should be safe. Well nite all.