Will this Owner Financing Deal Work?

Question

Hello Everyone can someone tell me if this scenario would work in the real world.

I want to put 25% down on a 90,000 purchase ( 22,500) .  The loan terms are 5% at on 20 year fixed term loan.

I then want to do 20,000 worth of rehab. Then sell it for 150,000.

However I want to sell it and owner finance it to someone. I would ask them to come up with 5% of 150,000, I would also have them pay a 6% interest rate on a 20 year loan.  No points, no closing costs. Credit, tax, and income verification only.

Would something like this work?

What would happen if they decided to sell? Would would I lose my 22,500 investment?

Thank you for the help in this matter.

Curt Smith · Answer

@shawn

Yes I'm sure, you sell a flip, it doesn't mater how you get paid, cash or a note you pay the tax in the year of sale, right??

Only selling an investment property do you get to take installment sale gain tactic.

Then again, it's a function of whether you get audited.  :)   Lots of mistakes go into past returns.  The IRS only catches a few.

Wayne Brooks · Answer

Well, you'll have due on sale clause risks when you do the wrap to the end buyer.  You've got Dodd frank issues if they are an owner occupant.  You've got the problem of having to maintain your payments, if you have to foreclose on the buyer.  There Will be some closing costs, on both sides, when you sell. You'll have $5k or so in closing costs on your purchase.  I don't like the idea of putting out $27k or so, plus another $20k, and only collecting $7500 down from the sale.  Will the property actually be worth $150k on the open market to a normal buyer?

Rich Hupper · Answer

@Curt Sm

@Curt Smith Thank you again for your education in this matter. If knew anyone else other than biggerpockets forum members to turn to for this type of clarification I wouldn't be taking up your time.

However in the real world I do not know anyone.

I wish I had a degree in accounting or more legal knowledge to assist my investing business.

Wish you the best in your deals!

Cheers!

Shawn Thom · Answer

@Curt Smith are you sure about having the to pay full capital gains taxes 1st year?  Everything I find says it is spread over the length of the loan.

Curt Smith · Answer

LMLO = Licensed Mortgage Loan Originator.  You find these guys who'll originate your seller financed mortgage by calling all the real estate attorneys / title offices around asking for who is the originator on seller notes?

Cash flow in the first year...   It depends on if the sale is in Jan, then you collect Feb-Dec mortgage payments P&I.  This note has P&I of $1020 ( $150k less down of 5%=$7500, $142500 loan amount at 6% at 20yr amortization.  Is $1020/mo.  The first month is $308 principal and $712 interest.  So your net cash flow is dependant on what month the borrower closes in.   Now whether you include the 5% down ($7500) plus P&I collected or just P I guess you are right.  Cash recved is cash so include both P and I to offset the taxes you'll have to pay.  To be more correct, the net cash flow in the first year is dependant on what month the borrower closes.  You can be negative to a few $k positive in the first year inspite of taxes in this case.

When you seller finance investment property (a rental) that has been held longer than a year (or your personal residence), the tax treatment is quite different.

25% marginal tax rate x ($7500 (the down is principal) + $3840 (principal collected for 12 months assuming closed in Jan) = $2820 tax due instead of $10k.

In year 2 the tax due is much lower because you are only taxed on the principal received via the borrowers mortgage payments, which does not include the 1st year down payment received.  But taxes go up each year there after as principal collected goes up.

Rich Hupper · Answer

@Curt Smith

Thank you again for your thoughtful insight into this. You clearly have a better handle on this than I do. After this discussion I will not be pursuing this strategy. However two questions about the points you made:

1) "Your taxes of $10k will be almost balanced by the buyers down payment and principal payments." It was my understanding that buyer would be paying an amortized loan. Where for the first half he is paying mostly interest and very little principle.  Or does my interest get offset because of the capital gains expense?

2) Could you tell me what a LMLO is?

Thank you again for your wisdom.

Curt Smith · Answer

Your "basis" on this deal is $90k + $20k rehab = $110k.  Your sale is $150k, making for $40k capital gain which for short term gains, is taxed at your ordinary income marginal rate.  Lets say you are in the 25% marginal tax rate tax bracket, you'll owe the IRS the full tax of $10k in the year of sale, the following April 15.

If you flip for a living and are already a broker dealer, then you'll owe an additional amount for both sides of FICA as well, I believe is 15% more.

But you'll only get from the buyer 5% down (principal) plus the small amount of principal that comes in from the buyer's mortgage payments to you.

Side note:  when you sell on a note (seller financing) always use a mortgage servicer.  I use TrustFCI.com .   The CFPB issued a clarification of Dodd Frank 6-9 mo ago requireing useing a servicer if the taxes and ins are escrowed.  It's nuts to not escrow, and also nuts to not use a servicer to handle the 1098's to the borrowers.

It looks like the first year post sale on a note your cash flow will be somewhat negative cash flow.  Your taxes of $10k will be almost balanced by the buyers down payment and principal payments.

Most of the time the math shows a big negative cash flow in the first year due to having to pay cap gains taxes all in the first year, instead of installed each year over the life of the loan.

Personally I don;t like strategies that are even close to cash flow break even, even if just for the first year.  You've got your down to the seller plus your rehab costs all "dead money".

>>No points, no closing costs. Credit, tax, and income verification only.

I would never do this!!  You have to close at an attorneys office to file the Lien against the deed, that costs $1500 to $4k depending on state.   If it's an occupant you need to follow Dodd Frank and do a full doc "Ability To Repay" doc process via a Licensed Mortgage Loan Originator.   According to Dodd Frank if this is your only loan in 12 months, you can skip the LMLO, but you'd be crazy to (in my view).

I charge 9.5% to my borrowers, you should to.  And charge points up front too.  You are making very little in this deal.

This sounds like a "favor to a relative" type deal and they rarely go well.  Google around.

Rich Hupper · Answer

@Curt Smith

Thank you for this information. I do not quite understand all of it however the last sentence pretty much sums it up for me.

What do you mean when you say: " Youll be killed on cap gains taxes come April yet not recieved the principal from the buyer for years."

Thank you

Curt Smith · Answer

The IRS will want 100% of the capital gains in the year of sale.  Standard flip math!

It never makes sense to seller finance (you the owner / investor financing to a buyer) of "inventory", because of the tax implications.  Youll be killed on cap gains taxes come April yet not recieved the principal from the buyer for years.

Tax regs allow taking installment sale treatment of the gain if it's an "investment property", IE a rental.  We rent to own our deals, rent for 1 year, long term capital gains, then finance to an occupant, Dodd Frank compliantly (just some steps), then take long term installment sale treatment of the gain received annually in the form of the principal received.

You should NOT finance your buyer!!!  For tax reasons.  If you lived in the home for some years, or rented for a year, then sure.

Rich Hupper · Answer

Yes it definitely will be worth 150,000 I have thoroughly gone over the comps, for the area.

You're right. owner financing this would be tying up to much of money correct?

Will this Owner Financing Deal Work?

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