Tax Implications of Seller Financing via Note

14 Replies

Hi all,

I just read this related topic on tax implications of Subject To: 

http://www.biggerpockets.com/forums/51/topics/1303...

My question is what are the tax implications of seller financing that is done via the creation of a note, both for seller and the buyer?

Let's just create the following hypothetical transaction with easy numbers:

Seller owns a property free and clear, selling it for $100k. Buyer pays $40k down, and the rest will be paid via sellers financing at 5% interest on a 10 year note, 20 year amortizations with a balloon payment at the end.

Is it correct to assume that:

1. The $40k down is subject to capital gain on the year of closing.

2. The 5% interest is considered a regular interest income. Buyer can deduct this part. What about the portion of the payment that goes to the principal ?

3. When the balloon payment is paid, this is considered as capital gain on the year of the payment. 

Correct? Absolutely wrong?

Originally posted by @Ezra Nugroho:

Hi all,

I just read this related topic on tax implications of Subject To: 

http://www.biggerpockets.com/forums/51/topics/1303...

My question is what are the tax implications of seller financing that is done via the creation of a note, both for seller and the buyer?

Let's just create the following hypothetical transaction with easy numbers:

Seller owns a property free and clear, selling it for $100k. Buyer pays $40k down, and the rest will be paid via sellers financing at 5% interest on a 10 year note, 20 year amortizations with a balloon payment at the end.

Is it correct to assume that:

1. The $40k down is subject to capital gain on the year of closing.

2. The 5% interest is considered a regular interest income. Buyer can deduct this part. What about the portion of the payment that goes to the principal ?

3. When the balloon payment is paid, this is considered as capital gain on the year of the payment. 

Correct? Absolutely wrong?

 Ezra,

I will add some facts of my own to answer your question:

-Seller originally bought the property for $60,000. 

-Seller was renting property out prior to sale, and $10,000 of depreciation has been taken.

In this case, the capital gain on the property is $50,000 ($100K sales price less purchase basis of $60,000 plus $10,000 depreciation recapture). 

By selling the property on a note, the seller qualifies for the installment method of reporting capital gains. Meaning, tax can be paid proportionately to seller being paid on his contract. For every $1 of principal seller receives, $.50 of it will be taxed as capital gains. If the only principal received in year one is $40,000 down payment, $20,000 of it will be taxable capital gains. 

If/when the note balloons, whatever lump sum principal payment will also be subject to the same capital gain treatment. So, if balloon calls for $60,000 to be paid then $30,000 of that payment will be capital gain. 

From the buyer's perspective, the interest will be deductible. Payment of principal really has no bearing on his taxes as principal is not deductible. However, the buyer will presumably be depreciating the property and will use the initial purchase price of $100,000 for depreciation purposes. 

Changing the facts a little bit: if the originally seller was not holding the property for rental purposes, rather, acquired it and immediately turned around to sell on financing, there is a potential tax trap here. The IRS has an argument that the intent of the seller was not for speculation or investment purposes, rather, to deal the property in the ordinary course of business. If this argument would hold up, the installment method would not qualify and the seller is at risk of having to recognize the entire $50,000 gain up front even though he won't receive payment of the purchase price in the first year. My recommendation to clients is to consider putting the property on a lease option for at least a year, then converting it into a seller financed note. This way, the property is seasoned as an investment property and the IRS' argument about intent is completely dissolved. The buyer still retains an ownership aspect in the property in the form of option consideration that can be applied to the downpayment after a year. 

Nathaniel Busch, CPA 

@ Ezra Nugroho

Nathaniel overlooked the tax on unrecaptured depreciation in his sale of rental property scenario.  If the seller had taken $10K in depreciation, then principal received is first allocated to unrecaptured depreciation.  The first $10K of a $40K downpayment will be allocated to unrecaptured depreciation and taxed in full in the year of sale -- making the depreciation recaptured.  The recaptured depreciation is added back to the tax basis, making the tax basis $60K for the rest of the installment payment calculations.  

This means that only $40K of the remaining principal to be received will be taxed as capital gain.  Since there is only $90K of the $100K sale price left to be allocated, 4/9 of any additional principal received will be taxed as capital gain and 5/9 of the remaining principal received will be a tax-free return of basis.  So of the $30K balance of the downpayment, 4/9 or roughly $13,333 will be taxed as capital gain while $16,667 will be a tax-free return of basis.   The same 4/9 ratio is applied to all remaining principal payments to determine the amount of the principal payment that is taxable capital gain.  

The capital gain portion of each installment payment is taxed at the capital gains tax rate in effect for the taxpayer's tax bracket for the year in which the payments are received.  

Of course, interest is taxable as ordinary income when and as received.  

Originally posted by @Dave T:

@ Ezra Nugroho

Nathaniel overlooked the tax on unrecaptured depreciation in his sale of rental property scenario.  If the seller had taken $10K in depreciation, then principal received is first allocated to unrecaptured depreciation.  The first $10K of a $40K downpayment will be allocated to unrecaptured depreciation and taxed in full in the year of sale -- making the depreciation recaptured.  The recaptured depreciation is added back to the tax basis, making the tax basis $60K for the rest of the installment payment calculations.  

This means that only $40K of the remaining principal to be received will be taxed as capital gain.  Since there is only $90K of the $100K sale price left to be allocated, 4/9 of any additional principal received will be taxed as capital gain and 5/9 of the remaining principal received will be a tax-free return of basis.  So of the $30K balance of the downpayment, 4/9 or roughly $13,333 will be taxed as capital gain while $16,667 will be a tax-free return of basis.   The same 4/9 ratio is applied to all remaining principal payments to determine the amount of the principal payment that is taxable capital gain.  

The capital gain portion of each installment payment is taxed at the capital gains tax rate in effect for the taxpayer's tax bracket for the year in which the payments are received.  

Of course, interest is taxable as ordinary income when and as received.  

 Dave T,

The depreciation only needs recognized all in the first year if the depreciation is considered ordinary income recapture under IRC 1245 or 1250. Although I didn't state it in my example, I am trying to keep it simple by assuming the $10,000 of depreciation is straight line, normal depreciation on 27.5 year property. 

As a result, "normal" depreciation would not be subject to the immediate recapture rules and would still be deferred under the installment method. 

Nathaniel Busch, CPA 

The example provided also mentioned that it was rental property.  The seller could consider the possibility of structuring a 1031 Exchange.  The 1031 Exchange is possible with a seller carry back note, but it gets more complicated.  For example, if the seller carry back note was $60,000, then the seller could loan or contribute the $60,000 into the transaction (serve as the lender), and the full $100,000 would then be part of a 1031 Exchange transaction and be completely tax-deferred.

I made an offer to purchase a property.  The owner bought it in 1977 for $55,000.  It's been fully rented (house and mobile on property) for 5+ years.  Sale price is $525,000.  I'm having difficulty financing because of the mobile on the property, but I believe the rental income outweighs removing the mobile for financing simplicity.

The seller countered with provisions including:

"1031 Exchange.The Buyer shall cooperate in taking any and all actions, and executing any and all documents necessary to effect a tax deferred exchange for the benefit of Seller.
Should there be any cost or expense arising from or out of the Section 1031 exchange, the party seeking such 1031 treatment shall pay all such cost or expense."

"Seller may elect to have their attorney/accountant draw up a Structured Sale, in the event Seller determines that they want to use the Structured Sale strategy for capital gain deferral. Buyer agrees to sign such documents with no extra expense to Buyer."

So, it is obvious the seller is trying to avoid the huge capital gains hit. Would it be advantageous for me to suggest seller financing? At a competitive rate (80% LTV, 5/1 ARM, 30yr, 4%?), it would simplify my financing.

Would it be advantageous to him to seller finance?

@Nathaniel Busch

Excerpt from IRS Pub 537, Installment Sales.  i don't see where this does not apply to Section 1231 property.

Depreciation Recapture Income

If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544.

@Bill Exeter Had a few questions on the example you provided above... if the seller carries back the $60K note inside the 1031 exchange to serve as the "lender" on the property he is selling, does this then complete the 1031 transaction? Or, would he (or his qualified intermediary) still then be required to go looking for a new property (i.e. not the one he is selling) to purchase/exchange into?  Also, since the intermediary would be holding the note on behalf of the seller then my understanding is that note payments would go to the intermediary (correct me if incorrect).  If the seller needs to access the proceeds from the note for whatever reason at some later date after transaction finalized, can they fairly easily access those funds (I'm assuming withdrawals would be taxed based on amount pulled out)?

@Account Closed , Placing a note inside a 1031 exchange does not change the basic structure or calendar of the exchange.  In the example above the exchange is started with an exchange account that includes the cash of 60K and the note for 40K.  In order to defer all tax the exchanger must use those proceeds to purchase a new property worth at least 100K.  They could take the note as boot and keep it outside the exchange.  That 40K would be taxable but only as paid.  If they put it into the exchange they need to use it to purchase the new property.  However, if during the exchange the exchanger accesses 40K from some other source they can "buy" the note from the exchange.  Now they have 100K in their exchange account to purchase 100K of real estate.  That works and keeps the full deferral by virtue of the 1031.

Meanwhile, outside the 1031 the exchanger now has a note that is worth 40K that they "paid" 40K for.  So the capital amount of the note is tax free and only interest attached is taxed.

While the note is in the exchange account it is critical that the proceeds from the note stay in the account until the exchange is over.  Otherwise they can not only be seen as boot but also as constructive/actual receipt of exchange funds and jeopardize the entire exchange.  However, if the client buys the note out quickly that is not an issue and the time fixed maximum 180 days for the exchange ensure that the note does not complicate the process unnecessarily.

Okay, that makes sense.  Thanks for the clearing that up @Dave Foster that was helpful.

I have a scneario I would appreciate some advice on!!

I inherited a home 7 years ago that is owned free and clear.  It has been a rental property the past 7 years.  The tenant has just moved out and the house is in terrible shape.  The house is also located in another city which makes managing it difficult as well as there is no appreciation in this city.  I would like to sell the property and invest in more real estate in the city where I live.  Here are the facts:

Upon inherting the house the value was 80,000.  Due to declining market and the condition of the house it is not worth about 55,000 (as is).  I am considering owner financing the house for 55,000 with 10,000 down payment and the remaining balance would be paid over 10 years at 12% interest.

OR

I could walk away from the house for 40,000 and sell it to another investor who would turn around and owner finance it.  

From a tax stand point is one way better than another?  

Thanks for any advice! 

I know this thread is not new... However... :-)

Is all of this in spreadsheet form anywhere so it can be consumed a bit differently and played with?

@Nathaniel Busch

@Dave Toelkes

So it sounds like selling a property using seller financing has great tax benefits, correct? From what I read above, it seems like, said simply, 50% of the proceeds from an installment sale are taxed at capital gains rate and 50% are tax free, correct? Obviously, I'm ignoring depreciation recapture here.

Seems like a huge plus that one could use when pitching seller financing.

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