Tax advantage on interest only?

10 Replies

Hello BP,

I am working on a deal with a seller willing to owner finance a 6plex. As part of my terms, i am asking for 12 months interest only at first and then start paying off the loan to the seller with interest. The seller's questions is:

Is there a tax advantage for the seller on the 12 months interest only? In other words, in 2018, the seller would only receive downpayment plus interest payments, no principal; will the seller have to pay taxes con all the income, or just the downpayment?

Thanks in advance!

Mauricio

They only pay taxes on their gain. Installment sales result in the seller receiving TAXABLE interest, plus principal. The disadvantage to you it no principal reduction the first 12 month. I like to pay off debt as quickly as possible. Principal payments are NOT deductible by you, but taxable to them. 

@Mauricio Ramos

If the seller is selling you his own home where he lived for at least 2 years - capital gains are not his concern, and neither is the schedule of principal repayment, from tax point of view. There is no disadvantage or advantage for him - except getting more interest up front. So he gets more income and more taxes, strictly from the additional interest.

If he is selling you an investment property, he is paying capital gains based on whatever principal portion he is receiving, including down payment. Delaying principal repayment is an advantage to him - because the later he receives back his principal, the later he pays his capital gains. Plus, he gets more interest.

Potential downside:  Unrecaptured depreciation is taxed in full in the year of the sale.  There is no installment treatment for unrecaptured depreciation.  If the seller has not received a large enough downpayment to cover the tax liability, the seller will have to come out of pocket to pay taxes.

Originally posted by @Dave Toelkes :

Potential downside:  Unrecaptured depreciation is taxed in full in the year of the sale.  There is no installment treatment for unrecaptured depreciation.  If the seller has not received a large enough downpayment to cover the tax liability, the seller will have to come out of pocket to pay taxes.

That is incorrect. The provision you're referring to applies to the actual depreciation recapture, which is depreciation in excess of the straight-line method - a mythical creature never seen after 1986 tax reform. 

What we're dealing with these days, casually termed depreciation recapture, is properly called unrecaptured Section 1250 gain. Unlike its similarly named relative, it is included in installment sales treatment.

Originally posted by @Michael Plaks :
Originally posted by @Dave Toelkes:

Potential downside:  Unrecaptured depreciation is taxed in full in the year of the sale.  There is no installment treatment for unrecaptured depreciation.  If the seller has not received a large enough downpayment to cover the tax liability, the seller will have to come out of pocket to pay taxes.

That is incorrect. The provision you're referring to applies to the actual depreciation recapture, which is depreciation in excess of the straight-line method - a mythical creature never seen after 1986 tax reform. 

What we're dealing with these days, casually termed depreciation recapture, is properly called unrecaptured Section 1250 gain. Unlike its similarly named relative, it is included in installment sales treatment.

Michael is correct. 

I think we should also mention that although the Unrecaptured sec1250  depreciation tax is not due on sale, all the gain in the first few instalment payment is treated as the recapture of the SL depreciation. Meaning that the depreciation recapture is front-loaded before capital gain kicks in, so the 25% tax on gain will be due with each payment on each installment gain until the depreciation is fully recaptured. 

 Maybe this is too much technical, but seller needs to be prepared that the 25% taxes are not divided over the term of the entire installment term, rather than it is front loaded. 

Me and @Ashish Acharya should always answer jointly. I will explain a simplified concept, and he will load it with technical details. :)  Ashish is correct, but only we tax pros care about these details.

There is only capital gains tax to pay when there is constructive receipt. If the contract is interest-only, the seller will never have constructive receipt of the sales proceeds until the last and final balloon payment is received - even if that is 30 years in the future.

So if you pay interest only for the first year and then begin making principal payments, the seller will have NO capital gains tax or depreciation recapture during the first year.

How can there be depreciation recapture if the seller has not received the proceeds? 

Understand the implications of an interest-only loan.

@Michael Plaks , @Ashish Acharya

How do i reconcile this excerpt from Pub 544 with your comments?

Excert from IRS Pub 544, pg 33

Installment Sales.   If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.

Originally posted by :@Ashish Acharya

How do i reconcile this excerpt from Pub 544 with your comments?

Excert from IRS Pub 544, pg 33

Installment Sales.   If you report the sale of property under the installment method, any depreciation recapture under section 1245 or 1250 is taxable as ordinary income in the year of sale. This applies even if no payments are received in that year. If the gain is more than the depreciation recapture income, report the rest of the gain using the rules of the installment method. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.

 Dave, 

"Section 1250 depreciation recapture" is not "Unrecaptured section 1250 depreciation"

I know it is confusing. unfortunately, IRS publication always does not provide you with the full picture. 

If a Real Property  ( house) is depreciated using SL, there is no section 1250 recapture. 

Section 1250 recapture = additional dep on top of  SL depreciation tax as ordinary income.

Unrecaptured section 1250 depreciation  = SL depreciation on property taxed at 25