Taxes implications for buyers and seller on finance deals!?

11 Replies

Taxes implications for buyers and seller on Seller finance deals!?

I’m working on a seller finance deal and have some questions on Taxes.

Seller: Family member

Seller’s Purchase price in 2009: $180,000

Property owned free and clear

6 unit building

Interest: 4%

Our plan:

Purchase price (in 2018): $550,000

15 years mortgage

We understand the seller will have to pay CAP gain taxes.

1, But will this taxes be deferred since he will be receiving his $$$$ monthly for 15 years?

2. Or would the seller have to pay taxes up front the sales occurs?

3. Will my monthly payments including Principal and Interest be taxable at the end of the year? 

Thanks in advance for you feedback.

Jaime 

@Jaime Navarro

1, But will this taxes be deferred since he will be receiving his $$$$ monthly for 15 years?

  • Gain recognized from the sale or exchange of depreciable property between related persons is treated as ordinary gain
  • Yes, the gain has to be recognized on yearly basis for 15 years. But…… as you know whenever someone sells the depreciated real property, he/she also have to recognize the unrecaptured 1250 gain that is taxed at 25% in addition to Cap gain. This gain is not deferred for 15 years, but a front-loaded approach applies to the installment recognition of unrecaptured 1250 gain If yearly gain from an installment sale includes both unrecaptured Section 1250 gain (25% gain) and capital gain. The unrecaptured Section 1250 gain is reported before the adjusted net capital gain.
  • Since you this transaction is between related individuals, the two-year disposition apply. If you dispose within two years, there are tax implications.

2. Or would the seller have to pay taxes up front the sales occurs?

  • See above:

3. Will my monthly payments including Principal and Interest be taxable at the end of the year?

Your monthly payment will include both principle and interest. For Seller’ the monthly payment will include capital or depreciation recapture gain and also interest income. 

@Jaime Navarro

If the seller goes with seller financing, the cap gains is spread out as the money is received each year.

Your rental income will be declared on your income taxes each year, with expenses off setting it like mortgage interest...

you should speak with a CPA about the best way to setup everything so that you can stay organized and minimize taxes each year.

@Jaime Navarro

Let me be blunt. Relying on free online advice for a $400k+ profit transaction is reckless. This has to be planned carefully, with an expert accountant. Too much money at stake to risk a mistake.


Regular rules for installment (owner-financed) sales.

Buyer has $550k to depreciate starting right away, regardless of the down payment and other terms. From that point forward, he deducts only the interest portion of his payments.

Each payment that seller receives, including down payment, is divided into 3 parts:

  1. Fully taxable interest component
  2. Non-taxable portion of the principal component (return of the $180k, more-or-less)
  3. Taxable portion of the principal component (taxed under a mixture of capital gain rate and depreciation recapture rate)

Details and formulas are quite complicated.


Special rules for sales between related parties.

@Ashish Acharya explained some, but he seemingly was in a hurry, so important details were not mentioned.

Related party sales bring several potential complications to the regular rules, including these 3.

1. Ordinary tax rate instead of capital gain rate. That's pretty bad, but luckily this rule is not for sales between family members. It is for sales between related business entities - like from one business you control to another business you control. 

2. The worst one. Spreading of the tax ("installment sale treatment") may be prohibited for some transactions between related entities AND also between relatives. Relative means specifically:

  • spouse
  • siblings and half-siblings
  • lineal descendants
  • ancestors

Not a problem for cousins, nephews etc. But if your relationship is on the list - make sure to discuss with a competent accountant.

3. Additional complications if you try to resell it within 2 years from purchase.

Granted - there's much more to these rules. Don't risk a major mistake on your own, use an expert (to make those same mistakes on your behalf, haha)

@Michael Plaks , @Ashish Acharya .

I am confused.  How to I reconcile this excerpt from IRS Pub 537 (2017) with your comments?

"... 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."

This tells me that the unrecaptured depreciation is taxed in full in the year of sale whether or not any installment payments have been received, and, not included as a component of any installment payments.

@Dave Toelkes

I know its confusing.  Two kinds of recapture.  1250 Recapture that is taxed as ordinary income (its due at the installment sale) and Unrecaptured section 1250 gain that is taxed at 25% and can be deferred but is front-loaded like mentioned above. 

@Michael Plaks , busy season you know :). However, I tried to not complicate the answer with the code that is not applicable to @Jaime Navarro

1. Ordinary tax rate instead of capital gain rate. That's pretty bad, but luckily this rule is not for sales between family members. It is for sales between related business entities - like from one business you control to another business you control.

->Really not applicable to him.  and you wrote the same.  There are other rules that apply to Installment sale, wouldn't make sense to write all that if not applicable, would it? 

2. The worst one. Spreading of the tax ("installment sale treatment") may be prohibited for some transactions between related entities AND also between relatives. Relative means specifically:

  • spouse
  • siblings and half-siblings
  • lineal descendants
  • ancestors

Not a problem for cousins, nephews etc. But if your relationship is on the list - make sure to discuss with a competent accountant.

- > Not applicable to him as well. Sales between related individuals (e.g., parent and child) are not subject to this "related persons "exception to the installment sale rules. Instead, the two-year disposition rule.  Related person is defined differently for this exception. 

3. Additional complications if you try to resell it within 2 years from purchase.

Already mentioned. 

Thanks 

Appreciate your input! 

@Michael Plaks, @ashish acharya, @christopher Phillips,

Definitely need to get a CPA professional to assist me on my business, seems like it's time to get into LLCs, etc..

Do you guys have an idea on how much it would cost to set up LLCs. I'm starting, have a couple of rental properties, the plan is to add more with time. I would like to start this right.

Do I need an attorney and a CPA to set LLCs? 

Do you guys know a company that offers this service in Chicago for a decent price?

(I know, I know we get what we pay for... I'm curious about the different options)

Have you heard of any online company that can help on this?

sooo many questions .. lol 😂🙄🤑

Appreciate your thoughts, in advance.

@Michael Plaks , @ashish acharya , @christopher Phillips

Originally posted by @Dave Toelkes :

@Michael Plaks, @Ashish Acharya .

I am confused.  How to I reconcile this excerpt from IRS Pub 537 (2017) with your comments?

"... 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."

This tells me that the unrecaptured depreciation is taxed in full in the year of sale whether or not any installment payments have been received, and, not included as a component of any installment payments.

They are talking about "true" depreciation recapture, which is depreciation in excess of straight-line. Since all real estate depreciation after 1986 is straight-line, this concept is pretty much irrelevant these days. They should stop referring to it and confusing people, if you ask me.

What you called "unrecaptured depreciation" and what most CPAs casually call "depreciation recapture" is a different animal. Its proper name is "unrecaptured Sec 1250 gain" and it does go into installment treatment. You can spread it, but it is front-loaded, as Ashish explained.

@Ashish Acharya

On my #1 - conversion from cap gain to ordinary - you and I agree: it does not apply. I also agree on not complicating. This is precisely why I was surprised that you brought it up, without indicating that it was not applicable. 

On my #2/#3 - that was me being in a hurry - tax season, you know :)  When I added the thing about relatives, I accidentally added it to #2 and not #3 where it belongs. Oops. We agree again. Sorry, @Jaime Navarro , if I confused you. #2 (prohibition) does not apply. #3 (2-year resale) does.

Maybe my #2 should not have been mentioned, but there was a chance that it could be relevant, depending on the details of the deal, which we do not know.

Thanks, Ashish.

Originally posted by @Jaime Navarro :

Do you guys have an idea on how much it would cost to set up LLCs. I'm starting, have a couple of rental properties, the plan is to add more with time. I would like to start this right.

Do I need an attorney and a CPA to set LLCs? 

Do you guys know a company that offers this service in Chicago for a decent price?

Have you heard of any online company that can help on this?

How much to set up?  Illinois recently reduced its state fee to $150. Here is the Secretary of State website. Attorney's assistance will add between $200 - $1,000 to that fee. 

Attorney and CPA? Attorney - yes, if you want your liability protection done correctly. If it's not a big concern, then maybe you do not even need an LLC, since liability protection is the main reason to create one. CPA - probably, to determine the best method of taxation for this LLC. CPAs should not be forming LLCs, even though some do.

Online company? Google "Illinois LLC" - and you will find several. The quality of their work varies.

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