Tax implications for owner financing

11 Replies

Hi all.  I was wondering if someone could explain the tax implications for both sides of an owner financing deal for a rental property?  I am just starting to research this financing strategy and I'm wondering how much the length of payment benefits a seller in terms of capital gains tax.  In addition, is there any difference from a conventional mortgage regarding interest payment write offs for the buyer?  Any input is appreciated!

@Brandon Craig

The seller pays taxes on interest income and the buyer can deduct the interest he/she pays. 

It doesn’t matter from a tax perspective if it is a bank or individual. 

I am not sure about the length time question. You can do it however it makes sense to both parties. Interest rate, amortization schedule, balloon payments, pre-payment penalties, adjustable rate vs fixed rate, assumesbility, personal guarantee, primary residence laws if not a business loan, servicing, etc are all items that need to be addressed. If this is your first loan get an attorney on your team. 

I always liked selling places and financing them because on every one of the 30 or so that I did I sold the house for ABOVE MARKET price. When people answer an ad that reads; XYZ neighborhood, 3/2/2, owner will finance with $3,000 down". You're attracting the kind of buyers that walk into a car dealer and just ask what their monthly note is.

NOTE: The last one I did was almost 20 years ago, in Texas and was for a $59,000 sales price. So $3,000 wasn't too out of line at 5%. 

I liked doing it because I had quit my salaried job which allowed me to work on my rentals while collecting my salary and I realized that Texas' weird tax set up, no personal income tax but they more than make up for it property tax, and UNREGULATED homeowner's insurance rates were crimping my style as a landlord.

@Brandon Craig

It's fairly simple. The buyer gets to deduct interest just as if it was a bank mortgage. If he is an investor, he also gets to depreciate the full cost of the property, as if it was purchased for cash.

The seller receives interest and principal. Interest is always taxable when received. From principal part, a fixed percentage is considered a tax-free return of the investment, and the rest is taxable capital gain.

The tax effect for the seller is that he spreads his capital gain tax over the length of the loan. Not evenly though: it is a fixed % of the principal portion. So, a large down payment also creates a corresponding capital gain in the first year.

Another way to say it: the seller pays capital gain taxes as he receives payments, as opposed to everything at once.

@Michael Plaks

Michael, I'm wondering what the fixed percentage of the principle payments are the tax-free return, and what is taxed.

I read this on another biggerpockets article, but haven't validated it yet: "For every $1 of principal seller receives, $.50 of it will be taxed as capital gains"

I'm trying to offer a principle only seller financing offer, and want to outline the tax benefits to the seller.

Originally posted by @Aaron Smith :

@Michael Plaks

Michael, I'm wondering what the fixed percentage of the principle payments are the tax-free return, and what is taxed.

I read this on another biggerpockets article, but haven't validated it yet: "For every $1 of principal seller receives, $.50 of it will be taxed as capital gains"

I'm trying to offer a principle only seller financing offer, and want to outline the tax benefits to the seller.

You must have read an example, as 50% is certainly not the rule.

Here is a simplified example. 

  • You bought a property for $170k and accumulated $20k of depreciation.
  • Your new "tax basis" in the property is $150k.
  • You sell for $200k. If you sell outright, you have a $50k capital gain, including $20k depreciation recapture.
  • With owner financing, you figure out a profit ratio: $50k of the $200k is profit, and it is 25%.
  • 25% of all principal payments, including the down payment, is taxable gain. 75% is a tax-free return of principal.
  • Interest portion is always 100% taxable as received.

If the seller is a homeowner (as opposed to an investor), then he probably qualifies for a capital gain exclusion ($250k if single) - which works the same with or without owner financing.

@Michael Plaks

Thanks, that makes sense and is pretty straighforward. So, does that mean that there are no tax savings or benefits from an installment sale vs selling the property lump sum?

According to this method you outlined above, they should be the same.

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@Aaron Smith Yeah, that’s total BS.  Seller financing only Defers the tax “until you start receiving principal”....the down payment and monthly principal payments AS you receive them.

The podcasts is about talking sellers into 0% seller financing......so I guess you need to convince them of some BS to agree to no interest (even though the IRS taxes you at a minimum interest rate anyway).

Originally posted by @Aaron Smith :

@Michael Plaks

Thanks, that makes sense and is pretty straighforward. So, does that mean that there are no tax savings or benefits from an installment sale vs selling the property lump sum?

According to this method you outlined above, they should be the same.

Tax benefit for whom? A non-investor homeowner does not normally pay tax on selling his house, as long as he owned it for 2 years, and the profit is under $250k ($500k if married.)  So he would have no tax benefit from an installment sale. His benefit is a higher selling price and extra income from interest.

An investor selling  with owner financing has a tax benefit of spreading his capital gain over multiple years.

Originally posted by @Wayne Brooks :

@Aaron Smith Yeah, that’s total BS.  Seller financing only Defers the tax “until you start receiving principal”....the down payment and monthly principal payments AS you receive them.

The podcasts is about talking sellers into 0% seller financing......so I guess you need to convince them of some BS to agree to no interest (even though the IRS taxes you at a minimum interest rate anyway).

The concept taught by a certain guru makes sense. To talk a seller into 0% seller financing, you offer him a price significantly above his asking price. If he is weak at math, he does not realize that he would lose on such deal. His loss is your gain.

@Wayne Brooks

Right, they would have to pay imputed interest. 

What your saying makes sense about capital gains. Strange that the guy said there's no capital gains taxes on an installment sale. The only thing I can think of is that maybe that's the case with state capital gains tax, specifically. For example, in DC there is a state capital gains tax of 8.5%. I wonder if that is eliminated in an installment sale.

@Michael Plaks

Yes, I was assuming that the seller was renting it out beforehand, and it would be subject to capital gains. I was trying to figure out if there is indeed a tax benefit to selling as an installment, but there doesn't appear to be...with the exception that if the lump sum sale puts you in a higher tax bracket for capital gains, then spreading it out would help.

@Brandon Hall Chime in if you like.

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