Seller Finance Question: P&I Vs Principle Reduction Payments

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Seller Finance Question: P&I Vs Principle Reduction Payments

Hadar OrkibiPro Member
Rental Property Investor · USA / NZ · Member since 2016 · 1k+ posts · 812 votes

** Seller Finance Question** HI Guys, Im working on possible deal and the seller is willing to finance 85% of the price. His reason is that he doesn't want to pay income Tax or depreciation recovery. (Sold a business and have high income this year) We agreed on: 5% P&I, 10Y Balloon, and 25y Amort.

My Questions is: What if I suggest to him that we do SAME Amount of PAYMENTS BUT principle reduction payments and Not have interest component. this way i pay the property off faster. Would that way have any "worse" Tax implications on him?  Thanks In advance for your help!
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Ashish AcharyaBusiness Member
CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
8y

@Hadar Orkibi , 

Got it. I have seen people do Zero percent interest loan. It is not illegal. It's just that the seller's side has to compute interest component with they do taxes. 

When selling straight out seller pays-

-capital gain tax 

-depreciation recapture tax at max 25%

-net investment income tax at 3.8 percent if his MAGI greater than 200k. Next year, when his income is lower, the installment sale ( seller's financing) could possibly avoid this tax for him. Most people also do sellers financing to avoid this tax.

With Installment sale, seller pays same taxes but in smaller chunks each year with total yearly payment. Not to get too technical, but the depreciation recapture is front-loaded before seller will pay capital gain tax rate.  Meaning all the depreciation have to be recaptured (possibly at 25%) first he can recognize lower capital gain. If his MAGI is less than 200k each year after this year, he will avoid 3.8% NIIT tax mentioned above. 

Let me know if that helps.  

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  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Hadar Orkibi , 

    Are you asking what happens if you deviate from original agreed upon 5% interest payment and do a seller financing with no interest component?

    If your transaction fails to provide for interest at a minimum rate specified by the Code or by IRS, then the part of the payments received by the seller is treated as interest (“unstated interest”) that's taxable to the seller despite any contrary intention your and the seller. 

    If there is no interest, IRS wants you to calculate what called imputed interest. So from the tax side, there will be an interest component. 

    Is that what you were asking? 

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  • Nicholas Scatton
    Lansdale, PA · Member since 2017 · 174 posts · 77 votes
    8y
    why would he finance at 0%
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  • Carl FischerPro Member
    Rental Property Investor · Ambler, PA · Member since 2015 · 2k+ posts · 1k+ votes
    8y

    @Nicholas Scatton

    People finance at the imputed rate (usually very low) and raise the sale price to have capital gains tax vs interest income tax. 

    [email protected]215-283-2868
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  • Hadar OrkibiPro Member
    OP
    Rental Property Investor · USA / NZ · Member since 2016 · 1k+ posts · 812 votes
    8y

    @Ashish Acharya, thanks for the answer. the deal is still drafted so no diversion from an agreement. But in affect yes, if there in NO interest charge and only principle repayment over a set period of time, I understand that anyway the Imputed interest should be applied. 

    @Ashish Acharya What is the different (from income Tax point of view) between straight out sell when Capital gain and depreciation recovery is due. And a sale by principle installments like what im describing above?

    @Nicholas Scatton, because he wants to sell and doesn't want the hassle of owning.  

    2Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Hadar Orkibi , 

    Got it. I have seen people do Zero percent interest loan. It is not illegal. It's just that the seller's side has to compute interest component with they do taxes. 

    When selling straight out seller pays-

    -capital gain tax 

    -depreciation recapture tax at max 25%

    -net investment income tax at 3.8 percent if his MAGI greater than 200k. Next year, when his income is lower, the installment sale ( seller's financing) could possibly avoid this tax for him. Most people also do sellers financing to avoid this tax.

    With Installment sale, seller pays same taxes but in smaller chunks each year with total yearly payment. Not to get too technical, but the depreciation recapture is front-loaded before seller will pay capital gain tax rate.  Meaning all the depreciation have to be recaptured (possibly at 25%) first he can recognize lower capital gain. If his MAGI is less than 200k each year after this year, he will avoid 3.8% NIIT tax mentioned above. 

    Let me know if that helps.  

    [email protected]941-914-7779
    INVESTOR FRIENDLY CPA®5240 Reviews
    WebsiteView Page
    TaxMD® | Tax Planning Software
    WebsiteView Page
    2Reply
  • Daniel DietzPro Member
    Rental Property Investor · Reedsburg, WI · Member since 2011 · 1k+ posts · 857 votes
    8y

    @Ashish Acharya, first, thanks for all the time you take to share you knowledge and help us understand things. 

    As for the Recapture Tax, I recently learned in another thread that is is "up to" 25%. I had previously thought it was "always" 25% before (I have not sold any properties yet, but want to fully understand it for when I do start selling some off :-) )

    I am trying to understand what "order" they are applied in. For example, I (as a dingle filer) have 30K of ordinary income and pay tax @ 12% on 18K of AGI income after standard deduction. 

    Now I sell a property and have say 40K of depreciation to recapture. I assume that bumps me up to 58K of 'ordinary income' and the 22% bracket since it counts as "income" and not capital gain? 

    On that same property I also have say 10K of capital gains. Is the capital gains taxed at 0% based of of my normal ordinary income being in the 0% bracket, or is it 'bump up' to 15% since my ordinary income + recapture tax are all tax at the same rate and is now 58K? 

    Hope that makes sense!

    Thanks, Dan Dietz

    [email protected]608-524-4899
    1Reply
  • Ashish AcharyaBusiness Member
    CPA, CFP®, PFS · FL · Member since 2017 · 5k+ posts · 3k+ votes
    8y

    @Daniel Dietz , No problem, I am just returning the value I derive from the BP. 

    Yes, the rate is taxed as ordinary rate up to a max of 25%. So If your marginal rate is lower than that, it is taxed at a lower marginal rate, and if your marginal rate is greater than 25 %, the recapture is taxed at max 25%. Remember, we are not just looking at gain from the sale of the property to determine the marginal rate. The rate is determined as your whole income level, not just from the sale of the property. 

    To answer your question, both the long-term capital gain and/or depreciation recapture will bump your tax bracket. Thus the capital gain or recapture might be taxed at two different rates based on the gain or recapture bumps you up a bracket. 

    So out of 40k recapture, part of it taxed at 12%  and part is taxed at 22%.

    Depreciation recapture comes first as it is ordinary income before capital gain.

    Does that make sense?  

    [email protected]941-914-7779
    INVESTOR FRIENDLY CPA®5240 Reviews
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    1Reply
  • Hadar OrkibiPro Member
    OP
    Rental Property Investor · USA / NZ · Member since 2016 · 1k+ posts · 812 votes
    8y

    Thanks for your contribution @Ashish Acharya

    1Reply
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