Tax benefits of using seller financing

21 Replies

What are some of the benefits for the SELLER when using seller financing? I am in Minnesota and I'm trying to buy a rental property using contract for deed. I want to know all the benefits to the seller. How can the seller benefit from this on their taxes? How does it effect capital gains tax? How can they write off the payments or the interest? How can they lessen the tax burden of the sale by doing contract for deed?

@Tanner K. With seller financing the seller only picks up the gain as they collect principal. Any sales price for the personal property (things like appliances) is picked up as income in the year of the sale. Lets assume the following:

Sales Price $500k

Original Cost $300k

1250 Depreciation Taken $100k

Adjusted Basis $200k

There would be a $300k gain 60% profit

As principal is collected the payments are split between return of capital, capital gain and unrecaptured 1250 depreciation. Year 1 seller collects $100k in principal payments. The amounts reported would be $$60k long term capital gain with $20k being unrecaptured 1250 depreciation, and $40k return of basis. The seller would also report all of the interest income received for the payments.

Overall seller financing allows the seller to spread out the income to potentially take more advantage of lower rates since all of the income isn't included in one year, and they end up with more cash since they get interest payments as well

@Tanner K. There aren't really any tax benefits for the seller, there may actually be an adverse cost to the seller.

@Zachary Bohn is partially correct, the seller can defer the capital gain over several years under the installment sale method but IRC 453(i)(1)(A) requires that the depreciation recapture be reported in the year of the sale....

So in the example above the seller would have to report $100k of depreciation recapture in the first year.  Let's say payments received in the first year are only $20k, the seller still has to report $100k of recapture income in the first year...  Not a good situation.

Capital gains rates aren't expected to change so deferring income subject to capital gains doesn't really generate a tax savings.  Seller is likely better avoiding all risk and collecting in year one

@Tanner K.

I agree with @John Woodrich - depreciation recapture is reported in full in the year of sale. Using @Zachary Bohn 's example above, if your depreciation to be recaptured is $100k and, assuming you will pay 25% on that recaptured amount, you would be looking at a $25k federal tax bill as a result of depreciation recapture alone.

The remainder (capital gain) will be taxed as payments are received.

That said, I also disagree with @John Woodrich - although there may be disadvantages to structuring a sale this way for the seller (namely, cash flow issues if enough proceeds are not received to cover the depreciation recapture tax liability in Year 1), there are, in fact, advantages to the seller when selling on an installment basis.

Let's assume a seller sells a rental property and collects the full amount of the proceeds in Year 1. Seller would be liable for depreciation recapture and capital gains tax all in Year 1. If a seller collects installments instead, he or she has the ability to defer taxes on capital gains and collect interest income on the balance owed to him or her.

Additionally, complimenting strategies could be explored such as tax-gain harvesting if the seller is in a position to do so. If the seller is in the bottom two tax brackets (inclusive of the gain), there would be 0% federal tax on long-term capital gains. This may not be possible if 100% of the gain was recognized in Year 1.

@Nicholas Aiola The only tax advantage would be for a low-income taxpayer who could try to hit the 0% rate but I suspect most people who are in the bottom tax brackets are not those who would want to collect a check for 30 years.  I didn't mention this in my post as I deem it unlikely in more cases than not.  More likely situation is that someone enters this arrangement not knowing about recapture and gets a tax bomb they weren't expecting.

Ignoring the low-income taxpayer the taxes paid by the seller under the installment sale or by reporting in year one is expected to be the same. The recapture will hit at the same time and there aren't expectations of the capital gains rates getting any cheaper. No reason to factor interest income into this scenario as they could invest money elsewhere and have more investment options - say additional real estate.

There are exceptions to everything but in general most sellers will not benefit from an installment sale and those who do not understand the recapture consequences could be in trouble.  

@John Woodrich and @Nicholas Aiola your assesment is incorrect. If the seller elects the installment sale method, and the property has been depreciated under MACRS for the 27.5 or 39 year life then the total unrecaptured 1250 depreciation is allocated as principal payments are collected. The only 1250 recapture that is picked up in the year of the sale is if you used an accelerated depreciation method. If you carefully read through the instructions for Schedule D, Form 4797 and Form 6262 my method is correct. 

Zachary Bohn, CPA

@John Woodrich    

@Nicholas Aiola

Form 6252 instructions for Line 12(Ordinary income recapture) only includes depreciation from line 31 of Form 4797 which would be $0 in the case of MACRS real property. If you have a different analysis please let me know.

@Tanner K. There can be significant savings for a seller financing the deal, depending on the other remaining income items they have.  For someone who is always in the top tax brackets and that will continue going forward it may not be as advantageous. But with proper planning it can be a great tool to avoid paying for a large tax hit in one year

@Zachary Bohn we are in the weeds on this -  the poster is asking a general question.  We break out personal property on most all of our rentals and do cost seg studies on others.  My point about recapture is that it is something that could hurt a seller, not benefit them.  I think we can all agree on this.  

Outside of a low-income taxpayer who can hit the 0% rate I don't see any blanket example we can give the poster.  There are exceptions for everything but generally there isn't a tax advantage to the seller.  Sure, more tax due in the first year but we can't guarantee that they would be paying less under an installment sale.  We would need to know individual circumstances.

@John Woodrich you right it could potentially hurt the seller, but not often since most sales don't have an allocation for the personal property and that depreciation is about the only one that would get recaptured in the year of the sale. Your assessment that all 1250 depreciation(which is how I stated in my original post) would be recaptured in the first year is still incorrect. There is still a general tax advantage to the seller since this allows the income to be spread out, unless the seller would be in the highest brackets annually. 

@Zachary Bohn I didn't mention 1250 above and didn't notice you wrote it as 1250 in the post.  Most of our clients have broken out assets for purposes of bonus depreciation accelerated depreciation, etc.  As I said above, I mentioned this as it is an areas that could hurt the seller.

There is no tax advantage as unless the rates change.  They would pay tax at the same rate in year 1 as they would in year 15 unless they hit the 0% CG rate or unless the rates change.  And I don't hear anyone fighting to make the cap gains rate lower....

@Tanner K. - I wouldn't focus too much on the tax implications of it but more on the additional money they would be making. Instead of you paying a bank 5% you're paying the SELLER. That increases their total yield. Depending on the part of their life they are in they may want this passive income without the hassle of taking care of the property. I would try to understand what your seller is looking for, if possible, and try to come up with a solution that would work for all parties involved. 

I agree with @Armin Nazarinia , I would focus on other areas than tax in this deal.  You won't know his tax situation and by bringing it up it could hurt the deal.

I would focus on him getting a good rate of interest, no realtor fees associated with the sale (?), he can make money without having to manage the property, he would be receiving an annuity payment for XX amount of years, etc.  

Originally posted by @Zachary Bohn :

@John Woodrich  and @Nicholas Aiola your assesment is incorrect. If the seller elects the installment sale method, and the property has been depreciated under MACRS for the 27.5 or 39 year life then the total unrecaptured 1250 depreciation is allocated as principal payments are collected. The only 1250 recapture that is picked up in the year of the sale is if you used an accelerated depreciation method. If you carefully read through the instructions for Schedule D, Form 4797 and Form 6262 my method is correct. 

Zachary Bohn, CPA

I agree with Zachary with one change. When the gain from an installment sale of depreciable real property consists of both Unrecaptured Section 1250 gain (25%-rate gain) and adjusted net capital gain, the taxpayer recognizes 25%-rate gain as payments are received before recognizing any adjusted net capital gain. This “front-loaded” allocation method is consistent with IRC § 1(h)(3), which defines adjusted net capital gain as the residual category of capital gain not taxed at higher rates.

@Tanner K.

I think everyone was confused  here as we we are used to use depreciation recapture without separating it out. ( 1250 recapture vs Unrecaptured 1250)

The Unrecaptured 25%-rate Section 1250 gain is different from the IRC § 1250 recapture income discussed here, which is taxed as ordinary income. 

Basically, unrecaptured 25%-rate Section 1250 gain is the gain resulting from straight-line depreciation; Section 1250 recapture income is the gain resulting from depreciation deductions claimed in excess of straight-line depreciation.

Most likely, your seller will deal with Unrecaptured 1250 gain. 

And there is one huge tax benefit with installment sale. The installment sale will prevent the seller from extra 3.8% NIIT tax, if seller would be above the threshold if sold without installment sale. 

Originally posted by @Ashish Acharya :

And there is one huge tax benefit with installment sale. The installment sale will prevent the seller from extra 3.8% NIIT tax, if seller would be above the threshold if sold without installment sale. 

Once again we are calling something a "huge tax benefit" IF.....  If someone is active in RE they will not be paying NIIT in the first place...

So to summarize, a low income taxpayer may be able to hit the 0% cap gains rate and a high income person who isn't active in RE may avoid 3.8% tax.  Otherwise people in the middle are generally unaffected.  I will stick to my point of there generally being no tax benefit in selling on an installment sale.  

Focus on the other considerations in trying to put together this deal.  I would avoid the tax talk all together as this could lead the conversation against you a bit.

@Tanner K.

Wow. And how is one supposed to trust us accountants when we so wildly disagree?

ALL OF YOU are wrong, my friends. :)

The first question should be - are you buying from a homeowner or an investor? If you're buying from a homeowner who has lived there for at least 2 years - his capital gain is tax free up to $250k if single or $500k if married. In this case, there is no tax difference to him between a straight sale and an installment sale (owner financing).

Whether a homeowner or an investor, they will pay tax on the interest they receive. It's not a benefit, but the opposite: a small extra tax because, well, they will receive extra money as interest.

If it is an investor (or a howeowner not qualifying for the exclusion) - then owner financing spreads his capital gain tax over the life of the loan. The benefit is that he does not pay all his capital gain immediately - but it's the flip side of not receiving all his money upfront. Highly debatable what is better from an overall financial perspective, and the answer is different for different people in different financial situations: young families vs retirees, for example.

Is it better to spread the capital gain tax? Also totally depends on the overall financial situations. I'm disappointed that my colleagues resorted to generalizations here. If I'm in a high tax bracket, I may be able to reduce the overall tax by spreading it over multiple years, while simultaneously reducing taxation of other pieces of my tax return and/or avoiding extra taxes (like NIIT). If I'm in a low bracket, I may be able to keep my capital gain at zero by spreading it, while taking it all in one year can trigger tax.

But then what if I have just one year with low bracket (like between jobs or before marrying a high-income person)? What if I have suspended capital losses from the past years? What if I'm having a large capital loss this year from selling something else? What if I have a Net operating loss carryforward? What if I'm selling a rental property with a lot of suspended losses in the same year? I can think of many other scenarios where taking it all in one year could be beneficial.

Bottom line: it's all case by case. Trying to tell your seller it's beneficial for him (as well as telling him the opposite!) is wrong, without an individual analysis of his situation.

Part 2, technical, for my accountant buddies - on the great depreciation recapture debate.

We mixed together 3 kinds of depreciation recaptures, confusing everybody and ourselves in the process.

A. What we traditionally call "depreciation recapture" but what should be properly called "unrecaptured Sec 1250 gain." If we take a $300k property, allocate $30k to land and depreciate the remaining $270k over 27.5 years, we deduct $10k of depreciation per year. After 5 years, we have $50k of this depreciation. 

If sold under installment sale, it will become $50k unrecaptured Sec 1250 gain, which is taxed at the rate of up to 25%. It is NOT paid in the first year. It is spread over the life of the note, but it is taken first, before the regular capital gain from appreciating value. In other words, in early years you start paying 25%, and when it is all paid, then you start paying 15% on the remaining capital gain.

B. True depreciation recapture. It would happen if we somehow depreciated the real property faster than the standard 27.5 yr straight line method.  THIS is the kind that is supposed to be recaptured in the first year. However - it does not happen in real life, except the extremely rare cases of very old assets. We should not be talking about it, really.

C. Recapture of depreciation of assets segregated out of the real property: 15-yr land improvements like fences and concrete and 5-yr personal property like appliances and carpets. While, in theory, they can be subject to the 1st year recapture, it only matters if:

a. there really was asset segregation

b. the residual value of these assets exceeds their adjusted (post-depreciation) basis

This last condition is not that common, really, so the issue is not highly relevant for practical purposes. In reality, we usually allocate to these assets a small part of sales price, resulting in zero gain. 

Bottom line: there is no real problem with 1st year depreciation recapture.

@Michael Plaks The reason I was trying to generalize is because most areas of tax the answer is "it depends" and there are exceptions to most scenarios as you pointed out.  There is no way to give a definite answer so all we can do is make general statements.

My responses have been geared toward the intent in what the OP has been asking for - He is looking for ideas how to convince the seller to sell on CD and is wondering what tax advantages he can mention.  My response was that he should focus on other areas and that this could go against him bringing up taxes.

If one person showed up here and answered "it depends" the OP would have no help.  I think this discussion helped make it clear that this isn't a topic he wants to pitch.


Originally posted by @Michael Plaks :

C. Recapture of depreciation of assets segregated out of the real property: 15-yr land improvements like fences and concrete and 5-yr personal property like appliances and carpets. While, in theory, they can be subject to the 1st year recapture, it only matters if:

a. there really was asset segregation

b. the residual value of these assets exceeds their adjusted (post-depreciation) basis

This last condition is not that common, really, so the issue is not highly relevant for practical purposes. In reality, we usually allocate to these assets a small part of sales price, resulting in zero gain. 

Bottom line: there is no real problem with 1st year depreciation recapture.

I disagree with this part - this is a huge problem for people who have completed a cost seg study or for people who have completed a renovation and taken bonus depreciation.  

Originally posted by @John Woodrich :
Originally posted by @Ashish Acharya:

And there is one huge tax benefit with installment sale. The installment sale will prevent the seller from extra 3.8% NIIT tax, if seller would be above the threshold if sold without installment sale. 

Once again we are calling something a "huge tax benefit" IF.....  If someone is active in RE they will not be paying NIIT in the first place...

So to summarize, a low income taxpayer may be able to hit the 0% cap gains rate and a high income person who isn't active in RE may avoid 3.8% tax.  Otherwise people in the middle are generally unaffected.  I will stick to my point of there generally being no tax benefit in selling on an installment sale.  

Focus on the other considerations in trying to put together this deal.  I would avoid the tax talk all together as this could lead the conversation against you a bit.

John, appreciate your input. What do you mean by “active in RE”?

 As far as I know, the gain from sale of a rental property is included for the purpose of NIIT if the activity is passive to taxpayer. Rental is alway passive (unless treated as non passive with RE pro status) even if the activity raises to trade or business level.  

By “Active in RE you mean a RE pro, then yes, if seller meets other material participation rules, then yes seller wouldn’t be subject to NIIT.  

Thank you all for the input, I have re-read this thread a few times to grasp all your points but I fell I understand what your all saying. So, I wanna add some small details that I should have originally, it is a rental duplex, the seller is retirement age, trying to get out of the game and is in no rush to do so. Her husband is retired and they own 5 rental properties. seller is an active realtor and knowledgeable in real estate. I'm trying to fully understand both pros and cons of seller financing to make sure I'm not pitching what I think is a win-win, when in reality there's unknown risk similar to what @John Woodrich was saying about the unexpected tax from recapture income. I also want to make sure I'm aware of any benefits such as preventing the NIIT tax mentioned by @Ashish Acharya . If anyone has any other pros or cons related to seller financing, please mention them, tax related or not. Also, @Ashish Acharya can you explain what the NIIT tax is and how that works?

Thanks all for this thread. Although it got pretty technical tax-law-wise, I found it helpful to understand seller financing tax considerations, even if in the end the answer depends on the seller's unique situation. 

I'm in a similar situation as Tanner, however my 80+ yr old seller is also considering a 1031, so side-stepping the tax altogether. In this case, the consideration is can they move from their multifamily to a NNN and secure the work&worry-free cashflow they want as tax efficiently as possible.

As I understand it, for my seller this really comes down to what is the difference between income tax rate and depreciation recapture /capital gains tax rate, assuming the same 'cap rate' between the NNN and 'seller financed' options. Correct? or am I missing something?

Also, I think this is where it gets shakier for seller financing, because now you are comparing risk of me holding a property vs paying outright for something leased to a national chain like Carls Jr or whatever.  After hearing about seller financing multiple times on BP I was thinking it was a great option but it is so far not working out that way for me.