Tax Considerations of Owner Financing
At one level taxes on seller financed transaction are fairly simple. The payments are split into the interest portion and the principal portion; presumably someone did an amortization table as part of the closing so everyone knows what amounts to report. If this is a sale of a personal residence the seller should have no taxes to pay on the capital portion of the payment. The interest portion will be taxable as income on Schedule B, which already has a place for seller financed mortgages. The buyers will be able to deduct the interest paid from their taxes.
However, the above assumes the contract is paying as scheduled and payments are credited as arriving at the same time each month. Sometimes sellers try to maximize their income by requiring the exact interest to be calculated for the day on which the payment was received. They don’t want the buyer to “beat” them out of some income by paying late, but before the late payment penalty date. They stop this by calculating the exact daily interest amount do.
There is a reason conventional mortgages are always due on the first; it makes the calculations easy and predictable. If interest is calculated for exact days there is no way to know what the amount of interest paid is until after the payment is received. If a payment check bounces the interest will be recalculated. I suspect the extra hassle and confusion ends up costing a lot more than any extra income.
Taxes get exceptionally complex if the contract is sold at a discount to a third party. When that happens the original seller is out of the loop. He reports whatever he was paid for the contract as a capital gain (probably tax free since it was his home) and that’s the end of it. The buyer keeps making payments as normal and deducting the interest.
The third party buyer will have to split the payments received into three segments. One segment is the return of capital; no taxes due on this. A second segment is the interest. This is clearly interest income to the contract buyer and is reported as such. The third segment is the profit from the discount. If the contract buyer bought the mortgage for seventy-five cents per dollar then twenty-five cents of every dollar of capital paid by the buyer is profit. Depending on holding period this would be long or short term capital gain to the contract buyer.
Taxing authorities tend to have a somewhat naive/simplistic view of mortgages and think the amounts and terms written in the contract mean something. As you might imagine, contract buyers have developed techniques and strategies to minimize and/or postpone the taxes due. If you lust for more detail about how corporations, LLC’s, Trusts and other techniques are used to accomplish this visit Invest in Debt and affiliated sites to learn more. It can be a fascinating and profitable game.
{ 10 comments… read them below or add one }
Is seller financing an option when the property is part of an estate? Can the seller pay the estate and then the executor send out payments to the recipients and or bill collectors?
Not being a lawyer I can’t speak to the legal implications. However, if there are multiple heirs, I can’t imagine a situation more likely to create a family fight. Someone is certain to need their cash immediately and/or do something dumb financially, go bankrupt, etc.
My thought would be to get it out of the estate as quickly as possible and, if appropriate, move it into a family limited partnership or some other entity better structured for dealing with ongoing issues and do any financing from there.
When I last attempted to sell my rental house (several years ago) with owner financing, I was told that there is a legal minimum interest that I can charge. Where can I find this percentage?
You might check this link
http://www.irs.gov/pub/irs-drop/rr-09-35.pdf
Am I correct that there is no tax on what would otherwise be a capital gain if I carry a note for the full purchase price? How do I report the sale on my income tax — just as a mortgage?
If only that were true!
When you sell with owner financing you have the choice of recognizing the gain and paying all the taxes in the year of the sale, or electing to do an installment sale.
If you do an installment sale you pay taxes on the income as you receive it. You will need an amortization table that shows the interest portion of each payment. That is taxed as interest income. The principle payment is divided into two parts; return of capital and capital gain. You pay taxes on the capital gain as it is received.
For example, lets say you sold a house for $100,000 of which your profit is $20,000. (Remember that profit is the sale price less your basis, not what you still owe. Loan over basis may be another separate ugly issue in that case.) Lets also say that the monthly payment is $1,000 of which $700 is interest (keep in mind this changes each month so you need your amortization table to get the correct amounts.)
Under the installment method you report the $700 as mortgage interest income. Your profit was $20,000/100,000 or twenty percent. So 20% or $60 of the $300 applied to principle was profit and should be reported as a capital gain. The other $240 was a return of principle, and therefore not taxable.
If you have a large profit an installment sale spreads the income over a long time period. If you have, or can create, other capital losses (Stock losses for example) you may be able to net the gains and losses and benefit from not taking the installment sale. As you can see, there are lots of choices. The correct ones depend of how well you can predict your future.
Help! We sold our home for the same price we paid (no gain) and are financing the buyers mortgage for 3 years. We only get $100 more per month than the amount on our own mortgage for the home (FHA so don’t have to pay the balance upon sale). Can we take any deductions similar to what a landlord would take such as depreciation or do we really have to claim the entire amount of interest as income with nothing to offset the tax liability? If the latter is the case, why on earth didn’t my lawyer tell me I was going to be paying them to live in my home?
You can’t deduct repairs or depreciation like a landlord would. You can deduct your own interest expenses. For example lets say the interest and principle you pay on the existing loan is $1,000 and that $200 of that is principle and $800 is interest. The buyer pays you $1,100 and of that $900 is interest. You would subtract $900-800 and pay taxes on $100 per month of net interest income.
I have an offer for a seller financed option to sell my home at a $1,000 loss. The selling price of the home would be $155,000. The buyer is offering a $20,000 downpayment and a 3 year finance option on the remaining $135,000. With this difference, my loan will be greater than what I am being paid monthly by the buyer. My three questions are do I have to pay taxes on the $20,000 down payment? Would I have to pay taxes on the monthly interest I receive from the buyer even though it is less than what I am paying out? Lastly, can I write off my interest rates on my personal taxes?
Good questions. Unfortunately they go well past my knowledge of tax law and accounting. That said, since you are selling at a loss the $20,000 is a return of capital, not a profit, so I don’t believe it will be taxed. I think there must be a way to offset the interest income you receive from the buyer with the interest you pay to your lender. That would produce a loss for you.
Losses on the sale of personal residences are not deductible. I don’t know if that means on the capital gains portion only, or if it would include your extra interest expense. Good CPA questions