Tax Implications of Seller Financing
If you've never heard of “seller financing” (AKA “owner financing”) in relation to real estate, the good news is it's an easy concept to understand. The better news is that it could be a tax-advantaged strategy when selling your home.
What Is Seller Financing?
Seller financing in real estate is, quite literally, when the seller of a property finances the transaction. The buyer furnishes a down payment and borrows the rest from the seller; the seller essentially acts as the bank and holds a note.
See? I told you it was easy!
But I know what you may be thinking…
Who on Earth Would Agree to That?
Those who are selling their primary residences with little to no debt on the property and capital gains in excess of the Section 121 exclusion (if applicable) are prime examples of who should consider seller-financed transactions.
There are multiple reasons that make owner financing an attractive option for sellers.
The repayment period of a seller-financed note can be any length of time; it's completely up to the buyer and seller. If it's spread over more than one tax year, it's considered an installment sale for tax purposes. An installment sale is when the proceeds and the gain from the sale are received and recognized, respectively, over time (in installments).
The installment sale treatment affects only the seller; on the buyer's end, it's treated the same way as if the property was financed with a traditional mortgage.
We'll dive deeper into installment sales in a minute – don't touch that dial.
Another benefit of seller financing is that the owner, as a result of holding the note, earns interest from the buyer, just like a bank would. In addition to a sale, it's an investment secured by the property that allows you to earn a steady return for an extended period of time.
Similar to the term of the note, the interest rate is agreed upon between the buyer and seller.
Tax Treatment of Installment Sales
An installment sale is taxed differently than a regular sale; each installment is taxed in the year received, making it favorable for sellers who want to spread out their tax liability over a number of years instead of pay 100% of the tax in the year of sale.
If you're anticipating a large capital gain, reporting the entire amount in the year of sale could bump you into a higher tax bracket, whereas reporting the gain in installments will allow you recognize smaller portions of the gain from year to year.
Here are the steps to calculate the taxable income on each installment received:
1. Calculate the total capital gain (total net proceeds less basis less Section 121 exclusion, if applicable).
2. Calculate the gross profit percentage (capital gain from Step 1 divided by total net proceeds).
3. Apply the gross profit percentage calculated in Step 2 to all future installment payments received during the given year to determine your taxable capital gain for the year.
For those who don’t know, long-term (more than one year) capital gains are taxed at lower rates than short-term (less than a year) capital gains. The holding period of the gain is determined based on the year of sale. For example, if you sell a property on an installment basis within a year of purchasing it, the gain is a short-term gain (taxed at ordinary rates). This holds true even if the future installment payments are received after a year.
It's Not Always the Right Move
Seller financing is not as attractive for investors and absentee owners because depreciation recapture cannot be reported in installments. In other words, the entire amount of depreciation to be recaptured must be taxed in the year of sale, even if the rest of the capital gain is being spread out over a period of time.
It often doesn't make sense for sellers with sizable existing debt on the property to agree to seller financing. It can be difficult to structure the deal if the seller is not in a position to satisfy his or her mortgage loan upon the sale and, oftentimes, this can't be done without a substantial portion of the proceeds from the sale.
Additionally, you will not receive a benefit from financing the sale and holding a note from the buyer if you're able to exclude 100% of your capital gain by using the Section 121 exclusion.
Not Everyone Can Do It
Hopefully, by now, you've seen how beneficial an installment sale can be to the right seller.
Unfortunately, not everyone has the option. If one of the below situations applies to you, I apologize for leading you on.
- Dealers – those who actively flip houses cannot sell a flip on an installment basis.
- $5 million limitation – interest will be charged on the deferred taxes if the total installment sale obligations that occurred during (and were outstanding as of the end of) the year exceeds $5 million dollars. Therefore, the benefit of deferring taxes via the installment sale method, in this case, is lessened.
- Related party limitations – selling your property to a related party can preclude you from utilizing an installment sale.
In any event, if you’re thinking of selling your property, make sure to discuss the opportunity of seller financing with your CPA. It never hurts to discuss the possibility of saving some tax dollars, right?