Does Captial Gains Tax prevent sellers from wanting to use seller financing?

Question

Thank you to everyone who takes the time to read these posts and share their experience.

My question is what would motivate a seller to use seller financing to sell their primary residence using seller financing when it would generally forfeit their exemption from paying capital gains tax? Why especially would a seller agree to a balloon payment after just 5 years since that would give them almost no time to spread out that tax over time?

The reason I ask is that I am interested in using seller financing as a buyer to purchase property and I want to be up front with the seller about the capital gains tax they would owe, but I don't see how I could make the deal look favorable to them.

Bill Gulley · Answer

The gain is computed as to the % of the payments received. As Will mentioned it is an advantage as the liability is spread over time unlike being due at the sale or closing and paid for that tax year. You don't avoid paying the gain on the sale over the basis.

I agree with Steve as to giving advice, you really shouldn't go there at all, especially since it appears you have little tax knowledge, no offense, but there is no exemption. Using the wrong words can get you in trouble. So, it's better to say, ask your tax adviser. I also suggest you see an attorney on your deal. :)

Will Barnard · Answer

Just another great example of the power of BP Nation!

David Beard · Answer

Yes, your question makes sense in the context of a lease option, and is a good one.  However, lease options are typically just for 1 to 3 years, so you can lease the home for up to three years and still pass the 2-out-of-5-years test for using the cap gains exclusion.  Beyond three years, however, and you will lose the exclusion.

Steven Hamilton II · Answer

@Matthew Pipkin ,

The sale is the initial losing date. The financing portion is completely separate.

Think of it as two parts.

1. Seller sold the house for $X number of dollars.

2. Seller offers mortgage to buyer.  The seller is essentially like the outside bank that you would use.

The sale occurs at the time the contract is signed.  That is when the deed is recorded and they are the new owner of record.

So you can see that they are not giving up the exclusion as it was allowed at the time of closing.

Will Barnard · Answer

Matthew, the seller does not lose the tax advantage when carrying a note long term, the sale is computed on the date of sale, thus the entire tax exemption is saved, the tax implications are spread over the years the payments are collected thus the seller gets to hold the tax advantage and a secondary one by spreading their liability over the years of the note!

Wayne Brooks · Answer

Matthew, if the owner is "selling" with owner financing, the "sale" occurs at the closing, not when the loan is finally paid off.  If the owner were doing a lease option, that would be different.

Will Barnard · Answer

To answer the thread named question, the answer is no. On the contrary, it benefits the seller to spread the gain over time as opposed to all in one tax year. That is a benefit, not a hindrance.

Steven Hamilton II · Answer

@Matthew Pipkin ,

Be careful as they could potentially hold you liable if you gave them incorrect information. Seller financing is an excellent way to adjust capital gains.  The seller financing does not negate the Section 121 Exclusion (aka the "home sale exclusion").  They are still eligible for it.

It is possible the seller will be in a different situation at that point in time.

@Wayne Brooks  is correct in that interest is taxed at ordinary rates.  The gain is taxed at capital gain rates in this case that gain is excluded.

-Steven

Shaun Reilly · Answer

Interesting thread.

The concept of why the owner occupied tax status is not lost makes perfect sense as explained here.

However it makes me wonder about the opposite situation where it is a non owner occupied home.

I've read many times that if the seller carries the note that one of the advantages is they get to spread the gains over time.  How does that happen if we assume that the gain would also be tagged at the date of the sale?  Wouldn't there be a "paper" gain that they just lend back out?  Why would it be any different than getting cashed out then making the same mortgage on an unrelated property to someone else (Which I can't imagine would be a scenario with any special tax benefits)?  It SEEMS like they would be on the hook to pay the gain on their taxes that year without actually reciving the cash to do it, which is clearly the worst of situations.

I assume I am missing something and am looking to be educated.  :)

Matthew Pipkin · Answer

Thanks, David. I'll keep that in mind if I decide to pursue the lease option route. I appreciate the feedback.

Does Captial Gains Tax prevent sellers from wanting to use seller financing?

Most Popular Reply