Seller Financing and Capital Gains. Are they not applied or just deferred?

Question

Trying to spell out the benefits of seller financing to a seller. Any suggestions are welcome.

Info: Seller owns the multifamily house outright and has owned it for 40 years. They will be facing a capital gains payment of around $110,000 (Ouch!).

Questions:

1. If i give them a down payment and they finance the sale over 20 years, are the capital gains deferred or is it taxed at the income tax rate?

2. If capital gains are deferred does that mean they pay each year?

3. Do they pay on the interest and the principal, or only one of them?

Thank you for any info.

Chris Seveney · Answer

@William Coet

I would be very careful providing sellers tax advice as you don’t know their situation.

At a very high level a property has a “tax basis”, once you exceed that basis you are subject to taxes, whether that happens when sold and paid in full or paid over time

The loan provided by seller financing is like any type of loan where the interest is taxed at ordinary income rates.

Sean Ross · Answer

@William Coet, there is a lot going on with this potential scenario and I want to second the other advice being given here -- tread very lightly with specific tax advice for specific transactions, especially with seller financing.

At a general level, capital gains taxes are recognized when the income from sale is received -- so a seller pays a pro rata share of capital gains on the purchase price as payments on the note are made. However, they are also likely recognizing interest income (ordinary income tax rate) with each payment received, and most importantly they will recognize 100% of their recaptured depreciation in the year of sale. Recapture depreciation does not prorate over time across an installment note.

Your seller should work with a competent CPA to thoroughly think through any potential sale with a carryback note.

Zane Cress · Answer

Not being a tax professional the way I understand it is that the capital gains are broken down as a gain each year based on whatever the payments were. So if your payments total $20k to them for the year that would be their gain for the year and it keeps them at a much lower tax bracket instead of having a massive gain all at once. There are minimums on the interest rate they can charge you as well so you probably can't structure a 1% rate. Need to speak to your trusted real estate attorney and your tax professional. Have the seller speak to them as well to get the info direct or draft them a letter/info packet on the benefits. Use actual numbers to show them how the savings and deferment work.

Seller Financing and Capital Gains. Are they not applied or just deferred?

Seller Financing and Capital Gains. Are they not applied or just deferred?

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