Owner Financing Note Death Inheritance Tax Question

[Mario Jay]

Hi everyone!

I ran into a situation that I could not seem to find the answer to. Essentially, I want to buy a multi family building from a friend who has owned the property for many years. He is in his late eighties, purchased the property for about 30k and wants 300k for it. He wants to lease it to me until his death to avoid the tax. I want to buy it so I can start paying it off.

He approached me offering to lease me the property until the date of his death at which point his kids would inherit the property, get a step up in basis, and sell it to me. (The selling price and time frame are established today). I saw the property, like it, and it is a great deal. He does not want to sell it because he does not want to pay capital gains tax on the 300k.

I do not want to possibly lease the building for the next 10-20 years and only start paying it off then, so I came up with an idea. What if he sells me the property and is the financer of it? I will pay him monthly interest (300k @ 5% = 1,500/month) (about $1,100interest / $400 principle). Of course he will pay tax on interest at ordinary tax rates but this is "free" money to him anyhow. He is still taxed on his capital gains as well but only gets a small portion of them every year as the note is paid off. (He pays taxes but receives much more income overall)

My question is, upon his death when we will call the note due (I will need a traditional loan on the property) how would this cash paid to his heirs/estate be taxed? Would it be covered under his estate gift tax allowance? Or would his kids then be forced to pay all capital gains as they receive a lump sum payment from me? I can't seem to get to the bottom of this myself.