Seller financing and capital gain taxes

Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes

Hey BP community!

I've been wondering a bit more about seller financing as of recently (thanks to Pace Morby's ep).

My question is if a person owns a property (rental) and they seller finance instead of selling the property and paying a huge chunk of capital gains, does the fact that they seller finance the deal would that mean they don't pay capital gain taxes?

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Wayne Brooks

Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes

Originally posted by @Alex Duarte:

Originally posted by @Wayne Brooks:

@Alex Duarte Over time, the life of your seller financed loan....the seller will have the Exact Same amount of taxable capital gain and depreciation recapture. Spreading it over multiple years May reduce his actual taxes, or it may not, depending on his other income.

I see what you're saying and that makes sense. Do you know if they have to pay taxes on the total mortgage payment (income for seller) or just the interest rate that is charged for the year?

They have to pay capital gains tax, and depreciation recapture, on the appropriate portions of all principal received....interest is taxed as interest income.

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Caroline Gerardo
Lender · Washington DC · Member since 2015 · 2k+ posts · 2k+ votes
4y
Depends on the state. The interest payments over time are taxable but spreads out the gain over time for IRS taxes
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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y
@Caroline Gerardo I'm located in Orange County, CA. I'm trying to see what would be the best way to structure this deal. Owner doesn't want to sell because they will pay nearly $100k in capital gain taxes so I'm trying to get creative here. Thanks for your input!
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Joe HomsBusiness Member
Flipper · Mission Viejo, CA · Member since 2014 · 2k+ posts · 1k+ votes
4y
@Alex Duarte your question can best be answered by a CPA, but have they considered a 1031 tax deferred exchange? If they sell on an installment basis, then they are only taxed on the money that they receive that year is my understanding.
Good Investing...
[email protected]949-625-4533
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Caroline Gerardo
Lender · Washington DC · Member since 2015 · 2k+ posts · 2k+ votes
4y
Owner occupied one person on title they have $250000 deduction, married $500000 this is IRS deduction. So say their gain is $350000 and it is one person that leaves $100000 or less gain after all things are subtracted (commission, improvements...) But if they are 30% tax bracket the IRS tax would be $30000 So we are dealing with a gain of perhaps $280000 - 300000 after the deductions, 6% commission, expenses improvements. It's difficult for you to play the role of their CPA to get the right number unless you are family.
Original basis: $400000 selling house for $1,400,000 - commission -84000 - title escrow -5000 - $500000 deduction for married couple = gain of 411000 30% tax on that is about $123,300. So say they carry a note with you for $411000 and charge you 8% second TD over 15 years $3928 monthly payment they will pay income tax on $47136 next year at 30% = $14140
But here is the problem ~ can you qualify for a new first plus that payment on the second?
You need to know how large their mortgage is, as that has to be settled with cash not a note
They need to have confidence in you that they won't have to pay the cost of foreclosing and they will need to put in the note a prepayment penalty if you sell or refinance in the first five years so they can plan.
They won't net as much cash as they may want to pay cash for their next upleg house.
They will need to pa someone to service the loan
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Wayne Brooks
Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
4y
@Alex Duarte Over time, the life of your seller financed loan....the seller will have the Exact Same amount of taxable capital gain and depreciation recapture. Spreading it over multiple years May reduce his actual taxes, or it may not, depending on his other income.
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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y
Originally posted by @Joe Homs:
@Alex Duarte your question can best be answered by a CPA, but have they considered a 1031 tax deferred exchange? If they sell on an installment basis, then they are only taxed on the money that they receive that year is my understanding.
Good Investing...

They did speak to their CPA and they ran the numbers on what they would pay in capital gain taxes if they cashed out. They have no desire in continuing to landlord unfortunately so the only way they would consider unloading this property is if it made sense for them. Thank you for your input.

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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y
Originally posted by @Caroline Gerardo:
Owner occupied one person on title they have $250000 deduction, married $500000 this is IRS deduction. So say their gain is $350000 and it is one person that leaves $100000 or less gain after all things are subtracted (commission, improvements...) But if they are 30% tax bracket the IRS tax would be $30000 So we are dealing with a gain of perhaps $280000 - 300000 after the deductions, 6% commission, expenses improvements. It's difficult for you to play the role of their CPA to get the right number unless you are family.
Original basis: $400000 selling house for $1,400,000 - commission -84000 - title escrow -5000 - $500000 deduction for married couple = gain of 411000 30% tax on that is about $123,300. So say they carry a note with you for $411000 and charge you 8% second TD over 15 years $3928 monthly payment they will pay income tax on $47136 next year at 30% = $14140
But here is the problem ~ can you qualify for a new first plus that payment on the second?
You need to know how large their mortgage is, as that has to be settled with cash not a note
They need to have confidence in you that they won't have to pay the cost of foreclosing and they will need to put in the note a prepayment penalty if you sell or refinance in the first five years so they can plan.
They won't net as much cash as they may want to pay cash for their next upleg house.
They will need to pa someone to service the loan

Very great information. I forgot to mention in my original post that this is a rental property and not a primary so they don't have home owners exemption, unfortunately. The main objective for them would be to cash out their rental and just have the cash liquid. No desire in 1031 exchanging.
Do you have any alternative solutions to something like this?

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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y
Originally posted by @Wayne Brooks:
@Alex Duarte Over time, the life of your seller financed loan....the seller will have the Exact Same amount of taxable capital gain and depreciation recapture. Spreading it over multiple years May reduce his actual taxes, or it may not, depending on his other income.

I see what you're saying and that makes sense. Do you know if they have to pay taxes on the total mortgage payment (income for seller) or just the interest rate that is charged for the year?
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Account Closed
Real Estate Agent · Brentwood, CA · Member since 2021 · 34 posts · 21 votes
4y
@Alex Duarte have they ever considered a 1031 exchange?
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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y

They want out of investing entirely. They would like to have the cash liquid.

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Wayne Brooks
Real Estate Professional · West Palm Beach, FL · Member since 2012 · 23k+ posts · 13k+ votes
4y
Originally posted by @Alex Duarte:
Originally posted by @Wayne Brooks:
@Alex Duarte Over time, the life of your seller financed loan....the seller will have the Exact Same amount of taxable capital gain and depreciation recapture. Spreading it over multiple years May reduce his actual taxes, or it may not, depending on his other income.

I see what you're saying and that makes sense. Do you know if they have to pay taxes on the total mortgage payment (income for seller) or just the interest rate that is charged for the year?

They have to pay capital gains tax, and depreciation recapture, on the appropriate portions of all principal received....interest is taxed as interest income.

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Basit SiddiqiBusiness Member
Accountant · New York, NY · Member since 2015 · 8k+ posts · 3k+ votes
4y
@Alex Duarte

When you do seller financing, the property is being sold.

The seller would then be required to report capital gains tax and interest income on an annual basis.
[email protected]917-280-8544
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Alex Duarte
OP
Real Estate Agent · Orange, CA · Member since 2014 · 50 posts · 12 votes
4y
@Basit Siddiqi That makes sense! So the only huge benefit for them to seller finance is to avoid paying the huge tax bill all at once then vs paying it throughout the agreed upon terms?
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Khari F.
Kissimmee, FL · Member since 2018 · 150 posts · 27 votes
4y
Summary:
When you do seller financing, the property is still being sold so seller is required to report capital gains tax and interest income on an annual basis on the appropriate portions of all principal received. the seller will have the Exact Same amount of taxable capital gain and depreciation recapture as they would selling it to cash buyer, theyre just spreading it over multiple years.
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