Principal payment only loans - legal?

[Ryan DeLange]

Hi, I've heard some gurus, Matt Terio to be specific, talk about a three option letter of intent.  The final option is a principal only loan, where you divide up the payments over 20 years and simply pay off the house that way - with no interest.  

A simple example, would be - lets say I agreed to buy a house for 30,000 dollars with a 20% down payment and a 20 year principal only loan for the rest (24,000).  I would divide the 24,000 into monthly payments (24,000/20 years/12 months = $100 per month.  You could do a balloon payment after a specified time. 

Somebody told me that this type of loan is illegal.  Can someone help put me straight, because I'd love to make an offer like this. 

Thanks

[Stephen Chittenden]

I do not believe it would be illegal, but the IRS might object to the characterization of the loan as principal-only payments. They might insist that the sales price was less than the price agreed and that interest was built into the purchase price. If the sale price was well-documented as being FMV, it would seem like a difficult case for them. I could see why the IRS would object in some cases though. For example, imagine a owner-occupant selling a home with significant appreciation and owner financing. If the house was purchased for $500k and was now worth $900k. A married joint owner-occupant might want to characterize the sale as a sale for $1m financed at 0% interest. All of the gain would be excludible. In contrast, if the sale was $900k with X% interest such that the payments were the same, the portion of each payment that represents interest would be includible in income. A CPA might have more thoughts.