Tax Implications for Seller in Seller-Financed Deal?

Question

What are the tax implications for the seller in an owner-financed deal?

I've identified an off-market property that I'd try to get seller financing on. They've held the property for a couple decades, and would likely have a significant capital gains tax liability if they were to sell it on the open market.

If they write a seller financed note, would they still need to pay that capital gains tax?

My thinking: seller financing represents a debt owed to the seller. Therefore, it's an installment sale. I am thinking that they wouldn't have to pay cap gains tax on the "sale" because they'd be earning interest income on the loan payments. There would be a separation between principal return and interest payments.

Similar thinking of how taxes would work at a traditional bank: they pay tax on only the interest earned, not on the principal repaid.

Can someone check my thinking/understanding of seller-financed tax implications?

Thanks in advance!

Michael Plaks · Answer

@Joshua Aycock The first question is whether they're selling their personal residence. If so, they receive $500k tax-free capital gain after living there for 2 years. So they may have no tax benefits from owner-financing in this case. If it's their investment property, then part of each principal payment is a tax-free return of principal, the other part is taxable. How it is taxable is quite complicated. Usually, but not always, owner-financing can reduce the seller's capital gain taxes. It can even backfire on them in some cases. Interest is always taxable, no matter what else is in play. Whatever their situation is, you should never give tax advice to the sellers and thus accept liability for such an advice. Tell them to consult their own accountant about their tax implications. You can just mention that it might be possible to reduce their taxes with owner-financing.Also, read this older thread: https://www.biggerpockets.com/...

Ashish Acharya · Answer

Seller financing has no negative tax consequences unless he has capital losses. And there is not much other than capital gain deferrals and NIIT tax avoidance for seller. - There will be capital gain but it can be lowered. Sellers can spread out capital gain so that they can lower the capital gain tax bracket from 23.8% to 15 or 0% depending on what are the payment terms. - If the seller has other capital gain transactions, then the interest-only transaction will help him not jump the capital gain tax bracket and also save 3.8% NIIT Tax.Taxes are paid on interest income and capital gain on the payments received that year.

Jeff Schemmel · Answer

@John Woodrich is a local, very qualified, CPA who may have time to give you guidance here.

John Woodrich · Answer

In general - the seller won't pay tax until they receive the cash. So they may defer income but they won't have the cash so that is somewhat expected. For most people paying tax now or later is somewhat neutral - sure you may be able to avoid 3.8% tax if there is a large gain but the risk of holding a note and losing liquidity is likely a bigger factor. I wouldn't try to pitch a seller on a CD for tax reasons. You can't advise them on tax and don't know what they have going on so a suspect is unlikely to believe you anyhow. Plus - interest rates are losing to inflation right now so locking in on a long-term contract may not be ideal for a seller unless they are in retirement mode and just looking for an annuity. I have 2 properties we bought on CD and both related to retirement income of the seller.

Steve Vaughan · Answer

I recently sold 3 smaller commercial apt building with SF for the benefit of stretching everything out per my 'profit %'. My last one sold yesterday for nothing down except closing costs because it was my 2nd of the year. I'm that tax conscious. The key for me selling this way aside from tax spreading was the method of conveyance. We have a hybrid contract for deed in my state. It goes into their name when they buy, but if they default, I have ease and control to get it back. This is a risk your seller will certainly be considering. As a buyer, you want a note and deed of trust / mortgage so the seller will have to foreclose. As a seller you want a Land Contract or CFD style where you get it back easily after 90 days of default. Research the SF methods in your state while you explore the tax angle and offer them the most reasonable protection you can👍

Rodolfo Palacios · Answer

im thinking of buying a subto deal ; that would then sell (450 mortgage+150 to seller via seller finance)then i can sell it for 600k but since theres no net profit ; would i be taxed ..? seems like i wouldnt even though on paper it would seem like a profit if you just look at the balacne 450 and sell at 600 ???

Joshua Aycock · Answer

@Steve Vaughan Thank you for the response and sharing your experience on the Seller side! What qualities have you looked for in prospective buyers to ensure they hold their end of the deal? I want to approach this in the best way possible. The property is owned by a personal trust registered to an address here in the same town. Any recommendations on how to approach them? The property is not currently on the market...I will approach them cold.

Joshua Aycock · Answer

@Ashish Acharya and @Michael Plaks thank you both for your input! Michael, especially the advice about not giving tax advice to the sellers, great reminder there. I should focus the proposal more on the potential interest opportunity vs the tax implications. That older thread was a good resource too! Got really technical, but I think it highlighted why I should stay away from using cap gains deferral as a core selling point. Michael, it's an Investment property registered to a personal trust. I'm assuming that how it is taxable would depend on the basis, current value, and value of the note, correct? Any other recommendations/tips for approaching based on the ownership vehicle being a trust?