Can you DEDUCT Payments being paid on a PRINCIPAL ONLY Note ?

Question

Situation; Elderly Seller bought their Triplex home for around $350K Many Many Years ago. She lives in One unit and rents out the other TWO Units. Today its value is around $1.4M +/-
She has discovered that IF she sells for Cash she will have a significant Tax Bite on the Capital Gain at BOTH the Federal and State Levels.
She is open to doing a Seller Financed Installment sale;

EG. $1.4M Purchase Price, $200K Cash Down, Balance of $1.2M financed at $4K per month for 300 Months (25 Years) - ALL Principal payments - NO INTEREST

NOTE: if the buyer was buying for cash or obtaining Bank Financing - they would NOT agree to pay $1.4M but likely a lower price closer to $1.1M or < LESS as a purchase price.

Q- The Buyer intends to OCCUPY the same unit that the seller was occupying and then continue to rent out the other (2) TWO Units.
However IF the seller is financing $1.2M @ $4K per month - ALL PRINCIPAL - Can the BUYER Deduct any of those PRINCIPAL ONLY Installment payments of $4K per month as if they were paying on a more normal Bank Financed Loan which would carry interest ?

Reason is the buyer makes good income and would be benefit from the INTEREST DEDUCTION Write Off against their Income.
Thus is weighing whether it might be better to INCLUDE INTEREST in the seller financing or simply pursue getting Bank financing so that they can DEDUCT the interest on that Bank loan (likely with a Lower Purchase price of the property also involved)

Not sure of the Tax Implications on this QUESTION ???

Dave Foster · Answer

@Michael Morrongiello, If income is driving this then the seller needs to take 1/3rd of the sale of the triplex as her primary residence exclusion tax free.  That puts $250kish tax free in her pocket.  Then she needs to 1031 the other 2/3rds into some passive cash flow DSTs.  This way her entire transaction pays no tax.  Part is tax free.  the rest is tax deferred until her death.  She gets cash in pocket and ongoing cash flow.  And when she goes to the great escrow in the sky (soooo sick and twisted but funny) her heirs inherit everything tax free.

Bill B. · Answer

She’s in her 90’s and I’ll and you’re suggesting a 30 year no interest loan? MAYBE with a 2 year balloon. You plan offers her a taxable $200k.

Selling for $1.1mil gives her a taxable gain of $500k at 15% fed long term and a max of 11.3% state tax (not average, max, up to $600k) is $125k in taxes which would leave her almost a million dollars in her pocket. But AGAIN, this is why selling is a bad idea for her. Either do the 1031 exchange for 2/3rds of the value and walk with $350k tax free instead of your $200k taxable and all the taxes go away when she passes or simply take a $200k tax free refi. If she does this deal her heirs are inheriting a $150k tax bill they shouldn’t have and a zero interest loan instead of cash.

Chris McCormack · Answer

Consider a CRT - all gains on sale are tax free and can take withdraws until death which then gets donated to a charity of her choice.

Darius Ogloza · Answer

The IRS will impute interest on the loan, which will be taxed even if not paid.  Not sure what the current rate is.  Easy to verify online.

Bill B. · Answer

@Eduardo Bilbao

That is correct. If you live in 100% of a SFR you get 100% tax free up to $250/500k. If you live in half of a duplex you get 1/2, if you live in 1/3rd of a triplex a third, and 1/4th of a quad plex 1/4th.

I’m not sure it works at all at 5 or above. I don’t think so but I’m guessing.

Ps. All these rules are only true if you lived in first, before it became a rental. The pioneers of real estate investing took too big of an advantage of this loophole and the government shut it down. (Imagine moving every 2 years in to rentals you’ve held for 20 or 30 years and selling each one tax free.). The new rule is if it was a rental first you only get the percent time it was your primary tax free. So a rental for 3 years and then your primary for 2, only 40% is eligible for the tax free gain.

Eduardo Bilbao · Answer

Why does the seller have to go through all this hustle? If the seller of the triplex has lived in the property for 2 years in the last 5 years then there should not be any capital gain tax. If the property were the seller is living is their primary residence. Please educate me if I am wrong.

@Bill Brandt if I read correctly the owner of the property would only be able to not pay capital gains taxes on 1/3 of the building since she lives in only one of the three units?

Bill B. · Answer

Sorry if I I wasn’t clear. I was only using a $250k deductions. I used the $1.1mil “lower sales price” instead of 1.2mil. Subtracted the $350k purchase price giving her $1.1mil minus $350k for a subtotal of $750k. Then I subtracted the $250k exemption giving her a $500k taxable gain.

Of course she should get a $500k or $700k cashout refi or whatever amount she “needs” and hold until she passes and save the $100k in federal and now state taxes. Maybe she finds a love interest and saves another $50k. :-)

But look up irs minimum interest rate. I don’t think I’m making that up. Now maybe they haven’t updated it for our interesting times and it’s only 1-2%? I dunno.

Another thought. She could do a 1031 of $750k in to another building and walk with her $375k tax free sec 121 ($250k plus $117k purchase percent.) since I assume her plan is to move in with her daughter if she doesn’t need the cash at closing.

Michael Morrongiello · Answer

Appreciate the reply - the negotiation is still ongoing. The CASH price (likely will be lower) and Actually its the Mom and her (2) TWO daughters who are PUSHING for an installment sale Vs a Cash purchase since they will need INCOME for Mom's ongoing care whether its in a care facility or in living with one of them.

Bill B. · Answer

You can’t deduct any of the $4,000 though your payment of $5,000+ with taxes and insurance will have that portion deductible. I BELIEVE the seller will owe extra taxes based on the idea that there’s a minimum amount of interest that can be charged.

If you could have 1.1million today or 1.2million 30 years from now which would you rather have? Make sure the seller isn’t consider elderly or you could face charges of taking advantage of the elderly. (You’d have to ask if 9% TOTAL interest in 30 years is abuse, but it sounds like it…) a 30 year mortgage at less than 1/3rd of 1% per year?

Anyway, seller should definately take the cash sale. $1.1mil minus $350k is $750k, minus 1/3rd lived in is $500k. You’re talking $75k in taxes to walk with a million. Be careful with this offer, especially if the seller has any children or beneficiaries. Good luck.

Can you DEDUCT Payments being paid on a PRINCIPAL ONLY Note ?

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