Who can claim interest paid on a seller finance property?

Question

Hello,

I sold a property on seller finance in August 2024. The loan is still on my name, but is being paid off every month by my buyer. So, for the interest paid on the loan from August through December, who can claim the interest for tax purposes? Can I claim since the loan is on my name? One of my associate mentioned that both me as a seller and the buyer can claim the interest paid every month, but I am not sure if that makes any sense.

Any help is greatly appreciated.

Thanks,

Ani

Michael Plaks · Answer

I'm hesitant to argue with your "associate" because who am I? He is a trusted associate, and I am merely a tax professional you never met. But I will take my chances. YOLO

General principle of taxation: to take a deduction, you mustA. be legally response for this payment and B. actually make the payment

The conclusion should be obvious. The buyer is entitled to the deduction from August forward, and you are not.

@JD Martin's argument that the loan is under your name does not change my answer. While the loan is indeed under your name, the contract between you and the buyer legally transferred the responsibility for that loan from you to him. You're no longer responsible for the loan payments and no longer entitled to the deduction.

Patrick Roberts · Answer

How is this deal structured? Is it a wrap note, where your seller-carryback note incorporated the first position note and the buyer pays you in full every month, and then you pay the first position lender? Or did the buyer take the property Subto and is making payment directly to the first position lender? Im not a tax expert but it seems like this would be an important distinction as the fundamental structure of the financing is different and dictates who is earning interest income.

Michael Plaks · Answer

Part 3 of 3 - In Subject-To deals, who is really entitled to the deduction?

I once heard that all arguments happen for one of the two reasons: either we call the same thing two different names, or we call two different things the same name. Here we're tripped by the latter.

The debate on this thread centered on who is legally responsible for payments on a loan taken Subject-To. Now, I'm not an attorney, so I'm basically mansplaining something that I am not qualified to comment on. I do hope that attorney on this forum will chime in and correct my unreliable layman's interpretation. Which goes like this.

I think we're confusing two very different things, calling both of them "legally responsible."

A. Who is obligated to make the payments. I believe (again, attorneys will hopefully either confirm or correct this) that once we signed a contract between me and Don, and that contract stipulates that from now on Don is making the payments - then Don is legally responsible. Our contract is enforceable, and I can sue Don to force him make the payments that he agreed to make.

B. Who is in trouble if the payments are not made? As far as bank is concerned, I am still the borrower, because we did this transfer behind the bank's back. If Don fails to pay, the bank will certainly go after me, it will at least ruin my credit and will likely take me to court. From this perspective, yes, I am still legally responsible.

But how can both people be legally responsible for the same loan? Must be only one at a time, right?

And I think that "one at a time" is what resolves the confusion. Once the Sub2 contract is signed, Don becomes legally responsible. As long as he is making his payments according to our contract, he remains legally responsible. But once he defaults, THEN the legal responsibility transfers back to me. I become legally responsible again, but only if he defaults.

Conclusion: Don is legally responsible, Don is making the payments, Don is entitled to the deduction. I am not.

Now, esteemed attorneys, please set me straight if I am wrong on this.

PS. Regardless of legal nuances, I can tell you from extensive professional experience: Don will WIN an IRS audit for his Subject-to interest, as long as he can show that he made the payments.

Michael Plaks · Answer

Part 2 of 3 - In Subject-to deals, can BOTH parties deduct the interest?

Short answer: not legally, but they can get away with it.

Long answer starts with a fundamental concept of our tax laws. You can only deduct what you actually paid. If someone else paid it - you cannot deduct it. (There're a few exceptions when it comes to dependents, but it's irrelevant here.)

Say, I sold my property to Don using Subject-To. The loan is under my name, so the bank will send me - and the IRS! - Form 1098 reporting the interest under my SSN. But Don is making actual payments to the bank, so he has these payments listed on his bank statements.

Both me and Don claim this interest as a deduction, and both of us are audited by the IRS. Who wins and who loses? Most likely, both of us "win." This is why.

I show my Form 1098 to my auditor. In my 25+ years of representing clients before the IRS, not once did the IRS ask to prove that the payments were actually made by my client. If the IRS has a Form 1098, they assume that the person listed on the form made the payments, and they move on.

To be clear: I am NOT entitled to the deduction since I did not make these payments. But I'm getting a pass because the IRS does not verify and does not even ask.

Don has a more difficult time with his auditor because he does not have Form 1098, and he does not want to show a form with my name on it, for obvious reasons. Don shows his auditor our written contract where it says that he is responsible for the payments, and then he shows her his bank statements proving that he did make these payments. He wins. I have successfully defended multiple clients in this situation.

Once again: Don is claiming his deduction correctly, and I am breaking the rules. But the IRS allows this deduction to both of us, due to them taking shortcuts in their auditing process.

Michael Plaks · Answer

Unlike some of our other tax-related debates, this one is actually important to a lot of people. Many investors buy properties Subject-to, and some even sell them Subject-to. So it matters, and I hope we will resolve the confusion. I will split my input into three parts.

Part 1 of 3:  Wrap vs Subject-To vs Assumption

Wraps are not controversial for taxes. We all agree that in case of a wrap, the interest deduction for the original ("inside") loan belongs to the seller. For a detailed explanation, see an earlier comment by @Ashish Acharya.

Assumptions are not controversial, either. The buyer completely takes over the original loan for all legal, tax and practical purposes. Again, we all agree that the interest deduction for the original ("inside") loan belongs to the buyer.

Subject-To is where the controversy is, because we do not agree on who is legally responsible for the loan. I'm writing a separate comment, "Part 3" to address this controversy.

===========

The remainder of this Part 1 comment is written for newer investors who are not familiar with the three terms.

Example. I own a property worth $200k. I have a mortgage with Chase for $150k. Don wants to buy it from me. But he has a bad credit and cannot qualify for a $200k loan to buy it. He is also a jerk, so none of his friends or family are willing to help him out. Don asks me to help him with financing, and I reluctantly agree. We have three potential options.

The first option is for me to completely owner-finance his purchase. He gives me a $20,000 down payment, and he will owe me $180k, making monthly payments for the next 20 years. But I still owe Chase $150k on my original mortgage, and I must continue making monthly payments to Chase. Every month, I collect a payment from Don, use a portion of his payment for my payment to Chase and keep the difference. This is a classic wrap.

The second option is for me to collect $50k cash from Don and let Don pay off my $150k loan to Chase. We contact Chase, and Chase transfers the loan from me to Don, allowing him to keep my original terms and payments. I'm out of the picture now. I got my $50k, and I'm relieved from my $150k loan. This is a classic assumption.

The third option exists due to the fact that assumptions are very rare these days. Banks do not like them. And for two valid reasons: they don't know if Don is a trustworthy borrower (which he is not), and they could get a lot better profit (for the bank) from a brand new loan. So now we're using a workaround. We do not contact Chase. We sign a contract between me and Don where he promises to make monthly payments to Chase, instead of me making these payments, The idea is similar to assumption, except that the bank does not know, and if Don does not make his payments as promised, I'm in trouble with Chase. This is Subject-To.We can make it more complicated by combining some elements of these different financing strategies. But it's already complex enough.

Ken M. · Answer

I am not an attorney, I've just been in enough litigation to know from personal experience and court orders as to how each side argues their case and how judges react. For clarification, As you may already be aware

1. SubTo, "Subject To" is not a contract between the new owner and the lender. The only contract involved is the Warranty Deed. The new owner simply takes over the existing payments. The lender typically is not aware that ownership has changed. If the Warranty Deed has been properly recorded, the court deems that, as "constructive notice". The lender can call the DOS if they find out & choose to. I won a case on this fact. I always record "openly and notoriously" and I do not try to hide the change of title by using Trusts or other techniques that may be regarded as deceptive. I always pay the mortgage payment on time. Those are big issues the court seems to care about. Perceived deception & missed payments are tantamount to losing the case.The lender sends the tax forms to the borrower under the borrower's SSN. I as, the new owner get that from the borrower and I cross off the borrower's name and SSN and insert my name and SSN. I also include the proof of the payments I made on the property and the IRS seems to not be annoyed by this.2. Assumptions (the lender is involved in the process and it goes through underwriting like any other loan)   A new deed of trust with right of foreclosure including Due On Sale is typically involved. There is a legal responsibility for the buyer who "assumes" the loan to make the payments and it is treated like a typical loan origination. The advantage, is that the buyer can wind up with a lower interest rate and instead of a 30 year loan, they have only the remaining number of years the original borrower hasn't yet paid down.3. Wrap, or in some states All-inclusive-Deed simply is a new deed of trust that "wraps" (rides on top of an existing Deed of Trust'  signed by the new buyer obligating the buyer to making the payments or facing foreclosure by the seller.  The lender is not normally aware that a "wrap" has been done. The underlying note from the lender is still in place and the Due On Sale can be triggered. Since the borrower has sold the property to someone on a Wrap, (not notifying the lender),  the borrower no longer can refinance to solve a DOS. The borrower can't sell the property to solve a DOS, they have already sold it with a "Wrap". The borrower can not foreclose on his buyer under a Wrap if it is a performing note.  The borrower is forced into paying off a Due On Sale on a property he no longer owns (is that a tax write-off?) (I know it would be a legal disaster if the property goes to foreclosure and the person he sold it to, loses the house and of course sues the borrower for being stupid). Bad legal stuff happens to the guy who sold on a "wrap" and makes a mistake. He should have been trained better.

4. Seller Finance - in it's pure form is for a property wholly owned "free & clear". The owner can sell and take payments, like bank financing.

However, If a mortgage is already against the property, then it's a hybrid seller financing and can wind up in several configurations, all of which still leave the original lender in first position with the option of Due On Sale if it was written into the original financing. It's still precarious to the buyer and seller. Typically it's actually a "wrap" if previous financing wasn't paid off. Doesn't really matter what you call it.

How payments get from whomever is making the payments, to the underlying lender varies by agreement.

Ashish Acharya · Answer

@Anirudh Reddy When it comes to a seller-financed property, who claims the mortgage interest depends on who’s responsible for the loan and who’s making the payments. Since the loan is still in your name, you can deduct the interest you’re paying to the lender
on your tax return. At the same time, any interest payments you’re receiving from your buyer need to be reported as interest income.

The buyer, on the other hand, can’t claim the interest paid to your lender because they’re not legally responsible for that loan. However, they can deduct the interest they pay to you as part of the seller-financed agreement—if the loan is secured by the property and you provide them with a Form 1098 (Mortgage Interest Statement) for their records. The IRS requires this form if you, as the seller, receive $600 or more in interest during the year.

Key Takeaways:

• You can deduct the interest you pay to your lender,      but you must report the interest you receive from the buyer as income.
• The buyer can deduct the interest paid to you (not      the lender), provided the property secures the loan and you provide a Form      1098.
• The IRS doesn’t allow both parties to claim the same      interest amount, so clear documentation is critical.

This post does not create a CPA-Client relationship. The information contained in this post is not to be relied upon. Readers should seek professional advice.

Patrick Roberts · Answer

I've started asking questions for clarity with scenario/situation posts like this. It's very easy to make one tiny, minor assumption to fill in an unknown that completely changes the context and consequently the answer - I've caught myself doing this a few times.

As far as the legal responsibility for the debt goes with Subject To, my guess would be that the contract basically provides a pathway for the seller to pursue the buyer for recourse related to losses they suffer from the default of the original loan, like a form of indemnification, but does not absolve the seller of responsibility for the debt. The lender is still going to pursue the seller who was the maker on the note and the original debtor. My understanding is that it adds people/entities to the chain but does not remove anyone. I could very well be wrong though.

Not an attorney, so Im interested to see if any attorneys chime in on this - I'd like to know the answer myself.

Michael Plaks · Answer

I disagree. The purchase contract makes the buyer legally responsible for the loan. Hence the buyer is the only one eligible to deduct the interest.

Who can claim interest paid on a seller finance property?

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