Tax Implications of Seller Financing via Note

[Ezra Nugroho]

Hi all,

I just read this related topic on tax implications of Subject To: 

http://www.biggerpockets.com/forums/51/topics/1303...

My question is what are the tax implications of seller financing that is done via the creation of a note, both for seller and the buyer?

Let's just create the following hypothetical transaction with easy numbers:

Seller owns a property free and clear, selling it for $100k. Buyer pays $40k down, and the rest will be paid via sellers financing at 5% interest on a 10 year note, 20 year amortizations with a balloon payment at the end.

Is it correct to assume that:

1. The $40k down is subject to capital gain on the year of closing.

2. The 5% interest is considered a regular interest income. Buyer can deduct this part. What about the portion of the payment that goes to the principal ?

3. When the balloon payment is paid, this is considered as capital gain on the year of the payment. 

Correct? Absolutely wrong?

[Nathaniel Busch]

Originally posted by @Ezra Nugroho:

Hi all,

I just read this related topic on tax implications of Subject To: 

http://www.biggerpockets.com/forums/51/topics/1303...

My question is what are the tax implications of seller financing that is done via the creation of a note, both for seller and the buyer?

Let's just create the following hypothetical transaction with easy numbers:

Seller owns a property free and clear, selling it for $100k. Buyer pays $40k down, and the rest will be paid via sellers financing at 5% interest on a 10 year note, 20 year amortizations with a balloon payment at the end.

Is it correct to assume that:

1. The $40k down is subject to capital gain on the year of closing.

2. The 5% interest is considered a regular interest income. Buyer can deduct this part. What about the portion of the payment that goes to the principal ?

3. When the balloon payment is paid, this is considered as capital gain on the year of the payment. 

Correct? Absolutely wrong?

 Ezra,

I will add some facts of my own to answer your question:

-Seller originally bought the property for $60,000. 

-Seller was renting property out prior to sale, and $10,000 of depreciation has been taken.

In this case, the capital gain on the property is $50,000 ($100K sales price less purchase basis of $60,000 plus $10,000 depreciation recapture). 

By selling the property on a note, the seller qualifies for the installment method of reporting capital gains. Meaning, tax can be paid proportionately to seller being paid on his contract. For every $1 of principal seller receives, $.50 of it will be taxed as capital gains. If the only principal received in year one is $40,000 down payment, $20,000 of it will be taxable capital gains. 

If/when the note balloons, whatever lump sum principal payment will also be subject to the same capital gain treatment. So, if balloon calls for $60,000 to be paid then $30,000 of that payment will be capital gain. 

From the buyer's perspective, the interest will be deductible. Payment of principal really has no bearing on his taxes as principal is not deductible. However, the buyer will presumably be depreciating the property and will use the initial purchase price of $100,000 for depreciation purposes. 

Changing the facts a little bit: if the originally seller was not holding the property for rental purposes, rather, acquired it and immediately turned around to sell on financing, there is a potential tax trap here. The IRS has an argument that the intent of the seller was not for speculation or investment purposes, rather, to deal the property in the ordinary course of business. If this argument would hold up, the installment method would not qualify and the seller is at risk of having to recognize the entire $50,000 gain up front even though he won't receive payment of the purchase price in the first year. My recommendation to clients is to consider putting the property on a lease option for at least a year, then converting it into a seller financed note. This way, the property is seasoned as an investment property and the IRS' argument about intent is completely dissolved. The buyer still retains an ownership aspect in the property in the form of option consideration that can be applied to the downpayment after a year. 

Nathaniel Busch, CPA