Seller-Financed Note Tax Implications...and Portland, OR CPA?

Question

Hello, I've searched a few of the threads in here, but I haven't quite found anything to answer my question fully. So, I'd like to propose a scenario here:

Property purchased for $1,000,000.

$50,000 in depreciation taken over the course of the ownership.

$250,000 in capital expenses put into the building.

Sale price of $1,150,000, on a seller-financed note. 5% down, 5% interest rate over 10 years (10 year amortization, no balloon).

The seller finances $1,092,500 (95% of purchase price).

My questions are:

1) Since the sale price (plus depreciation recapture) is less than the purchase price + capital improvements, it is treated as a capital loss, correct?

2) The interest earned on the loan - is that treated as a capital gain, or is that treated as interest income?

3) Is the first $50,000 in interest earned considered tax-free? The sale price is $1,200,000 ($1.15M + $50k depreciation recapture), but the purchase price is $1m + $250k in cap expenses. Therefore, can you count the interest earned against that $50k capital loss?

4) Can you take the entire $50k capital loss in the year you sell, or does it have to be spread out as you receive the money from the seller note?

Thanks in advance.

One last thing - we are moving from San Francisco to Portland, OR. We are not 100% happy with our CPA here, at least not happy enough with them to keep after we move. Any recommendations for a good CPA in Portland? We have 35 units now, after selling a bunch, but are actively buying more.

Thanks again everyone!

Nik

Brian Schmelzlen · Answer

Yes, it is a capital loss. The interest earned is taxed as interest, not a capital gain. No. The interest income is not offset by your capital loss. The capital loss is recognized right away (you can’t have installment sale treatment on a loss), and the interest is recognized as its received.

Neal Collins · Answer

Nik Divakaruni If you are the Seller then you may want to consider structuring the payments so that the payments are on a longer amortization schedule but with a balloon in Year 10. This way you will actually be receiving more interest income rather than most of the payments to you being principal. Model out two different scenarios with a 10 year AM no balloon, and a 25 year AM with a balloon and see which return structure you like better.

Nik Divakaruni · Answer

@Neal Collins and @Michael Plaks - thanks so much!

Michael Plaks · Answer

@Nik DivakaruniI hope @Brian Schmelzlen does not mind me jumping in. Your interest income is taxable in full, always. Your interest expense is deductible as investment interest on Schedule A (itemized deductions), as long as it is not higher than the interest you're making.If you're not itemizing - the likelihood of which is much higher if the tax reform passes - then you're not getting the benefit of the interest you're paying. Taxed on one and cannot deduct the other. Not fair, I know.This can be prevented if the owner financing is done inside a business entity.Also, your calculation of the capital loss produces the correct answer, but it is based on the wrong calculation. You do not add depreciation recapture to the purchase price. You subtract depreciation from the tax basis. Same result, but different numbers.

Nik Divakaruni · Answer

@Brian Schmelzlen one more question for you. If the interest income from the seller note is treated as such, how do I treat the interest expense on the loan I'm still paying the bank from my original loan? Is it the difference of interest payments that is deductible? Thanks again for your help.

Nik Divakaruni · Answer

@Brian Schmelzlen thank you - I figured that may be the case, but wanted to make sure. Thank you for your response.@Neal Collins I'm the potential seller here. A buyer approached me with the deal structure, and wasn't thinking of selling because I haven't finished turning the unit yet. It would be a loss, but a cash flow scenario would be very nice for 10 years.Thinking about tax implications first is a bit of the tail wagging the dog, but call me meticulous I guess. Thanks everyone for your help!Nik

Neal Collins · Answer

Nik Divakaruni What are you purchasing? Those will be some pretty steep payments with such a short AM schedule.

Tommy Ray · Answer

I agree with the first responder

Mathew Wray · Answer

Hi Nik,Welcome to Portland! (Or welcome soon)I’ll stay out of the tax questions (it’s definitely not my area of expertise) but if you’re interested in some CPA recommendations, please PM me and I’ll give you two I’ve used with my experiences. Portland has some down sides, but at its core, is filled with really nice people, good food, and great outdoor options. Mathew

Wayne Brooks · Answer

1-I think so 2-interest 3-no 4-no