0% owner financing and IRS imputed interest

[Michael Plaks]

Lately, this seems to be a frequent topic, as certain gurus teach people to request 0% owner financing from sellers, and a number of investors brag about having done so. The benefits to the investor are obvious. 

The benefits to the seller are non-existent. If the seller had some basic understanding of financing, they would realize why they should not accept it without substantially raising the selling price. But if you, as an investor, are able to dupe them into agreeing to 0% seller finance - good for you, I guess. My post is about taxes, not ethics.

Now, to taxes. The better informed investors have heard of the imputed interest issue. In a nutshell, here is the deal: the IRS requires that you treat at least some minimal portion of the interest-free payments as interest. So, if your payments are $1,000 per month, the IRS views them as $990 principal and $10 interest, even if your note states that the interest is 0%. I used random numbers, just to illustrate the point.

1. Why do we care if our payments are the same anyway?

We care because it affects the seller. Let's assume they are selling their own house where they lived for many years. Normally, they would have zero tax because of the capital gain tax exclusion on primary residence, known as the Section 121 exclusion. It's $250k tax-free for a single person or $500k for a couple. Whether they get a full cash payment or owner-finance - still zero tax. 

But now we introduce imputed interest, and suddenly a portion of the payments they receive from you is interest. Interest is always taxable, no matter how small. Look at that from the seller's side. Option A: get $300k lump-sum, no taxes. Option B: get the same $300k as $5k for 60 months, but now with a portion of it being taxable interest. You're asking them to agree to wait for their money for several years, assume the risk of you stopping the future payments, and they have to pay some taxes on top of it! How is it an attractive proposition for anybody?

Gurus tell you to not bring it up, as it is not your problem, it is the seller's. Besides, they reason, the IRS does not really enforce the rule anyway (more on that later). I disagree. I consider it deceptive, unethical and risky from legal liability angle. I tell my clients to bring it up to the seller, suggest that the seller contacts their own CPA for advice, and then slightly adjust the sales price to compensate the seller for the extra tax. Actually, I advise my clients to not pursue 0% owner financing at all, but it's a matter of personal choice.

2. So, how much interest are we talking about?

The IRS sets the minimum interest rate, known as AFR - applicable Federal Rate. AFRs change monthly and can be found here:
https://apps.irs.gov/app/picklist/list/federalRates.html
You need Table 1 from the monthly Revenue Ruling.

Currently, the rates are around 1% or below, depending on the term and size of the loan. Nothing to make a big deal out of, really.


3. But I never heard of anybody dealing with it!

Neither have I. I often compare imputed interest to due-on-sale. Both rules exist but are rarely, if ever, enforced. So it is up to you to respect or ignore them. 

Owner-financed transactions is not what the IRS really worries about when it comes to imputed interest. Their real target is executive compensation disguised as interest-free loans and large family gifts disguised as interest-free loans. In other words, attempts to bypass payroll taxes and gift/estate taxes.

I'm not for ignoring the rules, especially when it takes so little to comply. All you need to do is notify the seller and include imputed interest in your paperwork. If the seller decides to not report it - it's up to him. But you can sleep well.

4. When is it required?

Any owner financing, basically. The details are controlled by Section 483 of the Internal Revenue Code.
https://www.law.cornell.edu/uscode/text/26/483

Some bloggers, YouTubers, gurus etc. mistakenly refer to two other sections of the tax code, so let me address this confusion.

Section 7872, also described in IRS Publication 550 as "below-market loans."
https://www.irs.gov/publications/p550#en_US_2019_publink10009882
This is not for real estate owner-financing. It is for loans between relatives, between employers and employees (paycheck advances) etc. There's a $10,000 minimum and some other rules. Again, it's not about owner financing of real estate.

Section 1274 that quite attractively mentions exceptions for selling personal residence and for any loan under $250k. Sounds great, but this section has a completely different purpose. It requires revision of the stated principal of the loan, triggering specific rules known as OID - original issue discount. It's beyond the scope of this post. The key point: it does not override or loosen the imputed interest rules of Section 483, it adds more rules on top of it.