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.

[Linda Weygant]

I have this discussion frequently with my Corporate clients that always seem to borrow a little from the corp and never pay it back.  Depending on the structure, we then have the Loss in Excess discussion or the Deemed Dividends discussion as well.

Great post!

[Grant Waugh]

Awesome post! This was just the info I was looking for. Thank you

[Hunter Davis]

How would the tax computation work out on a 30 year note? Would the interest rate change year to year or be locked in forever at whatever the federal rate was at the time of closing. Would disclosing these terms in closing be sufficient for the seller especially if paying a higher price? 

[Michael Plaks]

Quote from @Hunter Davis:

How would the tax computation work out on a 30 year note? Would the interest rate change year to year or be locked in forever at whatever the federal rate was at the time of closing. Would disclosing these terms in closing be sufficient for the seller especially if paying a higher price? 

I do not really understand your question. Are you asking about an adjustable rate mortgage? Your tax deduction equals the interest that you actually paid each year. If your rate went up, and you paid more interest as a result, then your deduction is higher as well. This has nothing to do with capital gains however, and the post was about capital gains.

[Derrick Lloyd]

@Michael Plaks I think @Hunter Davis was asking about adjustments to the AFR.  The AFR looks to be constantly changing.  So if you bought a property with seller financing in 2020 when the AFR was ~1%, would the AFR now at ~4% apply for the seller or would they be locked in the AFR at purchase?

[Michael Plaks]

Quote from @Derrick Lloyd:

@Michael Plaks I think @Hunter Davis was asking about adjustments to the AFR.  The AFR looks to be constantly changing.  So if you bought a property with seller financing in 2020 when the AFR was ~1%, would the AFR now at ~4% apply for the seller or would they be locked in the AFR at purchase?

What does AFR have to do with this? Whatever the contract says. I have not seen adjustable rate owner-financed notes really.

[Derrick Lloyd]

@Michael Plaks Let me use an example to explain my question. Say I purchase a property with seller financing and an mortgage interest rate of 0% in 2020. I see that the 2020 AFR then was close to 1%.  Now fast forward to 2022, the AFR is closer to 4%.  Since the seller is not getting any interest from the payments, the IRS minimum interest would apply.  Would the minimum interest they need to pay to the IRS vary year to year with the AFR or would it be fixed at the 2020 AFR in this example?

[Jay Hinrichs]

keep in mind the gurus touting this basically have the same ethics as the wholesaler crowd.. I have used zero % very effectively over the years.

WE started using it back in the early 80s the last time interest rates went nuts. And I had some middle east clients that could not pay interest for religious reasons. 

in the near past I use it to sell off properties i foreclosed on and dont want to rehab.. buyers like it  I understand the rules.

but talking Mrs old lady into this is as you note just another way to make a deal without taking the sellers interest in mind.. thats what sells these guys but if you have a sophisticated seller then  its fair game in my mind.

[Michael Plaks]

Quote from @Derrick Lloyd:

@Michael Plaks Let me use an example to explain my question. Say I purchase a property with seller financing and an mortgage interest rate of 0% in 2020. I see that the 2020 AFR then was close to 1%.  Now fast forward to 2022, the AFR is closer to 4%.  Since the seller is not getting any interest from the payments, the IRS minimum interest would apply.  Would the minimum interest they need to pay to the IRS vary year to year with the AFR or would it be fixed at the 2020 AFR in this example?

Gotcha, sorry, I was not paying attention under which post we had this discussion. So, we're talking about imputed interest.

I do not have a definitive answer to your question, only a guess. As all guesses, mine could be wrong. That said, I expect the IRS to apply this calculation on a monthly basis since AFRs can be adjusted monthly. As in, you received a $1,000 payment in November 2022. The applicable AFR was 4%, so $40 would be reclassified as interest. If December AFR jumps to 4.5%, then $45 of your December payment is interest. Once again, it is only a guess, I have never had imputed interest assessed against my clients in real life.

[Eric Imhof]

This is by far the most helpful thread I've found on this subject. I'm currently working on getting a triplex deal across the finish line. Seller wants to do owner finance, and has given me discretion on terms. All I need to do is have a final number that totals $550k (a high price for this home)

I was looking at doing 0% interest, 30 yr amortization, with a 10 yr balloon. It would give me a low payment, and gets her the sale price she wants. The overall number is what matters to her most. My biggest concern here was the imputed interest, and making sure I'm being fair to my seller. 

But now reading this thread, I'm considering instead to ask her to do a sale price of her basis + 250k so she can avoid capital gains (she has lived in the home a long time). Then I'd take the difference of that and the $550k and work that as interest. I'd ask for interest only payments to keep my monthly payment low. Her basis is $154k original purchase + work done on the house over 20 years. 

Is there any reason to go with the first option over the second, especially given the AFR being 4+% at this time? Again thank you for your post! 

[Julien Jeannot]

@Michael Plaks

Solid post, thanks for sharing!