Owner Financing - Is interest a good idea?

Question

Hello BP Community!I'm considering offering owner financing on one of my properties. Property is worth 135K and is free and clear. I want to offer a 5 year note on it to a potential buyer. I've already spoken with a title company on putting it together, so I know it is possible. My Question is...From a tax perspective, should I charge interest? My end target is to make AT LEAST 140K back. Knowing that 140K is my end number once the note has matured, is it better to factor in interest and manipulate sale price to end with 140K or have no interest on the note and just get 140K in five years? Does it matter from a tax perspective?

Don Konipol · Answer

If you do "manipulate" i.e. lower the price and charge interest to make up the difference you will have to find another investment that pays the same interest as you were charging if the note you hold pays off early.Essentially, you are placing no "time value" on your money, saying that one dollar five years from now is the same as one dollar today.The IRS will "impute" an interest rate when a rate of 0 or below a certain threshold is contracted. In today's low interest environment it's probably not much. The goal of the IRS is not to allow interest income to be converted to capital gainsYou, of course, can make any decision you want with your assets. But if your goal ( or at least one of your goals) is to built wealth, then maximizing the value and return on your investments should be a primary concern. If you can sell a property for $135,000 with owner financing and interest at 8%, why would you sell it for $135,000 with interest at 0%.? If you offer 30 year amortization with a 5 year balloon you would be costing yourself over $50,000 in interest.The only two rationals I see are if (1) the property will only sell for $135,000 if owner financing at 0 interest is offered ( in which case it is not worth $135,000), or (2) you are thing about offering a loan which fully amortizes in 5 years (so foregoing interest brings down the high monthly payments significantly and equity build fast).Both the above scenarios are "marketing ploys", which are used much more extensively in high interest environment, rather than our current low interest environment. However, it is possible that you can attract a niche buyer who has high income but for some reason does not qualify for a conventional loan.

Patrick Desjardins · Answer

Your question is kind of vague. Is there a tax reason you DON'T want to charge interest? Like, is the income going to push you to a higher bracket and make it not worth it?Doing a no interest loan is silly (to me). If I can sell something for 125k and go buy a 10-12%+ reperforming note, I would do that over owner financing 135k at 0% interest. 10% return on 125k is $12,500 a year mailbox money.For your seller finance scenario to be worth it, you would need to get at least 8% from the borrower + 10% cash down.Just in my opinion.

Tony Gunter · Answer

If your lending money for free let me know. I would love to get in on that action. Bad idea to try manipulate the price on an owner financed deal IMHO. When a property is appraised it is appraised independently of any financing considerations, even if being bought with cash. Maybe not be likely, but it could potentially come back to bite you later if the buyer gets sideways and talk with a lawyer. I am not a lawyer, nor giving legal advice, but you might be placing a foot into the zone of predatory practices. I would go for the interest personally as I like to put my money to work. To my understanding you still want to follow Dodd/Frank guidelines to be safe as the seller/owner finance in the deal.

Steve Hodgdon · Answer

@John T. What did you decide to do? I had concerns. Was the property close to you? Credit worthiness of borrower? Potential of creating a non conforming, unmarketable loan. There's an old axiom "Lend short, borrow long".

Loren Clive · Answer

The interest-only is not a rule, it's simply what I was taught in realtor classes pertaining to how owner financing usually works. I think it's recommended for simplicity of calculating interest. Obviously you can make any terms you like.

Account Closed · Answer

@John T. If you are getting anything back other than the $135,000, then the finance charge can't be 0; if you are getting $135,000 in 5 years, the exact amount you loaned out, then the finance charge is 0. Do you have any pictures of this property?

John T. · Answer

@Mike Fletcher Wow...how did I not get that lol. Okay...now that I'M caught up...using your numbers, for argument's sake, which would be more advantageous for me: 140K for 5 years at 0% interest or 135K for 5 years at 1.4402% interest? Would it matter? Thanks!

Account Closed · Answer

@John T. lol... no it isn't... you had mentioned initially that you wanted to do a seller financing for a term of 5 years and total mortgage principal of $135,000. You also mentioned that for the entire 5 years, you wanted whoever the borrower was to pay back $140,000; so thats only a total interest of $5000 in 5 years. For that to happen... that would be the rate you would charge, anything more, you would exceed $5,000 in interest earnings.

John T. · Answer

@Mike Fletcher Thanks for the post. Yes, Guam. The reasoning is to ascertain the tax implications if the property is ineligible for conventional financing. By the way, is the 1.4402% some IRS requirement? Thanks!@Loren Clive Thanks for the reply. I understand the rationale for the 10% down, but is the interest-only for X years the norm or the rule? Supposing the property is ineligible for conventional financing, I'm trying to figure out an exit strategy via owner financing that would minimize tax liability. Property is currently being rented and exceeds the 1% rule. Thanks for your input!

Loren Clive · Answer

Typically owner financing requires at least 10% down from borrowers to cover worst-case scenario cost of foreclosure and is an interest-only loan for five years with balloon payment. So if you get $14k down on $140k purchase price, you're financing $126k interest-only at 6%=$7560 annual interest income until the borrower can qualify for a loan. This would be over $37k income over the five year term. And if the borrower doesn't refinance after five years, you've still made over $51k. I have no idea of tax consequences on this, but just looking at the numbers, could you not rent it for more than $630/mo? Is there an accountant out there who could address renting vs. offering as owner financed? I believe rental income is treated differently from interest income, at least it is for me as a real estate professional.