Seller-Financed Real Estate raises serious questions
It is not uncommon for sellers to self-finance the real estate, both personal and business, that they want to sell. In many cases this may be the only way an owner can sell their property as many buyers cannot qualify for financing or the real estate will not satisfy the requirements of a lender. Also, buyers may not have the required funds for a down payment. So, how can the owner sell the property? They can carry the loan and self-finance the transaction. This means that the seller takes back a note (becomes the creditor) from the buyer to cover part, or all, of the sale price. The plan is to get some money down and then have the buyer make regular monthly payments over a period of time. This can be a win-win situation since the owner sells their property and the buyer is able to acquire it.
Congress has created a great mechanism to recognize the gain (profit) and defer the taxes to the year the payments are received. This is called an “installment method” of reporting the gain. It is reported on the Internal Revenue form 6252 and attached to the seller’s regular tax return. This option is available for both residential and nonresidential real estate transactions.
The seller must understand the implications before they enter into this type of transaction. First of all, they are assuming a risk by carrying the note. What happens if the buyer, after several payments, defaults on the commitment and the seller forecloses and repossesses the property? What are the tax consequences to the seller upon the repossession? What if the seller was selling their primary residence, holding the note and the buyer defaulted? Do they have to pay taxes on that gain, or are they excluded since it was their primary residence? If there are taxes owed, when will they be due? What if the transaction is between two related parties? How does this affect the tax liabilities, if any? These questions may have current or future tax and financial implications and should be investigated before the transaction is executed.
Other issues to consider: if the buyer takes over (assumes) a mortgage of the seller or pays some of the sellers closing expenses, what are the tax affects? What if the property was used for business or investment purposes such as a rental unit, and the seller depreciated the building over the years that it was owned? How does this affect the taxes and the timing of the payments?
The seller should be aware that there is no free lunch. If things do go south, they should understand the consequences and have a plan to deal with the effects. Do your due diligence before acting. Make sure that your situation qualifies for the installment sale method and seek professional advice before, not after, the transaction.