Seller Financing 101

BENEFITS OF SELLER FINANCING

Real estate sales which involve seller financing are referred to as installment sales for tax purposes.  This type of transaction can be beneficial to both buyers and sellers.  Installment sales allow buyers to close quickly without having to endure the over-scrutinzation of now "gun-shy" lenders, and they give sellers a way to reap higher returns on their equity while deferring income taxes.  If a property is not a seller's principal residence, spreading out the capital gains tax over the years of receiving buyer payments is usually far better than paying a large capital gain tax in the year of the sale. 

• Defer capital gains 
• Collect monthly income for years 
• No more property taxes or insurance

How Do Installment Sales Work?

An installment sale of real estate allows for the deferral of gain recognition from the sale or disposition where there is at least one payment of the purchase price that will be received after the close of the year of sale.  In addition to producing regular income for the seller, the installment method allows the seller/taxpayer to recognize only the percentage of the overall capital gain received in any one tax year, instead of all in the year of the sale.  Because the seller recognizes the gain over the taxable years in which the payments are actually received, the seller is able to defer payment of income taxes that are assessed on that gain.  Deferring taxes can be a real benefit to homeowners.

Computing Gain

Each installment payment on a home usually consists of three elements:

1. A partial return of the seller's adjusted basis in the property sold, which is not taxable to the seller,
2. A portion of the taxpayer's realized gain on the sale, which is taxable as a capital gain, and
3. Accrued interest, which is taxable as ordinary interest income.

Each year, a seller receiving payments from an installment sale must determine how much of the year's payments is taxable as capital gains and how much is a nontaxable recovery of the seller's cost basis.  The tax payer multiplies the non-interest portion of the total payments received in that year by the gross profit ratio for the sale.

The gross profit ratio is the taxpayer's total anticipated gross profit, divided by the total contract price.  The anticipated gross profit is the contract price less the taxpayer's adjusted basis.  The taxpayer's adjusted basis starts with the original purchase price, including initial closing costs: then increased by any capital improvements and the selling expenses incurred in the sale: then reduced by any depreciation taken during the time of the seller's ownership.

The "contract price" is equal to the selling price, reduced by the amount of any qualifying indebtedness which is assumed or taken subject to by the buyer. Qualifying indebtedness may include any mortgage or other debt encumbering the property, plus any debt that is incurred or assumed by the buyer incident to the buyers' acquisition.

Consider the following for the sale of 1234 West Main Street:

The gross profit of $84,972 is divided by the contract price of $292,500 to determine a gross profit ratio of 29 percent. In applying the gross profit percentage of 29 percent to the cash received in Year 1, the Seller will recognize only a fraction of the gain in the year of the sale.

The necessary mortgage paperwork may be prepared by the title or escrow company after the terms are worked out between the buyer and seller.

Sellers should consult a CPA or an attorney for a better understanding of owner financing and the installment sale process.