Seller Financed Mortgage and IRS Considerations

Seller financing, also known as owner financing, involves the seller of a property acting as the lender, providing a mortgage to the buyer. While this can be a beneficial arrangement for both parties, it carries important IRS implications that must be understood and addressed.

For the Seller (Lender):

The IRS views the seller as receiving payments composed of principal and interest. The interest portion is taxable income, just like interest earned from a traditional mortgage. The seller must report this interest income on Schedule B of Form 1040.

The principal portion is generally a return of capital and not taxable, but it reduces the seller’s basis in the property. When calculating capital gains taxes, the original cost basis is reduced by the amount of principal received through the seller-financed mortgage.

The sale itself is considered a taxable event. The seller must determine if they have a capital gain or loss by comparing the selling price (including the mortgage note received) to their adjusted basis in the property. If a gain is realized, it may be subject to capital gains tax rates, which are generally lower than ordinary income tax rates.

Installment Sale Rules: Seller financing typically qualifies as an installment sale. This allows the seller to spread the capital gain tax liability over the years they receive payments, rather than paying it all in the year of the sale. Form 6252, Installment Sale Income, must be filed with the seller’s tax return to report the sale and calculate the taxable portion of the gain each year.

Imputed Interest: The IRS requires that a certain minimum interest rate, known as the Applicable Federal Rate (AFR), be charged on seller-financed loans. If the stated interest rate is below the AFR, the IRS will impute (or assume) a higher interest rate, potentially increasing the seller’s taxable interest income and decreasing the capital gain.

For the Buyer (Borrower):

Like a traditional mortgage, the buyer can deduct the interest paid on a seller-financed mortgage on Schedule A of Form 1040, provided they itemize deductions. The buyer must also adhere to the IRS requirements regarding mortgage interest deductibility.

The buyer’s basis in the property is equal to the purchase price, which includes the seller-financed mortgage. This basis is used to calculate depreciation (if applicable for a rental property) and any future capital gain or loss when the buyer eventually sells the property.

General Considerations:

Accurate Recordkeeping: Both the buyer and seller should maintain meticulous records of all payments made and received, including the amounts allocated to principal and interest.

Professional Advice: Due to the complexities involved, both the buyer and seller should consult with qualified tax professionals or real estate attorneys to ensure compliance with IRS regulations and to optimize their tax positions. This is especially crucial in navigating installment sale rules and imputed interest considerations.

Failure to comply with IRS rules regarding seller financing can result in penalties and interest charges. Careful planning and adherence to proper reporting procedures are essential for a successful and tax-efficient transaction.