Seller financing and installment sales can allow sellers to defer taxes and earn a return on their money at the same time.
What is Seller Financing?
Seller financing is used when a seller of a property agrees to sell the property to a buyer and provide a loan, also known as a purchase-money mortgage, to the buyer instead of the bank.
This loan acts in a similar way that a traditional mortgage from a bank would. The buyer pays the seller a monthly payment that is part principle repayment and part interest. The length of the loan and interest rate can be whatever the buyer and seller agree to, which can be higher or lower than what a traditional lender would offer. Similarly, the consequences for default are also decided by the buyer and the seller, and typically include foreclosure.
What is an Installment Sale?
An installment sale is defined as a sale that has at least one payment that is not made until the following year. The installment method allows sellers to defer part of the capital gains tax into future years as each payment is broken down into two parts (three if you include interest), a return of the seller's cost basis in the property and the gain from the sale.
Why Consider Using Seller Financing and Installment Sales?
When you decide to sell your property and aren't going to be using the proceeds immediately to purchase a larger property, pay off a debt, or make large purchase elsewhere, then you may want to consider using an installment sale. Especially if you plan on just parking the money in a bank account.
Let's start with the tax benefits, capital gains tax has the ability to put you in a higher tax bracket if you sell a property that you hold for less than a year. Let's say you purchased a property for $750,000 in January 2017 and the property has now appreciated to $1,000,000 and you decide to sell in December 2017 without seller financing or utilizing a 1031 exchange. You would have a short term capital gain of $250,000 that has to be recognized in 2017 as ordinary income, which can be taxed as high as 39.60% by the federal government.
By using an installment sale, you can spread that capital gain out over several years, potentially leaving you in a much lower tax bracket, which means paying less taxes.
Even if you hold the property for longer than a year and pay the long-term capital gains tax of 15%, installment sales can still be beneficial. By using seller financing, you can earn a return on your money by charging the buyer interest on the loan. This interest rate is determined by the buyer and the seller and can be higher than that offered by traditional financing methods.
For example, on the same sale as above, you require the buyer to put 25% down and agree to carry back a mortgage of the remaining 75% at an interest rate of 6.5%. That means you will be earning 6.5% on the principal balance of the loan. Based on a 30 year amortization, the monthly payments would amount to $4,740.51 a month or $56,886.12 per year. Not bad if you consider the abysmal interest rates you would receive from parking your money at a bank.
The Bottom Line
If you plan to sell your property and park their money in a bank account, you should consider using seller financing because you can earn a higher rate of return on your money by charging the buyer interest on the loan.
Also, if you are looking to defer your tax liability and spread it out over several years, then seller financing is worth considering.