What Are The Tax Implications of Seller Financing?
Essential Concepts
If you are the seller or buyer of a business or property involving seller financing, how much do you need to know about the tax implications? Perhaps more than you want to know. Of course it's important that you utilize qualified professionals in your dealings. Howver you need sufficient knowledge of your own to close transactions, and to be prepared for future tax returns. I am not a tax adisor, but I have done the research to make your life easier.
For tax purposes, seller financing is referred to as an Installment Sale. While there are many benefits to seller financing apart from the tax benefits, you need to know what the tax implications are, and how to work within IRS regulations.
The term Installment Sale comes from the IRS. Internal Revenue Code(IRC) 453 is the section of the tax code that regulates installment sales. Publication 537 is the detailed and helpful guide from the IRS that explains installment sales.
Here is a key paragraph from the introduction to Publication 537. "An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. If you realize a gain on an installment sale, you may be able to report part of your gain when you receive each payment. This method of reporting gain is called the installment method. You can’t use the installment method to report a loss. You can choose to report all of your gain in the year of sale."
A key distinction in the paragraph above is between "installment sale" and "installment method." The installment sale is the process where the sale of real estate or a business takes place, wherein some of the sales price is made in payments to the seller. The IRS approved way of reporting installment sales is called the "installment method." Not all installment sales will qualify for the installment method.
If you are doing an installment sale you want to qualify to use the installment method. This is a big reason to understand the tax implications of seller financing. Even if you choose seller financing mostly for other reasons, you should make sure ahead of time that you will qualify to take advantage of the tax benefits as well.
For reference material, Internal Revenue Code 453 can be found through the Legal Information Institure at Cornell University. IRS Publication 537 provides a lot of information. If you scroll down to the bottom there is an index with links to the relevant sections.
The Basics
The tax implications of seller financing can vary depending on the specific details of the arrangement. However, here are some basic points to consider:
Seller financing is synonomous with owner financing.
By providing seller financing you are not loaning money. In discussiions and artiicles about seller financing reference is sometimes made to the lender and "be the bank.' This may facilitate the conversation, but the seller is actually taking part of the sales price in payments.
Interest income is part of seller financing. This income is taxed as ordinary income. Use Form 1040 Schedule B, Interest and Ordinary Dividends.
After you have determined the amount of interest, seller financing payments are made up of two additional parts. They are the return of your adjusted basis in the property and the gain on the sale.
Basis is your investment in the property for installment sale purposes. Return of basis is not taxed. The basis of property you buy is generally its cost. If you acquire the property some other way, you should take a look at IRS Publication 551. Improvements you make add to the basis. Other events such as deductible casualty losses and the application of depreciation reduce the basis. The result is called adjusted basis.
Selling expenses include commissions, attorney fees, and any other expenses paid doing the sale. Selling expenses are added to the basis of the sold property.
Adjusted basis needs to be distinguished from adjusted basis for intstallment sale purposes. Adjusted basis for installment sale purposes is the total of adjusted basis as defined above, selling expenses and depreciation recapture.
If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. The gain equal to the recapture income is reported in full in the year of the sale and taxed as ordinary income.. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 of Publication 544.
Gross profit is the total gain you report on the installment method. To figure your gross profit, subtract your adjusted basis for installment sale purposes from the selling price. For this purpose, include the recapture income in your installment sale basis to determine your gross profit on the installment sale.
A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing your gross profit from the sale by the contract price. Multiply the payments you receive each year (less interest) by the gross profit percentage. The result is your installment sale income for the tax year. Below is an image of the IRS worksheet for figuring adjusted basis and gross profit percentage.
For property held for more than one year, capital gains rates will apply to installment sale income. Depending on the amount of your taxable income and filing status the rates are 0%. 15% or 20%. The long-term capital gains rates and income thresholds for 2022 and 2023 are shown in the tables below. This compares with ordinary income tax rates up to 37%.
| Capital Gains Tax Rate | Taxable Income(Single) | Taxable Income(Married Filing Separate) | Taxable Income(Head of Household) | Taxable Income(Married Filing Jointly) |
|---|---|---|---|---|
| Capital Gains Tax Rate:0% | Taxable Income(Single):Up to $41,675 | Taxable Income(Married Filing Separate):Up to $41,675 | Taxable Income(Head of Household):Up to $55,800 | Taxable Income(Married Filing Jointly):Up to $83,350 |
| Capital Gains Tax Rate:15% | Taxable Income(Single):$41,676 to $459,750 | Taxable Income(Married Filing Separate):$41,676 to $258,600 | Taxable Income(Head of Household):$55,801 to $488,500 | Taxable Income(Married Filing Jointly):$83,351 to $517,200 |
| Capital Gains Tax Rate:20% | Taxable Income(Single):Over $459,750 | Taxable Income(Married Filing Separate):Over $258,600 | Taxable Income(Head of Household):Over $488,500 | Taxable Income(Married Filing Jointly):Over $517,200 |
| Source: IRS | ||||
| Capital Gains Tax Rate | Taxable Income(Single) | Taxable Income(Married Filing Separate) | Taxable Income(Head of Household) | Taxable Income(Married Filing Jointly) |
|---|---|---|---|---|
| Capital Gains Tax Rate:0% | Taxable Income(Single):Up to $44,625 | Taxable Income(Married Filing Separate):Up to $44,625 | Taxable Income(Head of Household):Up to $59,750 | Taxable Income(Married Filing Jointly):Up to $89,250 |
| Capital Gains Tax Rate:15% | Taxable Income(Single):$44,626 to $492,300 | Taxable Income(Married Filing Separate):$44,626 to $276,900 | Taxable Income(Head of Household):$59,751 to $523,050 | Taxable Income(Married Filing Jointly):$89,251 to $553,850 |
| Capital Gains Tax Rate:20% | Taxable Income(Single):Over $492,300 | Taxable Income(Married Filing Separate):Over $276,900 | Taxable Income(Head of Household):Over $523,050 | Taxable Income(Married Filing Jointly):Over $553,850 |
| Source: IRS | ||||
The IRS has published the ordinary income tax rates for 2023. The top tax rate remains 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly).
The other rates are:
- 35% for incomes over $231,250 ($462,500 for married couples filing jointly)
- 32% for incomes over $182,100 ($364,200 for married couples filing jointly)
- 24% for incomes over $95,375 ($190,750 for married couples filing jointly)
- 22% for incomes over $44,725 ($89,450 for married couples filing jointly)
- 12% for incomes over $11,000 ($22,000 for married couples filing jointly)
The lowest rate is 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).
By comparing these rates with long-term capital gains rates, you can see the potential tax benefits of seller financing
Generally, you will use Form 6252 to report installment sale income from casual sales of real or personal property during the tax year. You will also have to report the installment sale income on Schedule D (Form 1040), Form 4797-Sales of Business Property, or both. If the property was your main home, you may be able to exclude part or all of the gain.
If an individual has income from investments, the individual may be subject to Net Investment Income Tax of 3.8%. This applies on the lesser of net investment income, or the amount by which modified adjusted gross income exceeds the statutory threshold amount based on filing status. Net investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, and non-qualified annuities.
The statutory threshold amounts are:
- Married filing jointly — $250,000
- Married filing separately — $125,000
- Single or head of household — $200,000
- Qualifying widow(er) with a child — $250,000
Seller financing allows you to choose the amount of interest charged to put a deal together. For some sellers even zero percent interest may make sense. If you decide to sell such a note in the future, zero interest will make it more difficult to do so. You will face a greater discount if you are successful at selling the note.
As an installment sale the IRS expects that the sales contract will include stated interest, and they expect the amount of interest to be adequate based on a test rate. The test rate is based on the Applicable Federal Rate (AFR) published monthly by the IRS. These rates are available at https://apps.IRS.gov/app/picklist/list/federalRates.html. Expected interest is also referred to as imputed interest. Depending on the section of the IRS code that applies, the IRS refers to this category of interest as "unstated interest" or "original issue discount" (OID). More information can be found in Publication 537.
You may be subject to interest on deferred tax if the property had a sales price over $150,000 and the total balance of all nondealer installment obligations arising during, and outstanding at the close of, the tax year is more than $5 million. This applies each year the note is outstanding and the balance exceeds $5 million. Spouses who each have separate ownership in a business or asset(s) sold are treated as separate sellers for the purpose of applying the $5 million limitation of IRC 453A. The applicable interest rate has been in the range of 3-5%. For more detailed information here is a PDF from the IRS.
Keeping in mind the distinction between installment sales and the installment method, you can elect out of the installment method within the tax year of sale including six month extensions. If you don't elect out at first, you can do so with an amended return up to six months after the due date. If you elect out, then you report the entire gain in the year of sale.
Electing out of the installment method depends on your individual circumstances, which may change from the date of sale to the due date for your tax return. For example, capital gains rates may change or you may decide to avoid the interest charge on deferred tax, You might want to reduce the value of an estate by the amount of tax paid. Or you may decide to absorb loss carryovers that will be expiring. Obviously you need to be in a position to pay a larger first year tax bill than you may have planned on.
The installment method can't be used for dealer sales. On this topic, Publication 537 states "Sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan aren’t installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule doesn’t apply to an installment sale of property used or produced in farming."
"Dealers of timeshares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge. For more information, see section 453(l)."
It's important to note that these are general guidelines and the specific tax implications of seller financing will depend on the individual circumstances and all applicable laws. It is recommended that you consult with a tax professional or attorney to understand the full tax implications of seller financing for your particular situation.
Fine Tuning Some Details
Regarding the requirements for an installment sale, here's something knowlegeable sources have written:
- "The first installment must be paid within one year after the tax year of the sale"
- "At least one payment must take place in the following tax year"
- "The first payment must be received in any subsequent year after the tax year in which the sale took place."
- "At least one installment is being paid in a different tax year"
- "At least one payment be received a year after the tax year of the sale"
- Here is what the tax code states: "The term “installment sale” means a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs."
- The IRS smooths out the code a bit in Publication 537. They state: "An installment sale is a sale of property where you receive at least one payment after the tax year of the sale."
Can you see the distinction between what the IRS states and what other sources put into their own words?
The IRS rules, and state and federal laws matter. So you really need to pay attention to them as you decide how to implement seller financing.
You should spend some time on your own to familiarize yourself, and rely on the professional advice of a tax advisor and an attorney to implement seller financing.
Many other sources of learning about seller financing can be helpful within these guidelines. While working within the regulations, these other information sources can provide much help in using seller financing to structure creative transactions. Be aware though that when such sources state that something has to be a certain way, it might not be accurate advice.
The IRS definition of "installment sale" does provide a lot of flexibility. You could simply sell a property at the end of one year, take one installment payment early the following year, and meet the regulation. Most installment sales will have a number of payments. You do not have to receive a payment in the next year after the sale, as long as you do receive one or more installments in following years.
Example - Sale Of Land
Here is an example from the 2014 IRS Nationwide Tax Forum, produced in conjunction with the American Institute of Certified Public Accountants. The sales price was $300,000 payable in equal installments over 5 years at 3% interest.
| Asset | Sales Price | Installment Sale Basis | Gross Profit |
|---|---|---|---|
| Asset:Land | Sales Price:$300,000 | Installment Sale Basis:$10,000 | Gross Profit:$290,000 |
Gross profit percentage/Land: 290,000/300,000 = 96.67%
| Year | Principal | Gross Profit % | Gain | Interest |
|---|---|---|---|---|
| Year:One | Principal:$56,506 | Gross Profit % 96.67 | Gain:$54,622 | Interest:$9,000 |
| Year:Two | Principal:58,201 | Gross Profit % 96.67 | Gain:56,261 | Interest:7,304 |
| Year:Three | Principal:59,948 | Gross Profit % 96.67 | Gain:57,950 | Interest:5,558 |
| Year:Four | Principal:61,746 | Gross Profit % 96.67 | Gain:59,688 | Interest:3,760 |
| Year:Five | Principal:63,599 | Gross Profit % 96.67 | Gain:61,479 | Interest:1,907 |
| Year:Totals | Principal:$300,000 | Gross Profit % | Gain:$290,000 | Interest:$27,529 |
If we assume wages of $145,000, here is the impact of an installment sale on net investment income tax (NIIT)
| Wages | Gain | Total Income | NIIT Exclusion | NIIT Rate | NIIT Tax |
|---|---|---|---|---|---|
| Wages:$145,000 | Gain:$290,000 | Total Income:$435,000 | NIIT Exclusion:($200,000) | NIIT Rate:3.8% | NIIT Tax:$8,930 |
| Wages | Gain | Total Income | NIIT Exclusion | NIIT Rate | NIIT Tax |
|---|---|---|---|---|---|
| Wages:$145,000 | Gain:$54,620 | Total Income:$199,622 | NIIT Exclusion:($200,000) | NIIT Rate:3.8% | NIIT Tax:$0 |
Of course the numbers used in the example will make more sense depending on your location and experience, and the years of purchase and sale. But the tax factors applied are relevant either way. And the news gets even better.
Using all the same numbers, let's assume that the land was held for more than one year, so capital gains tax rates apply. Without the installment method the full gain of $290,000 applies in the tax year of sale. At a capital gains rate of 15% the tax is $43,500. Using the installment method the year one gain is $54,620. At a 15% rate the tax is $8,193.
So one of the key concepts utilized above is taking action that reduces your Adjusted Gross Income. Understanding the tax code helps you to do so. Seller financing along with the installment method provide more tools for you to impact the tax you pay.
You Can Sell The Note Or Part Of It
By selling a business or propety using seller financing, and in turn doing an installment sale, you will create a secured promissory note. This note is an asset which you can sell in whole or in part for a lump sum of cash. Throughout this website you will find more resources about creating notes and the process of selling notes.
When you make such a sale you do advance your gain, so you need to be prepared for how this will effect your next tax return.
Selling your note gives you the opportunity to adjust your cash position and adapt to changing needs. Partial sales are common and can be structured in a variety of ways. For example, you could sell 50% of each payment for cash while continuing to receive the other half of each payment. Or you could sell the next 24 monthly payments and resume receiving payments thereafter. In the future you could sell more payments, perhaps the remainder of your note.
As note broker I can provide winning alternatives to purchase your notes. Get started now!
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References
- Photo by the New York Public Library on Unsplash
- Internal Revenue Code 453
- IRS Publication 537