Owner financing (also known as "seller financing," "taking back the note," or "an installment sale") is estimated to be used in 10 percent to 15 percent of today's home sales. The term describes a legal transaction in which the buyer obtains financing to purchase a home through the seller, instead of through traditional banks, credit unions or other lending institutions. Essentially, the buyer makes payments directly to the seller.
Buyer and seller agree on a purchase price, down payment, and regular monthly payments to the seller. Payments are spread over time, like an installment plan. This spreads the seller's taxes due on capital gains over time. Sellers are taxed only as principal is received.
Could seller financing work for you?
Financial planner Richard Schank with PTS Brokerage in Mount Laurel, N.J., provides an example for the website Investors.com.
"To keep the numbers simple, say a tract of raw land was purchased two years ago for $100,000 and sold in 2010 for $200,000 -- with the seller taking back a note for $100,000," he said. "The total gain is $100,000. But the seller only recognizes the gain as dollars are collected, based on the gross profit percentage. In this case ... the gross profit percentage is 50 percent, and [so] 50 percent of every dollar collected is taxable."
Let's say the seller collects $100,000 from the buyer upfront. (These amounts are negotiable, and, the buyer may combine traditional funding with owner financing to produce the agreed amount.) The purchaser still owes the seller $100,000. Of this, just 50 percent, or $50,000, is immediately taxable. The rest is taxed as the principal is received.
Who should consider seller financing? Homeowners who are mortgage-free and anticipating a gain of $200,000 or more ($500,000 for married couples filing a joint return) should certainly consider this as an option to spread taxes over time. Owner financing may also be done if you have a mortgage, or if you anticipate fewer gains. Just be sure this isn't in violation of your original mortgage agreement with the bank. You are still responsible for this mortgage until it is fully paid, even after the house is sold using owner financing.
Owner financing is somewhat uncommon for a few reasons. First, most people have mortgages. They need to sell their home outright to repay their existing mortgage or access money for purchasing or upgrading their new home. So, most sellers prefer all their money up front. The other reason owner financing isn't common is that older sellers might not think they will live long enough to collect all the payments. But for a certain segment of sellers, seller financing is an excellent tool for raising interest in your property.
Realtors and bankers aren't rushing to let you know that you can arrange owner financing, another reason most people have not heard of the option. Check with your lawyer and tax professional, and refer to IRS Form 6252 for more details.
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