Nichole Y. Shafer
Guest Columnist
It is well known that interest rates on borrowed money are significantly higher now than they were last year, and even the year before that. With higher interest rates comes sellers looking for more creative alternatives to traditional mortgages.
When buyers are considering more creative alternatives to traditional mortgages, often the idea of “seller financing” comes up. In the context of real estate, seller financing arrangements are casually called “land contracts.” In legal contexts, these arrangements are called “installment sales” or “installment contracts.”
As one can imagine, installment sales tend to become more popular when the interest rate for borrowing money is significantly higher than the interest rate for invested money.
For example, if the seller of real estate is earning 5% interest on other investments and a buyer of real estate is looking at an interest rate of 8% to take out a traditional mortgage for the purchase, the parties might consider seller financing. In such circumstances, the parties may decide for the seller to finance the sale at an interest rate of 6%, which could benefit both parties.
When considering an installment sale, there are some things to take into consideration.
First, the seller in an installment sale should require documentation (loan agreements, security agreements and liens) just as a traditional lender or bank would require. If a seller doesn’t require these documents, the seller could find themselves without their money (and potentially without the property).
Next, sellers are required to charge interest on the payments of an installment sale. Yes, even if family, you should take interest into account when doing an installment sale to avoid the IRS imputing interest. The IRS has minimum interest rates that must be charged. The IRS minimum interest rates must be set at the beginning of the installment sale. These IRS minimum rates are different each month based upon the month within which the installment sale begins and based upon the duration of the payments.
If no interest is charged, or the amount is less than the IRS requires, the IRS “imputes” interest. This means the IRS treats a part of the no-interest payment as being interest. The IRS does this because interest is taxed as income, which is typically taxed higher than capital gains. Thus, even if selling something via seller financing, you need to consider the interest or else the IRS will.
Finally, there are more important tax considerations for installment sales. For the sale of real estate in installments sales, capital gains can sometimes be spread out proportionally over the duration of the installment payments. But just like the interest rate, a seller will want to consider the capital gains tax consequences prior to selling real estate. This applies for all sales, not just sales with seller financing.
However, unlike real estate, depreciated property’s sale proceeds cannot be spread out over the duration of installment payments. This is why in business sales, it is important to break out the components for tax purposes.
Nichole Y. Shafer is an Ohio-licensed attorney at Schroeder Law LTD in Putnam County. She limits her practice to business, real estate, estate planning and agriculture issues in northwest Ohio. She can be reached at [email protected] or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.
