Paying for something on an installment plan is familiar to almost everybody. Instead of paying the entire cost of an item upfront, you pay a little over time, over several months or years. Consumers commonly purchase items such as furniture and appliances on an installment plan. This method of payment is not limited to such items. Consumers can purchase almost anything on an installment plan, including real estate.
Installment sales of real estate are a form of seller financing. Instead of borrowing money from a bank to pay the seller, the buyer borrows from the seller. The buyer and seller enter into an installment agreement in which the buyer agrees to make a down payment and pay the remainder of the sales price over a term of years. It can be one year or 30 years; it’s up to the buyer and seller to decide. The buyer also agrees to pay interest on the payments. It’s up to the buyer and seller to agree on the interest rate—it can be higher or lower than the rates lenders charge. The seller ordinarily takes back a purchase money mortgage from the buyer. This way, the buyer’s promise to pay the seller is secured by the property—that is, if the buyer doesn’t pay, the seller can foreclose and get the property
Sales in which at least one payment is not due until the following year qualifies as an installment sale for tax purposes. Such sales must be reported to the IRS using the installment method unless the seller opts out of using this method by filing an election with the IRS.
Under the installment method, the payments received by the seller are divided into two classes:
Taxes need not be paid on the portion of the payments representing the return of basis—the amount the seller originally paid for the property. Tax must be paid on the portion representing the gain from the sale; this is paid at capital gains rates, which are usually lower than ordinary income tax rates. The seller must also pay regular income tax on the interest paid each year. The following example shows how this works.
Example: Bob sells her rental house to John for $200,000. Bob pays John a $20,000 down payment and agrees to pay the remainder in equal $20,000 installments over the next nine years, plus 5% interest. John paid $80,000 for the house and owns it free and clear; so her total gain is $200,000 – $80,000 = $120,000. This means that 60% of each payment represents gain from the sale, and the other 40% is a return of Liz’s basis. When John receives her annual $20,000 payments from Bob he will have to pay capital gains tax on $12,000. He will also have to pay tax at ordinary income rates on the $10,000 in interest he receives each year.
Why would a seller do this? Isn’t it always better to get the entire sale price upfront? Not always. There are many instances when getting paid over several years is better for a seller. If John from the above example had been paid the $200,000 sale price upfront, she would have had to pay tax on her entire $120,000 gain in the year of the sale. With the installment sale, she pays tax on $12,000 each year for 10 years. He pays tax on this amount at the 15% long-term capital gains rate, for a $1,800 annual tax. But she also is receiving interest payments from Bob on $200,000. This means that after he pays her tax, he effectively has $198,200 in earning interest. If John receives the entire $200,000 sales price upfront, she would have had to pay an $18,000 capital gains tax on his $120,000 gain the year of the sale. This leaves him with only $182,000 to earn interest.
Installment sales can also save sellers money if the income from the sale would put them in a higher tax bracket if they receive it in one year. This is especially important for higher-income sellers who could be subject to the 3.8% net investment income tax. Single taxpayers with an adjusted gross income (AGI) over $200,000, and marrieds filing jointly who have an AGI over $250,000, are subject to this tax. Depending on their income, such taxpayers end up paying an 18.8% or 23.8% capital gains tax on their gains, instead of 15% or 20%. The key to avoiding this tax is to keep your AGI below these threshold levels. Using an installment sale can help you achieve this.
For more on the subject, see IRS Publication 537, Installment Sales. Also, be sure to consult with your tax professional, lawyer, and real estate broker before doing an installment sale. There are many issues to consider and a lot at stake, so it pays to get advice from the pros in structuring a house installment sale agreement with a buyer.
Here’s a quick look at some of the most common types of seller financing.
All-inclusive mortgage. In an all-inclusive mortgage or all-inclusive trust deed (AITD), the seller carries the promissory note and mortgage for the entire balance of the home price, less any down payment.
Junior mortgage. Sometimes lenders are reluctant to finance more than 80% of a home’s value. Sellers can potentially extend credit to buyers to make up the difference: The seller can carry a second or “junior” mortgage for the balance of the purchase price, less any down payment. In this case, the seller immediately gets the proceeds from the first mortgage from the buyer’s first mortgage lender. However, the seller’s risk in carrying a second mortgage is that he or she accepts a lower priority should the borrower default. In a foreclosure or repossession, the seller’s second, or junior, the mortgage is paid only after the first mortgage lender is paid off and only if there are sufficient proceeds from the sale. Also, the bank may not agree to make a loan to someone carrying so much debt.
Land contract. Land contracts don’t pass title to the buyer, but give the buyer “equitable title,” a temporarily shared ownership. The buyer makes payments to the seller and, after the final payment, the buyer gets the deed.
Lease option. The seller leases the property to the buyer for a contracted term, like an ordinary rental—except that the seller also agrees, in return for an upfront fee, to sell the property to the buyer within some specified time in the future, at agreed-upon terms (possibly including price). Some or all of the rental payments can be credited against the purchase price. Numerous variations exist on lease options.
Assumable mortgage. Assumable mortgages allow the buyer to take the seller’s place on the existing mortgage. Some FHA and VA loans, as well as conventional adjustable mortgage rate (ARM) loans, are assumable, with the bank’s approval.
Paying for something on an installment plan is familiar to almost everybody. Instead of paying the entire cost of an item upfront, you pay a little over time, over several months or years. Consumers commonly purchase items such as furniture and appliances on an installment plan. This method of payment is not limited to such items. Consumers can purchase almost anything on an installment plan, including real estate. Ins
Installment sales of real estate are a form of seller financing. Instead of borrowing money from a bank to pay the seller, the buyer borrows from the seller. The buyer and seller enter into an installment agreement in which the buyer agrees to make a down payment and pay the remainder of the sales price over a term of years. It can be one year or 30 years; it’s up to the buyer and seller to decide. The buyer also agrees to pay interest on the payments. It’s up to the buyer and seller to agree on the interest rate—it can be higher or lower than the rates lenders charge. The seller ordinarily takes back a purchase money mortgage from the buyer. This way, the buyer’s promise to pay the seller is secured by the property—that is, if the buyer doesn’t pay, the seller can foreclose and get the property back.
Sales in which at least one payment is not due until the following year qualifies as an installment sale for tax purposes. Such sales must be reported to the IRS using the installment method unless the seller opts out of using this method by filing an election with the IRS.
Under the installment method, the payments received by the seller are divided into two classes:
Taxes need not be paid on the portion of the payments representing the return of basis—the amount the seller originally paid for the property. Tax must be paid on the portion representing the gain from the sale; this is paid at capital gains rates, which are usually lower than ordinary income tax rates. The seller must also pay regular income tax on the interest paid each year. The following example shows how this works.
Example: Bob sells her rental house to John for $200,000. Bob pays John a $20,000 down payment and agrees to pay the remainder in equal $20,000 installments over the next nine years, plus 5% interest. John paid $80,000 for the house and owns it free and clear; so her total gain is $200,000 – $80,000 = $120,000. This means that 60% of each payment represents gain from the sale, and the other 40% is a return of Liz’s basis. When John receives her annual $20,000 payments from Bob he will have to pay capital gains tax on $12,000. He will also have to pay tax at ordinary income rates on the $10,000 in interest he receives each year.
Why would a seller do this? Isn’t it always better to get the entire sale price upfront? Not always. There are many instances when getting paid over several years is better for a seller. If John from the above example had been paid the $200,000 sale price upfront, she would have had to pay tax on her entire $120,000 gain in the year of the sale. With the installment sale, she pays tax on $12,000 each year for 10 years. He pays tax on this amount at the 15% long-term capital gains rate, for a $1,800 annual tax. But she also is receiving interest payments from Bob on $200,000. This means that after he pays her tax, he effectively has $198,200 in earning interest. If John receives the entire $200,000 sales price upfront, she would have had to pay an $18,000 capital gains tax on his $120,000 gain the year of the sale. This leaves him with only $182,000 to earn interest.
Installment sales can also save sellers money if the income from the sale would put them in a higher tax bracket if they receive it in one year. This is especially important for higher-income sellers who could be subject to the 3.8% net investment income tax. Single taxpayers with an adjusted gross income (AGI) over $200,000, and marrieds filing jointly who have an AGI over $250,000, are subject to this tax. Depending on their income, such taxpayers end up paying an 18.8% or 23.8% capital gains tax on their gains, instead of 15% or 20%. The key to avoiding this tax is to keep your AGI below these threshold levels. Using an installment sale can help you achieve this.
For more on the subject, see IRS Publication 537, Installment Sales. Also, be sure to consult with your tax professional, lawyer, and real estate broker before doing an installment sale. There are many issues to consider and a lot at stake, so it pays to get advice from the pros in structuring a house installment sale agreement with a buyer.
Here’s a quick look at some of the most common types of seller financing.
All-inclusive mortgage. In an all-inclusive mortgage or all-inclusive trust deed (AITD), the seller carries the promissory note and mortgage for the entire balance of the home price, less any down payment.
Junior mortgage. Sometimes lenders are reluctant to finance more than 80% of a home’s value. Sellers can potentially extend credit to buyers to make up the difference: The seller can carry a second or “junior” mortgage for the balance of the purchase price, less any down payment. In this case, the seller immediately gets the proceeds from the first mortgage from the buyer’s first mortgage lender. However, the seller’s risk in carrying a second mortgage is that he or she accepts a lower priority should the borrower default. In a foreclosure or repossession, the seller’s second, or junior, the mortgage is paid only after the first mortgage lender is paid off and only if there are sufficient proceeds from the sale. Also, the bank may not agree to make a loan to someone carrying so much debt.
Land contract. Land contracts don’t pass title to the buyer, but give the buyer “equitable title,” a temporarily shared ownership. The buyer makes payments to the seller and, after the final payment, the buyer gets the deed.
Lease option. The seller leases the property to the buyer for a contracted term, like an ordinary rental—except that the seller also agrees, in return for an upfront fee, to sell the property to the buyer within some specified time in the future, at agreed-upon terms (possibly including price). Some or all of the rental payments can be credited against the purchase price. Numerous variations exist on lease options.
Assumable mortgage. Assumable mortgages allow the buyer to take the seller’s place on the existing mortgage. Some FHA and VA loans, as well as conventional adjustable mortgage rate (ARM) loans, are assumable, with the bank’s approval.
Many sellers are hesitant to underwrite a mortgage. They fear the buyer will default (not make the loan payments). The seller can take certain steps to reduce the risk of default. A professional can assis the seller in doing the following:
The seller should require the buyer to sign a detailed loan application form, also thoroughly check all of the info the buyer adds there. This entails doing a credit check/vetting employment, assets, financial claims, references, and other background information and documentation.
Allow for seller approval of the buyer’s finances. The written sales contract — which specifies the terms of the deal along with the loan amount, interest rate, and term — should be made contingent upon the seller’s approval of the buyer’s financial situation.
Secure the loan with the home. This way the seller (lender) can foreclose if the buyer should default on payments. The house should be correctly appraised to validate that the value is equal to or more than the buying price.
Require a down payment. 10-20% Traditional lenders will ask for down payments to give a sort of cushion against the possibility of losing the investment. It also makes the buyer less likely to walk away if they run into financial trouble.
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