When selling a home, you may wish to use owner financing so that you can attract more potential buyers and make money on interest. If you choose to go this route, you will have to comply with some rules set forth by the Internal Revenue Service. As long as you follow the rules, it can be a worthy way to generate income.
Owner Financing Rules
Owner financing, also known as seller financing, can take one of many forms. Depending on the arrangement, it could involve you continuing to make your normal mortgage payment then having the buyer pay you back each month. If you own the property without a mortgage on it, you may simply provide the entire mortgage loan for the buyer.
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Whatever the structure, the key feature is that the buyer does not hand over any money when they purchase the property. Instead, the buyer will simply make a mortgage payment to you until the property is paid in full. By doing this, you get the purchase price and interest.
The buyer also benefits as they are able to purchase the property even if they cannot qualify for conventional credit. Both parties also benefit from faster closing.
IRS Rules on Owner Financing
Since you are making a loan, when you receive interest from a seller-financed mortgage, you must report it to the Internal Revenue Service on your taxes. When it comes to reporting this type of interest, you must fill out a Schedule B. On this form, you must include information about the buyer. This requires you to include the buyer's name, address and Social Security number.
The buyer is also required to do this on his tax return if claiming a tax deduction.
Consider also: Mortgages & Taxes: What You Need to Know
No Balloon Loans
When setting up an owner-financing arrangement, you also are not allowed to negotiate any owner financing balloon payments. In the past, homeowners could take regular payments for several years then get a balloon payment for the rest owed. The balloon payment would typically fall due five or 10 years after the date of the loan.
With the Frank-Dodd act passed in 2010, balloon payments are no longer allowed. Instead, homeowners using seller financing have to fully amortized the loan, which means that it must be paid in regular monthly installment payments. The risk of buyer default increases as the length of the loan increases as the buyer could stop making payments at any time.
Owner Financing to Avoid Capital Gains
When selling a home through owner financing, you can potentially spread out the capital gains taxes on what you receive. Traditionally, when you sell a home that is not your primary residence, you have to pay capital gains taxes on the amount in the same year.
Long-term capital gains tax applies if you held the property for more than a year. The long-term capital gains tax rates are 0 percent, 15 percent and 20 percent, depending on your income, in 2021 and 2022. However, since owner financing spreads out the sale of your home over several years, you only have to pay for capital gains taxes on the principal that you received that year.
Consider also: Deducting Mortgage Interest on a Second Home