Question: An aspect of owner financing of real estate transactions I have never seen discussed in the press is the impact of below-market financing on the value of the transaction. Is there an IRS-approved method of evaluating the transaction so that the value of the financing is used to arrive at the "true" sale price? What impact would this have on the distribution of future mortgage payments between interest and principal?
Answer: It is not news that continuing high interest rates have severely depressed the residential real estate market. "Creative financing" was born of the conjunction of home owners anxious to sell to the potential buyers squeezed out of the market -- with realtors, spurred by a compelling desire to survive, acting as midwives.
The mortgage banking industry developed a variety of new kinds of mortgage arrangements, but these have met with only limited success.
So "creative financing" has really meant "seller financing." Generally the home owner carried either the total financing or the surplus over an existing assumable mortgage, at an attractive below-market interest rate.
The lower rate makes it possible to convert a potential buyer to an actual buyer by reducing the monthly payment to some reasonably affordable amount.
The various documents related to the sale may show an unrealistically high selling price. In reality, however, seller financing at a below-market rate (perhaps even a zero rate) simply reflects a reduction in the selling price itself, converted into the form of a low-cost mortgage.
But now we run into income tax complications, as you suggest. If the admittedly overstated contract price of the house is used for tax purposes, the seller may be faced with a larger capital gain than he actually realizes. And the buyer starts with a higher cost basis than the facts warrant.
So the Internal Revenue Service came up with an answer (documented in Revenue Ruling 82-124) applying an "imputed" interest rate of 10 percent to home sales in which there is either no interest stated or the loan calls for a rate of less than 10 percent.
If the mortgage transaction specifies an interest rate equal to or greater than 10 percent, no adjustment is authorized. But for lower rates the contract price of the sale may be adjusted downward to reflect that imputed 10 percent rate.
This has income tax implications for both seller and buyer. The seller can reduce the contract sales price and thus end up with a smaller capital gain to report and pay tax on.
If the seller is buying a replacement residence, the purchase price of the new home can be lower and still permit deferral of tax on the capital gain. And the cost basis of the new home will be correspondingly higher.
The buyer is not immediately concerned with capital gain. But he must start with a lower initial cost base -- the same reduced price arrived at by taking out the imputed interest portion (to which the buyer may add, as usual, closing costs and other capitalized expenses).
After the sale, future mortgage payments must be allocated between interest and principal, using the 10 percent imputed rate.
The seller reports the interest component of each payment as ordinary income; then reports the "profit" portion of each principal payment as capital gain, based on a percentage calculated at the time of the sale.
Similarly, the buyer may claim an interest deduction on Schedule A for the same imputed amount as the seller reports in the form of interest income.
The amount of income to the seller and deduction to the buyer should be computed in accordance with Income Tax Regulations Section 1.483 -- 1(g)(2), Table VII. Your tax accountant or attorney should have a copy.