On June 21, the Internal Revenue Service issued an interpretive bulletin, clarifying the uncertainty that existed in the area of the "zero-based mortgage."
It was recently reported in this column that the Internal Revenue Service had not yet given a definitive ruling, so the home buyer (and seller) entered into this kind of transaction at his or her risk.
In its bulletin, however, the Internal Revenue Service decided that the home buyer is permitted to deduct a 10 percent per year interest on these zero-based mortgages.
Here's how the concept works:
Let us assume that the purchase price is $119,000. Generally speaking, the developer/seller wants a sizable amount of money as a down payment, and the balance of the sales proceeds are paid off--usually within seven years--in equal monthly installments. The monthly installments are often equal to what you would pay if you were to obtain conventional financing, and, of course, since there is no interest added to these monthly payments, the full purchase price is paid off in a relatively short period of time.
Sales price, $119,000;
Down payment (approximately one-third), $40,000;
Balance owed, $79,000;
Monthly payment, $940.50.
The monthly payment is calculated by dividing the balance owed ($79,000) by seven years, and then dividing that amount by 12 equal monthly payments.
As you can see, under this arrangement, the buyer is able to pay off the house in full within a seven year period. And at first blush, this sounds rather attractive.
Clearly, one of the uncertainties has now been resolved. The Internal Revenue Service has ruled that the home buyer is entitled to deduct the so-called "imputed interest," which currently is 10 percent a year. Under this example, the home buyer would be entitled to a deduction of $1,128.57 each year ($79,000 divided by 7 times 10 percent).
One word of caution must be given, however. According to the Internal Revenue Service, the deduction is permitted only if the itemized deductions are in excess of the taxpayer's "zero bracket amount." The tax law gives each individual taxpayer a flat deduction amount called the zero bracket amount. That amount varies depending upon the taxpayer's status. The amount is $2,300 for unmarried individuals and heads of households, $3,400 for married individuals filing jointly and surviving spouses, $1,700 for married individuals filing separately, and zero in any other case. Since each individual taxpayer receives the benefit of a zero bracket amount in the tax return, a taxpayer who itemizes deductions must reduce these itemized reductions by the amount of the applicable zero bracket amount.
In other words, to take advantage of the itemized deductions, they have to exceed the amount permitted by the zero bracket amount.
Accordingly, this puts the "zero-based mortgage" in a much better light and, for many home buyers, it may be a very attractive alternative to conventional financing. But, let's review some of the consequences of this "zero-based" mortgage. First, you are usually required to put down a sizable amount of money, in this case, $40,000. That is a lot of money to put down for a house purchase.
If you were to obtain a conventional mortgage, it is possible that you would only have to put down 5 or 10 percent of the prize. If you are able to get a 10 percent down mortgage, you would need only $11,900, and would be able to keep the $28,100 difference. That money could either be deposited in a money market fund, or at least you would have cash available for vacations, furniture or the like.
The second major problem with zero-based mortgages is whether the developer/seller, by offering this kind of financing, has actually increased the sales price to accomplish the transaction. Many developers have raised their prices, and thus the buyer may end up paying much more for the house under this type of transaction than if he or she were to obtain conventional financing.
More important, in today's marketplace, it is possible that if you obtain conventional financing, you may be able to get a better deal from the seller on the price. In other words, under a zero-based mortgage, the developer is not getting his cash up front, whereas he would be getting most--if not all--of the cash if you obtained financing elsewhere. Money talks, and you would probably be able to negotiate a discounted price below the $119,000 in our example.
You should carefully analyze a zero-based mortgage. It now makes a little more sense, with the recent Internal Revenue Service ruling. However, only you can "do the numbers," and you are advised to carefully analyze the situation before you sign a contract.
It should also be noted that some non-developer/sellers may also be able to offer this zero-based mortgage when they sell their house.
For example, if a seller was to obtain a sales price of $119,000 and if the seller's existing mortgage (if any) was less than $40,000, the seller could use the $40,000 received from the buyer to pay off the mortgage, and the $79,000 balance owed would be taken back by the seller in the form of a first trust on the property.
Sellers should be advised, however, that the imputed interest concept applies equally to them. Whereas the buyer is entitled to deduct 10 percent of the payments, the seller must report as ordinary income 10 percent of the monthly payments.
It should also be pointed out that where a purchaser is involved in a zero-based mortgage, the tax basis in the house must be reduced by the amount of interest imputed. In other words, when the purchaser pays $119,000 for this house, at the end of seven years, the purchaser will be required to reduce this basis by the amount of the interest deducted. In round figures, since 10 percent of $79,000 is $7,900, the new basis for tax purposes will be $111,100.
What this means in practical terms is that when the buyer ends up selling the house, he or she may have to pay a capital gains tax on this greater amount.
But you should review all of these factors with your tax advisers before you enter into any such transactions.