When you negotiate the terms of that creatively financed home sale or purchase you're planning this fall, don't forget to add a crucial ingredient that's often overlooked: taxes.
Accountants and attorneys active in real estate around the country say that the most common shortcoming they're seeing in seller-assisted and builder-financed "buy-down" plans this summer is a lack of tax savvy.
Home buyers, for example, routinely assume that the lower the interest rate they can squeeze out of a seller, the better off they'll be. But that's not necessarily so, particularly in a period of declining interest rates like we're in right now.
Sellers, on the other hand, commonly assume that the higher the price they get from a purchaser, the better off they'll be.
Income-tax factors can turn a seemingly clever transaction into an unnecessarily costly one. They can also spell the difference between a family being able to qualify for the monthly out-of-pocket costs of buying a new house or being frozen out of the market altogether.
"Think taxes at the negotiating table -- not just mortgage money and price," advises Ernest Fleischer, a prominent Kansas City tax attorney. "And think about the other guy's tax position, not just yours." That should open up the negotiations to better terms overall for you (and maybe even for both of you).
Fleischer says the subsidized interest rates that are part of most new and resale home transactions today have potential tax consequences that shouldn't be ignored in negotiations.
The below-market financing concessions offered by builders, for example, are often capitalized and tacked on to the selling price of homes. What would otherwise be a deductible item for buyers -- their interest expense -- is converted instead into a non-deductible capital item.
Fleischer's rule of thumb is that for each percentage point of of subsidization of the interest rate provided by the builder, the selling price may be adjusted upward by seven percent over the property's true, all-cash evaluation.
(Fleischer's rule involves calculation of the "present value" of the annual rate subsidy in a 15 percent market over a period of 12 years.)
If the cash value of a new home were $100,000, in other words, a builder who bought down the long-term fixed rate of a purchaser six months ago by three points -- say from 16 to 13 percent -- might have sold the house for about $120,000. The padding of the rate discount onto the true cash price probably wouldn't have been disclosed. Federal truth-in-lending regulations don't require it.
What looked like a good deal on the rate to the buyer six months ago, however, doesn't look quite as attractive in light of today's falling rates. Mortgages with adjustable-rate features are readily available in the 13 percent range or below. They cost little or nothing in extra capital outlays up front.
The buyers paid a price inflated by 20 percent to compensate for the cost of long-term capital in a 16 percent market. The $20,000 up-front interest-rate premium can't be deducted on the buyer's taxes, however, because it was never labeled as interest. It can't be written off, nor can the buyer refinance the deal to "wash out" the excess cost of money he's built in. In today's market, the $20,000 would be hard to recover in the event of a quick resale.
Had the buyer pushed the builder harder on price -- and calculated the padding he was getting stuck with -- he probably could have ended up closer to the $100,000 cash value of the property. He might have had a slightly higher mortgage rate -- all tax deductible -- but avoided the non-deductible financing premium he paid. Most likely he would have also limited his down payment to around $10,000 (at the $100,000 price), rather than having to pay $30,000 to qualify for the same size loan (but on a house priced at $120,000).
The extra $20,000 in down payment could have been working for him today in an investment, ideally a tax-exempt security yielding 14 percent or higher. Instead, his $20,000 is working against him, and may even result in higher local property-tax assessments.
All of which demonstrates, in Fleischer's view, that cut-rate financing can indeed carry too high a price--both before and after taxes.
Unless the buyer is certain he or she is getting a true discount off the cash value of the house -- not simply converting a deductible expense into a non-deductible premium -- the mortgage subsidy may not prove to be worth it.
Another tax factor that consumers should bear in mind is the after-tax income effects on a seller assisting a buyer with a take-back note. The interest to the seller will be treated for federal-tax purposes on ordinary income, not capital gain. That reduces its after-tax cash value to the seller.
By the way, if you're a seller in such a position, don't try to hide those creative-financing interest payments from Uncle Sam. The IRS plans to look hard for unreported mortgage-interest income via special audits this year and next.
If you're receiving interest on a first or second mortgage and not bothering to report it, watch out. You could be hit with an IRS fraud suit. You could even end up in the slammer.