Sunday, May 16, 2010

#1 Reason to Offer Seller Financing

1 - to sell your property more quickly, by appealing to a larger pool of prospective buyers.

If you have to sell in today's market, for whatever reason, then you can command a higher purchase price, attract more buyers, defer taxes indefinitely, and create a passive income stream without having to put up with tenants - simply by offering seller financing on your property.

Which sellers can offer seller financing?
- Sellers who own property free and clear
- Sellers with equity in their homes
- Sellers with assumable mortgages
- Sellers with no equity, who are willing to sell their properties "subject to" the existing mortgage
- Sellers who are planning to lease, with the option to purchase at some point in the future when their buyer can qualify for a mortgage.

Let's look at each of these situations separately, in this and subsequent blogs, as we explore the advantages (and disadvantages) of selling on an owner's contract.

First, let us look at the seller who bought their property for cash, or who has lived in it long enough to have paid off the mortgage. A seller who owns their property free and clear has a great deal of flexibility in how to sell their property. By offering creative financing, they will earn more money over time, sell for a higher purchase price, and create a dependable income stream, secured by real estate.

If a seller can, in effect, become the bank for their buyer, they can determine what criteria the buyer must meet in order to receive financing. A buyer that does not have to rely on qualifying for bank financing is more likely to offer a higher price for the property. The seller can set the interest rate at a percentage or monthly payment amount that meets their needs for living expenses.

In the case of an elderly seller, there are several advantages to receiving payments rather than a lump sum of cash for their property. If the sale would normally be subject to capital gains tax, an owner can defer paying those taxes by deferring the amount of principal paid by the buyer. If the buyer makes a low down payment (principal? or pre-paid interest? this can be negotiated by buyer and seller, depending on their needs for various tax reasons) and makes interest-only payments, then capital gains tax can be deferred until principal is paid. If the payments are amortized and include principal, then the seller pays capital gains tax only on the principal as it is received.

An elderly seller with medical issues may not want to have a large amount of liquid cash in their accounts, as Medicare/Medicaid eligibility is usually not available until those funds are exhausted. If those funds are not available, other than in the form of monthly income, then the seller may still be eligible for medical assistance through these government programs.

An elderly person may want the principal balance to go to their heirs at the time of his/her death, in which case the property may be taxed at a stepped-up basis. All of this estate planning should be discussed with a financial advisor or estate planner to determine the best course of action for a seller facing these issues. For many senior citizens who have lived in their homes long enough to own them free and clear, these are very common scenarios that make the sale of their house on an owner-financed contract more attractive.

The income that a senior seller receives will be taxed as ordinary income. Ideally, this income is enough to cover monthly living expenses, which may include medical costs and/or the cost of an assisted living facility. In effect, a senior seller may be earning interest on money that is technically not theirs, i.e. funds that would normally be paid to Uncle Sam in the form of capital gains tax.

For example, my father recently sold his vacation house that he owned free and clear. I could not convince him to accept seller financing (although I tried!). The next April, when taxes came due, he moaned about how he should have listened to me, as Uncle Sam collected 15% right off the top of his profits. If he had offered seller financing on an interest-only basis, then he would have continued to earn interest on that extra 15% (money that would eventually be due in federal taxes) up until he received any payments of principal. As capital gains tax goes up, this bite becomes even more significant. After 2010, the capital gains tax rate goes up to 20%.

Let's look at a hypothetical example on the sale of a $100,000 house owned free and clear. House A is sold on a conventional cash-out financing; House B on an owner contract, 6% annual interest only, with a balloon payment in 20 years:

House A / House B
Purchase Price $100,000 / $100,000
Down Payment $ 20,000 / $ 20,000
Capital Gains Taxes Pd $ 15,000 / $ 3,000
6% interest only - / $ 4,800
20 yrs of pymts - / $ 96,000
Balloon pymt - / $ 80,000
Cap gains (25%) on balloon pymt / $ 20,000
Total received: $ 85,000/

In this example, the seller of House B has received over twice the income from the sale of his $100,000 house as the seller of House A, simply because he has provided seller financing on the deal!

In a future blog, we'll look at a case where the seller has SOME equity, but still has an underlying mortgage.

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