If you’re unfamiliar with seller financing (also known as owner financing) in real estate, there’s no need to worry—it’s a straightforward concept.
What’s more, it could be a savvy method to save on taxes when selling your home or investment property.
What Exactly Is Seller Financing?
Seller financing occurs when the seller serves as the lender. Instead of the buyer securing a loan from a bank, they make a down payment and borrow the remaining amount directly from the seller, who holds a promissory note—similar to a bank.
Why Would a Seller Ever Do That?
Seller financing can be a fantastic option for homeowners with little or no mortgage left, especially if they expect to incur taxes on capital gains that exceed the Section 121 Exclusion. For more details, refer to our article on this exclusion.
Here are a few reasons why some sellers opt for this approach:
- Flexibility: The repayment schedule is negotiable, allowing the buyer and seller to agree on the loan duration.
- Tax Perks: If payments are spread out over several years, it’s classified as an installment sale, which allows the seller’s tax liability to be distributed over time rather than paid all at once.
- Extra Income: The seller earns interest on the loan, similar to a bank, transforming the sale into a long-term investment.
How Taxes Work with Installment Sales
Installment sales are taxed differently than standard home sales. Instead of paying taxes on the entire gain in the year of the sale, the seller pays taxes on each installment payment as it is received. This approach can reduce the overall tax burden each year and potentially keep the seller in a lower tax bracket.
Here’s how to calculate the taxable gain on each payment:
- Determine your total capital gain
- (Sale price – your cost basis – Section 121 exclusion, if applicable)
- Calculate the gross profit percentage
- (Capital gain/total sale price)
- Apply that percentage to each payment
- This reveals the percentage of each year’s payment that is taxable.
Advanced Tax Info: Long-term capital gains (for properties held over a year) are taxed at lower rates than short-term gains. However, the IRS bases this classification on the year of the sale—not when the payments are received.
Thus, if you sell a property less than a year after acquiring it—even if payments come later—it’s still considered a short-term gain and taxed at regular income rates.
When Seller Financing Isn’t a Good Idea
Seller financing may not always be the best choice. Here are situations where it might not be suitable:
- You’re an investor or absentee owner: You will still need to pay all depreciation recapture taxes in the year of sale, even if you’re spreading out the capital gain.
- You still owe a lot on your mortgage: If you can’t pay off your current loan at the time of sale, structuring a seller-financed deal can be challenging.
- You qualify to exclude the full gain: If Section 121 allows you to avoid all taxes on your gain, there’s no advantage to holding the note yourself.
Not Everyone Qualifies for Installment Sales
While seller financing can be an excellent tax strategy, it comes with certain restrictions. You cannot use it if:
- You’re a house flipper or classified as a dealer by the IRS.
- Your total installment obligations exceed $5 million in a year—this triggers interest on your deferred tax, diminishing the benefit.
- You’re selling to a related party—in many cases, and this prevents you from utilizing installment sale treatment.
Bottom Line:
If you’re contemplating selling your property, consult with us about seller financing. It may not be suitable for everyone, but in the right circumstances, it can be an effective way to reduce your tax burden and achieve a steady return on your investment.