Tax on regular house sale vs. tax on owner financing

[baconschteam]

I'm a bit naive, as I've never purchased or sold a house. I know that everybody's tax situation is completely different, but I'm seeking to generally understand the difference in taxes paid in a traditional sale vs. an owner financing situation.

As far as I understand, in a traditional sale capital gains tax is paid on any amount of profit over $250k. There is no ordinary income tax.

If the seller were to owner finance a buyer, any earned interest is taxed as ordinary income, but how does taxing the profit of the sale go? Is there a similar stipulation about a total profit over $250k for capital gains? Maybe I'm having a dumb, I can't seem to figure this out using the Google.

I'm asking this question specifically for a situation where I'd like to optimize the outcome for both the seller and the buyer. It is my wife's grandma. She is moving into an assisted living facility and she'd like to give me and my wife a good deal on her house. I'm trying to do the math to come up with a way that we could pay less than market value and have an unusually low interest rate (maybe 5%?) and she (or her estate) would come out with more in the end. In this situation the house is fully paid off and could possibly sell for $500k in a regular sale, the proceeds of which sale I'm sure would not be invested with growth in mind. Outside of the sale of the house she does seem to have enough money to live on for the foreseeable future—she does not need the money right away.

[secondcor521]

Your relative has to meet a few conditions in order to exclude $250K of gains.  Basically she has to have owned and lived in the home for 2 out of the last 5 years and not taken the $250K exclusion on any other home sale in the last two years.  There are more details and it gets more complicated if she ever used the home for business or rental.  See IRS Pub 523 for details on this.

In calculating gains, she can subtract for certain transaction fees (such as realtor fees) and permanent improvements.  These are also discussed in IRS Pub 523.  If she owned the home with a spouse before they died (a common scenario), that also can affect things.

You're right about seller financing interest being taxable as ordinary interest in the year received.  She has to charge you at least the IRS minimum interest rate; if she doesn't the math gets harder.  The minimum rates are called the federal AFRs and you have to look them up in an obscure notice somewhere.  The rate you should use depends on the length of your financing deal.

The scenario you're talking about is called an installment sale.  Any taxable gain after the $250K exclusion that is received after the year of sale is basically prorated.  So if she paid $50K for the house, sold it to you for $550K, and you had a five year contract that you paid evenly, she would recognize ($550K - $50K - $250K) / 5 = $50K of the taxable capital gain per year.  See https://www.irs.gov/taxtopics/tc705 and https://www.irs.gov/pub/irs-pdf/f6252.pdf

If she sells you the house significantly below market value then she would probably have been deemed to have given you a gift for the difference.  If more than $18K x 2 then she would probably need to file a federal gift tax return.  No tax would be due but it would cut into her lifetime exemption.  Not a problem unless she will have a multimillion dollar estate; most people don't.

The seller financing for her would work essentially like a bond, which would probably be reasonable for a grandma moving into assisted living, especially if she is risk averse.

[baconschteam]

Her husband died about 3 years ago and since then it’s been her house. They purchased the house in 1966 for $25k.it has never been used as a business.

If it would possibly sell for $500k and we bought it for $400k would that be considered a gift? Would there be somebody who would actually have to appraise the value of the house in a private party transaction? I feel like the savings in real estate agent and other fees could come close to justifying such a price adjustment.

[secondcor521]

Was he an owner of the house when he died?  What state is the house located in?  There is probably a step up in basis on at least half of the house to the FMV on his date of death.  That basis step up plus the $250K exemption amount if she qualifies (sounds like she does) would probably completely eliminate any capital gains for her.

I'm not actually sure on the rules on selling below FMV and if that constitutes a gift - in your example it might be considered a gift of $100K minus the selling expenses she might otherwise have.  I can see how it might be looked at that way, but I don't know for sure.  Maybe @MDM knows.

If you do elect to structure it as an installment sale, she could forgive $36K of the loan principal per year to use her annual gift exemption if she's willing to do so.  She could do that for multiple years in the future.  So maybe sell it to you for $472K payable $400K this year and $36K the next two years.  Then pay her $3K a month for two years, or not.

In a private party transaction, the appraisal is usually done on behalf of the buyer's lender and paid for by the buyer.  The lender wants to know that the house is actually worth what they're lending on; they want to avoid losing money in case they have to foreclose.  If you're not borrowing to buy, then there probably isn't any need for an appraisal.

[MDM]

I'm not actually sure on the rules on selling below FMV and if that constitutes a gift - in your example it might be considered a gift of $100K minus the selling expenses she might otherwise have.  I can see how it might be looked at that way, but I don't know for sure.  Maybe @MDM knows.

That's called a "gift of equity".  I forget the details, but Gift of Equity: What It Is, How It Works, Taxes, and Pros & Cons and similar internet articles should help.

[secondcor521]

I'm not actually sure on the rules on selling below FMV and if that constitutes a gift - in your example it might be considered a gift of $100K minus the selling expenses she might otherwise have.  I can see how it might be looked at that way, but I don't know for sure.  Maybe @MDM knows.

That's called a "gift of equity".  I forget the details, but Gift of Equity: What It Is, How It Works, Taxes, and Pros & Cons and similar internet articles should help.

Thanks!

[baconschteam]

Thanks for all of this information, very helpful.

After a little research my understanding of the gift tax is that it must be reported if it's over $17k/$36k but no taxes need to be paid unless somebody has gifted over $12.9 million in their lifetime? So not something to worry about for most people.

Sorry if I'm being naive here, but isn't it a somewhat regular thing to negotiate on the price of a house and try to find a sweet deal? And if you make/find an undermarket deal Uncle Sam considers it a gift? Like what if I find a run down property that's not on the market and I find the owner and they agree to sell it to me for cash for cheap because they're in another state and don't care about it or something... would they have to report this as a "gift of equity"? Doesn't seem.. right. Also, grandma (or her estate) in this situation will wind up with more money in the end than a traditional sale at the market price, even if the "sale price" is $100k less.

[secondcor521]

Thanks for all of this information, very helpful.

After a little research my understanding of the gift tax is that it must be reported if it's over $17k/$36k but no taxes need to be paid unless somebody has gifted over $12.9 million in their lifetime? So not something to worry about for most people.

It's $18K per person per year this year; the number goes up with inflation.

And it's $13.61M lifetime for people dying this year.  If the law doesn't change, that will drop to about $7M in two years.  If she passes away in 2026 with an $8M estate, her estate would owe federal estate tax (because $8M > $7M).  And there could be state estate or inheritance taxes at lower numbers.  But again, this applies to very few people.

Sorry if I'm being naive here, but isn't it a somewhat regular thing to negotiate on the price of a house and try to find a sweet deal? And if you make/find an undermarket deal Uncle Sam considers it a gift? Like what if I find a run down property that's not on the market and I find the owner and they agree to sell it to me for cash for cheap because they're in another state and don't care about it or something... would they have to report this as a "gift of equity"? Doesn't seem.. right. Also, grandma (or her estate) in this situation will wind up with more money in the end than a traditional sale at the market price, even if the "sale price" is $100k less.

It is regular to negotiate on the price, but most transactions between strangers are not at below market values because most sellers will market the property and take the best deal they can get, not the first deal that comes along.  Also, most sellers, even if they like their buyers, won't give their buyers a deal just because they like them.  Neither of those apply to your grandma situation AFAICT.

As mentioned, it would be reasonable for your grandma to discount the sales price from market by the selling costs she would avoid...but if you discounted by much more than that she and you may run afoul of the IRS.  I really doubt you can come up with $100K of selling costs she's avoiding.  Will you be caught?  Probably not, but it's up to you if you can sleep at night in that scenario.  It's also not that hard to do it by the rules - see next paragraph.

As alluded earlier, you can probably structure an installment deal where your grandma sells it to you for $472K, $400K this year and $36K a year for the next two years, and then she chooses to forgive whatever amount she feels like up to $72K.  Probably no capital gains taxes, no gift tax return, and you effectively get the house for $400K.  There's the niggling detail of interest at the AFR for those two years, but that shouldn't be much and you could probably massage the deal to handle that aspect also.

Given the unusual situation and your being new to the tax rules, I'd strongly suggest getting in touch with a local tax preparer who can guide you and your grandma on the numbers and the rules.

[MDM]

See Form 709 if the plan is to buy the property for less than (Market Value - $36K).  In that case, at least some minimal entries will be needed, and as you noticed the estate tax limit of $13 million means that nobody will be paying any gift tax.

Assuming grandma's child who is wife's parent is still alive, this will be a "generation skipping" gift, it is possible that Generation Skipping Transfer Tax (GSTT) entries will also be needed, even if no GSTT is owed.  I don't know, but you should find out.  A random CPA may or may not know either.

Grandma is the one who would need to file the form.  Having the house sell for the highest reasonable market value (i.e., the amount you pay plus the gift of equity) increases the amount you can eventually sell it for and owe no capital gain tax.  Considering that, you might tell grandma that you'll pay for someone to do her taxes, at least for the first year or two.

[SeattleCPA]

Your relative has to meet a few conditions in order to exclude $250K of gains.  Basically she has to have owned and lived in the home for 2 out of the last 5 years and not taken the $250K exclusion on any other home sale in the last two years.  There are more details and it gets more complicated if she ever used the home for business or rental.  See IRS Pub 523 for details on this.

In calculating gains, she can subtract for certain transaction fees (such as realtor fees) and permanent improvements.  These are also discussed in IRS Pub 523.  If she owned the home with a spouse before they died (a common scenario), that also can affect things.

You're right about seller financing interest being taxable as ordinary interest in the year received.  She has to charge you at least the IRS minimum interest rate; if she doesn't the math gets harder.  The minimum rates are called the federal AFRs and you have to look them up in an obscure notice somewhere.  The rate you should use depends on the length of your financing deal.

The scenario you're talking about is called an installment sale.  Any taxable gain after the $250K exclusion that is received after the year of sale is basically prorated.  So if she paid $50K for the house, sold it to you for $550K, and you had a five year contract that you paid evenly, she would recognize ($550K - $50K - $250K) / 5 = $50K of the taxable capital gain per year.  See https://www.irs.gov/taxtopics/tc705 and https://www.irs.gov/pub/irs-pdf/f6252.pdf

If she sells you the house significantly below market value then she would probably have been deemed to have given you a gift for the difference.  If more than $18K x 2 then she would probably need to file a federal gift tax return.  No tax would be due but it would cut into her lifetime exemption.  Not a problem unless she will have a multimillion dollar estate; most people don't.

The seller financing for her would work essentially like a bond, which would probably be reasonable for a grandma moving into assisted living, especially if she is risk averse.

+1 to all of the above.

FWIW I think if you guys and grandma skip using a real estate broker and share those cost savings? That seems fair to me and probably would seem fair to other family members too.

But grandma loaning you guys the money at a low rate seems like a really bad idea. First, she shouldn't subsidize your mortgage interest costs by, what, $8K a year? Second, logically, she shouldn't bear the credit risk. Third, she may need the cash proceeds for her living expenses. (What if she needs to upgrade her assisted living to a memory care unit that costs $12K a month?)

BTW I see no tax savings naturally stemming from the installment method accounting. When grandpa died the basis of either 100% or 50% of the house was stepped up due to Section 1014. She can exclude $250K of gain via Section 121.