IRS Rules on Owner Financing: A Tax Guide 2024

Latest News and Facts

• The IRS has updated Form 1098 for the 2024 tax year, affecting how mortgage interest is reported in owner financing arrangements.
• In 2023, approximately $28 billion in seller-financed notes were created, compared to $22.5 billion in 2022.
• Rising mortgage rates and stricter lending standards have made owner financing practical alternative financing for many U.S. buyers.

With rising mortgage rates and stricter lending requirements, owner financing has become a practical alternative in real estate transactions. While this option offers flexibility for both buyers and sellers, it also comes with specific tax obligations governed by the IRS rules on owner financing.

This blog sheds light on the key considerations surrounding these rules, helping you understand their impact on owner-financed agreements and why proper compliance is essential for a smooth process. Let’s get started. 

What is Owner Financing? 

Owner financing allows buyers to purchase a house by making monthly payments directly to the seller, bypassing a bank mortgage. This means the buyers must pay a portion of the purchase price, known as a downpayment. They then agree upon terms that have proportions like interest, promissory notes, payments, etc.

Along with all of this, abiding by the IRS rules on owner financing is equally necessary (more on that later).

This is an extremely useful option for buyers who cannot get a bank loan due to various reasons, one of which can include a poor credit rating. It is somewhat similar to buying an asset from a relative or a friend and agreeing to pay for it in parts where you do not make a full upfront payment.

Key Difference Between Traditional Mortgages and Owner Financing

Traditional mortgages involve banks and strict rules, while owner financing is more flexible and handled directly between the buyer and seller. The table below shows how they differ in a more detailed manner. Have a look:

Example of Owner Financing

Let’s say that the price of the house is $300,000, and the buyer’s down payment is $30,000 (10% of the price). The buyer can only qualify for a $120,000 loan from the bank due to one of the many reasons, which is the poor credit score issues, leaving $150,000 unpaid.

This unpaid amount becomes the basis for a seller financing agreement; here, the seller agrees to finance directly through a purchase-money mortgage. Let’s see how it works:

• The seller agrees to step in and cover this $150,000 as a loan to the buyer.
• The buyer makes monthly payments directly to the seller for 10 years at a fixed interest rate.
• After ten years, the buyer must pay a balloon payment (a large final amount) for the remainder of the loan, which is calculated as if it were spread out over 30 years.

It’s important to note that IRS rules on owner financing come into play in such agreements, ensuring proper reporting of interest income by the seller and potential deductions for the buyer.

How Does Owner Financing Work?

Knowing how owner financing works requires breaking it down into clear steps, keeping in mind that agreements often need to comply with IRS rules on owner financing to ensure proper financial and tax handling.

Here’s how it works step-by-step:

Step 1: Decide on the Type of Owner Financing

Initially, the buyer and the seller negotiate over the financing scheme. It may involve a second mortgage, a land contract in which a seller retains ownership until paid in full, a rent-to-own scheme, or a wraparound mortgage where the balance is taken care of by the seller. 

Step 2: Seller Extends Credit

Rather than borrowing money from the bank, the loan is given by the seller himself. Subsequently, the buyer pays the seller by making repayments over a duration agreed upon.

Step 3: Retaining or Transferring the Deed

On some occasion the seller retains the title deed of the property and its ownership remains with them until the buyer pays the agreed amount fully. Or the buyer enters into a legal relationship such as a promissory note (an agreement to pay) or the deed of trust. These enable the seller to regain the property once again in case the buyer fails to make the payment as agreed. The real estate ownership document is given to the buyer only after making all the payments.

Step 4: Duration of the Agreement

Most owner financing agreements have a time-varying between 5 to 10 years, significantly less than the 30 years that most conventional mortgages would take.

Step 5: Upfront Deposit

To show the seriousness of the on-going negotiations, the buyer might be required to put down a down payment at the beginning of the agreement.

Step 6: Payment and Completion

The buyer makes consistent payments to the seller throughout the duration agreed upon. After the total sum is paid, the seller legally hands over the rights of ownership to the buyer.

Promissory Notes and Legal Safeguards

We have already pointed out the situation before where the seller keeps ownership of the property until the full payment has been made. Now, let’s look at the promissory notes and other setting terms for financing that make owner financing safe for both sides.

A promissory note is a simple document that explains the owner financing process agreement between the buyer and seller, ensuring clarity of legal compliance and adherence to any IRS rules on owner financing where applicable. It includes:

• The interest income reporting rate the buyer will pay.
• The amortization schedules, also known as repayment schedules—how much, how often, and for how long the buyer will pay.
• What happens if the buyer stops paying? The seller can take the property back.

Additional Protections and Legal Requirements

To make owner financing agreements more secure and legally compliant, certain additional protections and requirements must be addressed. 

These steps go beyond basic promissory notes to safeguard both the buyer and the seller while also aligning with IRS rules on owner financing that govern aspects like interest reporting and tax obligations.

Key Legal Protections for Sellers

• Check the Buyer’s Credit: Get the buyer’s credit report and do a credit check to see if they can afford the payments. This helps you feel more secure about their ability to pay.
• Verify Employment: Make sure the buyer has a steady job and a good work history. Knowing they have regular income can give you peace of mind about their payments.
• Review the Paperwork: Ask a lawyer and accountant to look over the promissory note and other documents before the deal is finalized. This ensures everything is fair and protects you legally.
• Confirm the Down Payment: Ensure the buyer has enough money for the required down payment at closing. This shows they are serious about the purchase and lowers your risk.

Key Legal Protections for Buyers

• Get the Property Inspected: Hire an engineer to see whether there are hidden defects within the compound, such as major repair works or defects. This helps you avoid surprises after the purchase.
• Check the Title and Get Insurance: Make sure the seller owns the property by doing a title search. Next, get title insurance in order to avoid title questions or to be sued for the ownership of a property in the future.
• Confirm the Property’s Value: A professional appraiser should be hired so as to establish the value of the property. This way, you can be confident that you are paying the correct price for the services you are receiving.
• Have a Lawyer and Accountant Review the Deal: Ask a lawyer and accountant to review all the paperwork, like the promissory note. This ensures everything is clear, fair, and legal before you agree to it.

These protections, along with IRS rules on owner financing, help ensure secure and well-structured agreements. And more, as suggested in each section, offers valuable insights to guide both buyers and sellers effectively.

Benefits of Owner Financing

Owner financing has numerous advantages to both the buyer and the seller of the asset. This is an easy and convenient method of purchasing or selling a property without even involving banks so that everybody gets it quickly.

Advantages of Owner Financing for Sellers

• Sell Faster: Offering owner financing attracts more buyers, especially those who can’t get a loan from a bank. This helps sell the property quickly.
• Get a Higher Price: You can often sell your property for a higher price because of the flexibility you’re offering.
• Steady Monthly Income: Unlike in the other types of businesses where you receive all the money at once, you will be getting paid by the buyer regularly means regular cash inflow.
• Save on Taxes: By spreading the payments over time, you might pay less in taxes on the sale, especially on capital gains.

Advantages of Owner Financing for Buyers

• Easier to Qualify: Owner financing is beneficial when you have bad credit or do not qualify for a bank loan. Sellers are more lenient than banks.
• Flexible Payment Terms: As a buyer, you can always come to an agreement with the seller concerning some aspects, such as the amount of payment to be made, the interest income rates and the period within which the buyer will make the payments.
• Quick Closing: Since there is no need to wait for the bank’s approval, you can quickly close the deal and start living in your new home.
• Save on Costs: Some of the benefits of seller financing include that you do not have to pay for bank processing fees, loan origination fees or appraisals.
• Build Your Credit: The more often you make payments, the better your credit score will be, which means that in the future, you will have a greater chance of obtaining a loan from a bank.

While owner financing offers flexibility and benefits for both sides, it’s important that agreements also comply with IRS rules on owner financing to ensure proper handling of taxes and interest.

IRS Rules on Owner Financing 

It is important for buyers as well as sellers to learn the IRS rules on owner financing so that they can know the process of addressing taxes and declaring or reporting income. Sticking to these IRS regulations on owner financing guidelines will help in avoiding any breach and save you from any future surprises.

IRS rules on Owner Financing for Sellers

• Report Interest Income: The seller has to declare any interest gains from the buyer’s payments as income.
• Installment Sale Benefits: The IRS classifies owner financed sales as installment sales. This means sellers can spread out their capital gains tax over several years instead of paying it all at once.
• Depreciation Recapture: If the property that is being sold was put to use for business or rented and has been depreciated, the sellers have to pay depreciation recapture taxes. This refers to the gain from selling depreciable property, which is taxed as ordinary income rather than at the lower capital gains tax rate. According to the IRS, the seller must declare this on Form 4797. Refer to IRS. For more information, refer to IRS Publication 544.
• File IRS Form 6252: This form must be filled out by sellers to report the income derived from installment sales to the Internal Revenue Service.

IRS rules on Owner Financing for Buyers

• Interest Deduction: Buyers can deduct the interest they pay on the loan, just like with a traditional mortgage.
• Property Taxes: Buyers are responsible for paying property taxes on the home, and these taxes are also deductible.
• IRS Form 1098: The seller must provide buyers with this form, which shows how much interest the buyer has paid. This form helps buyers claim their interest deductions during tax season.

Is There a Difference Between an Installment Sale vs Seller Financing?

When selling a business or property, installment sales and seller financing are two popular options that provide flexibility for buyers and sellers. While these methods share similarities, they have key differences that may make them more suitable depending on the situation.

What is an Installment Sale?

An installment sale is a transaction where the buyer pays for the purchase over time, with at least one payment made after the tax year of the sale. The IRS provides specific rules for installment sales in Publication 537, which allow sellers to spread capital gains tax over the payment period. Interest may also be charged on the remaining balance, giving sellers additional profit.

What is the Seller Financing?

Seller financing, also referred to as owner financing, occurs when the seller plays the role of the lender. A detailed explanation of seller financing has previously been provided. However, to aid your understanding of its difference with installment sales, we are detailing it here again. Whereas seller financing allows for various opportunities depending on the agreement made, most importantly, it is paramount to comply with the  IRS rules on owner financing in order to manage tax obligations adequately.

Similarities Between Installment Sales and Seller Financing

• Long-Term Payment Plans: Both methods involve buyers paying over time instead of upfront.
• Ownership Transfer: Buyers typically take control of the business or property immediately, even before finishing payments.
• Interest Income: Sellers earn extra income by charging interest on the unpaid balance.
• Contracts: Both require legally binding agreements that outline payment terms, interest rates, and conditions.
• Tax Benefits: Sellers may enjoy deferred capital gains tax or other tax advantages depending on the structure.

Owner Financing vs Installment Sale

The decision between an installment sale and seller financing is based on what is best for both the buyer and the seller, as well as the specifics of the transaction. And to make it easy for you, here is the table of differences: 

If the difference is still unclear decide which suits best for you. Plus, if you need help understanding your options and making sure that everything follows the IRS rules on owner financing, Hall’s IRS can guide you every step of the way.

Strategies for Successful Owner Financing

Owner financing can be a great way to buy or sell property, but it’s important to follow the right owner financing strategies to make the process smooth and successful. Agreements should also align with IRS rules on owner financing, which is one of the many best financing compliance tips with tax and legal obligations.

Thorough Due Diligence

Before entering into any agreements, both buyers and sellers should do their homework to protect themselves.

• Credit Check: Sellers should check the credit worthiness of the buyer in order to be certain that he is in a position to afford the payments.
• Property Inspection: Buyers should carefully inspect the property so that they can identify any issues before finalizing the deal.
• Legal Advice: It’s always advisable for both seller and buyer to consult with a lawyer to ensure that all and the terms of the agreement meet state and federal laws, and IRS rules on owner financing.

Clear and Detailed Agreements

A detailed agreement is essential to avoid misunderstandings and keep the process on track.

• Interest Rate: Clearly state the interest rate and how it will be calculated.
• Repayment Schedule: Specify payment amounts, due dates, and the length of the loan.
• Default Terms: Outline what will happen if the buyer misses payments or fails to meet the agreement, ensuring compliance with IRS rules on owner financing for accurate reporting.

Regular Communication

Open and consistent communication between buyers and sellers helps prevent issues and resolve problems quickly.

• Payment Reminders: Sellers can send reminders to ensure payments are made on time.
• Transaction Records: Both parties should keep detailed records of all payments and communications, which can also help ensure accurate tax filings as per IRS rules on owner financing.
• Issue Resolution: Set up a clear plan to address any disputes or problems that might come up during the loan term.

In Closing!

Now that we’ve explored the essentials of owner financing, it’s clear that success lies in careful planning and compliance with tax regulations. Thinking creatively about structuring agreements, such as innovative payment terms or interest arrangements, can add value for both buyers and sellers.

Hall’s IRS is here to simplify the complexities, offering practical solutions that ensure your agreements meet the IRS rules on owner financing while working in your favor. Whether you’re buying or selling, we help make the process simple and stress-free. Get in touch today.