Seller financed deals can be a win-win strategy for buyers and seller of real estate or businesses. Seller financing means the seller of the asset, whether a business or property, agrees to take payments over time for the purchase price and as a result the seller is financing the sale of the asset to the buyer. This has many benefits for a seller as it only opens up more buyers and hopefully a higher sales price but it also includes a tax incentive to the seller who will get to consider the sale of the asset as an installment sale. An installment sale allows the seller to defer recognition of the gain until the time the payments and the resulting gain are received.
In an installment sale, you report your gain on the sale of asset only as it is received. Each payment will be partially non-taxable as it represents a return of basis (what you invested into the asset) and the taxable part which is your profit (gain, appreciation). So, when you sale an asset on an installment sale you do not pay all of the taxes in the year you sale the asset because you have not fully received payment. Instead, you pay taxes only as you receive payment. To correctly report the taxes, you need to determine what portion of each installment payment is a return of basis versus profit.
To do this, you divide your gross profit (selling price minus basis) by the contract price. For example, say you purchased a property for $100,000 and later sell it for $400,000 under seller financed terms. Since you purchased the property for $100,000, you have a basis of $100,000 (you would also adjust the basis for improvements, depreciation, and other factors) and we are assuming here a contract sale price is $400,000. This gives you a gross profit of $300,000 (selling price minus basis). You then divide your gross profit of $300,000 by the $400,000 contract sale price, which equals 75%. You then take this 75% and apply it to each payment to determine which portion of the payment is taxable. This makes sense because each payment you receive, in this example, equally consists of a return of your basis, which is not taxable, and a payment towards the gross profit, which is taxable. To finish this example at 75%, if the annual payments totaled $40K, you’d have $30K that is taxable and $10K that is not taxable. If there is interest charged on the amount due that interest portion is also taxable as it is received.
The tax benefit of the installment sale is that you only take a portion of the gain into income each year over time. This gives the advantage of deferring taxes over time and can also keep you in a lower tax bracket on your other income. The major disadvantage is that you do not obtain the sale proceeds immediately and as a result you cannot invest them elsewhere. To counter this, most sellers will charge the buyer interest on the seller financed balance that is due, say 7-10%, to offset the inability to invest the funds immediately. As a seller, you will want to have a properly drafted promissory note as well as a security document that is secured against the asset being sold (e.g. mortgage/deed of trust recorded against the property). Make sure you are collaborating with experienced professionals when selling assets with seller-financing as there are tax considerations and legal protections you want to ensure are being considered in the structuring and documents.