Most of the time we think of seller financing as being provided by the seller when we buy, but when it comes to converting equity into cash flow, seller financing and leasing are the two principal techniques we use. The best thing one can say about seller financing that you provide to a buyer who is buying your house is that there are very few rules except to create a Note or Contract that spells out the terms of the transaction and to find a way to secure it. As a rule, when a seller provides financing, the price can be adjusted to reflect any risk that might be posed by buyer’s with lower FICO scores, and the interest rate can be fiddled according to the degree of motivation of the parties. Additionally, net settlement costs are usually lower when the seller can create the documentation he or she needs.
Under the overall umbrella of "seller financing" we’ll find most of the other creative financing techniques that we can use to increase our cash flow. Let’s start with the way that we can handle interest:
The tax code can be used to increase cash flow to a seller and to increase basis to a seller. Here’s how. When a person is selling a personal residence within 3 years of being vacated that still qualifies for tax-exemption under IRC Section 121 interest will be taxed at ordinary income tax rates, but net gain up to $250,000 per person will not be taxed at all.
Let’s say that a $350,000 house is being sold and that all of the loan proceeds would be tax free. If it were sold with a down payment of $10,000 and a married seller carried back a $340,000 loan at with an 8% interest rate with interest-only payments of $2267 which ballooned in five years, the interest would be taxed as ordinary income.
But suppose the price were boosted to $340,000 plus the sum of 60 payments of $2267, or $476,000 at zero interest; so long as interest wasn‘t imputed to the transaction, there would be no tax to the sellers. All payments would be tax free. From the standpoint of the buyers, their taxable basis would be increased as well, reducing their taxes when they in turn sold the house.
This same approach can be used with any property that is sold even when it doesn’t qualify for the Section 121 tax exemption. The principal paid to the seller would be taxed at capital gains rates that peak out at 15% rather than at maximum ordinary income rates that are more than twice as high.
When buying a house from a seller, structuring interest-only terms reduces the monthly payment a little and provides more cash flow from rents, but it poses the threat that the buyer won’t be able to come up with a balloon payment if it comes due at a time when the buyer can’t get a loan. The way to offset this is to build in a "penalty" clause into the Note or Contract that states that the loan due date can be extended 1 year upon payment of 10% of the principal balance of the loan. In effect, this makes gives the payor interest deductions for the initial period of the loan, and extends the loan out 10 years past the original due date.
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