Carrying a Note Can Cost You Big Time


This post is in: Business, Real Estate
2 Comments

08-13-2010-1

One of the hottest creative real estate strategies is, again, seller financing. If the banks cut off the lending (which they largely have), then it’s going to be up to the seller and the buyer to work something out.

This past week my husband Richard told me about one of the prospective clients who had called in. In this case, the creative real estate investor, Warren, was still flipping properties.

The issue was that his buyers couldn’t get financing, so he needed to finance the deals. There are two primary strategies that creative real estate sellers will use in that case:

    (1)Wrap mortgage, and
    (1)Rent-to-own (lease option)

For now, we’re just going to address tax law. But we have to talk about state law that could really limit your choices first. For example, in Texas, lease options require so much disclosure and reporting that they have become almost impossible. Here’s a good perspective from a legal expert on the subject: http://www.nuwireinvestor.com/articles/texas-lease-options-52598.aspx

But, let’s assume that you’re in a state that has state law that still gives you the options. In this case, which is the best one to use?

If you are in the trade or business of flipping properties, you’re going to be considered a real estate dealer by the IRS.

That means any sales are subject to self-employment tax if you’re not in a corporate structure and it also means that you can’t take advantage of something called the “installment sales method” for taxation.

In the installment sales method, if you sell something over time, you only have to pay tax as you collect money. So if you sell your property so that the buyer makes payments to you, then you’ve got a problem if you’re also a dealer. You’ll owe tax on all of the gain from the sale, even if you’re still waiting for the money.

The rent-to-own (aka lease option method) doesn’t transfer title until the option is exercised. That means you’ve got a rental agreement and so there is no tax issue until it sells and at that time, you’re getting cash so you can just pay the tax.



2 Comments

  1. Bob says:

    Hey, very nice blog post!

  2. Jim says:

    Diane great post but I also might add that in addition to a wrap around mortgage and a rent to own situation, you can also sell a house using a land contract. A land contract states the terms of the agreement and once those terms are fulfilled by the buyer they get the deed to the property.

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