I often talk about the dangers of owner-financing flip properties, and my message is finally getting heard. Unfortunately, it is heard wrong. I was recently quoted as advising against owner-financing – supposedly it is bad for taxes. No! What I’m saying is:
Owner-financing can create a huge tax problem when you’re selling FLIP properties. Owner-financing RENTAL properties is OK.
Let’s compare these two situations – flips and rentals – and hopefully remove the confusion.
If you’re selling a property (flip or rental) outright, you’re getting the full amount immediately. Your taxes are calculated based on the full selling price. I wrote an article that illustrates taxation of properties sold outright. In contrast, with owner-financing, you’re not getting paid right away. You only collect a down payment, followed by regular monthly payments over several years. If taxes were simple (right!), you would pay taxes only on the money you actually received. In the year of sale, it would be your down payment plus maybe couple more payments – and that’s it. This is not how it works though, and it works very differently for flips and for rentals.
Owner-financing rental properties.
With rental properties, the IRS gives you an option of “installment sale treatment.” It is close enough to being taxed only on the money received, but not exactly so. The real calculation is rather confusing, but for practical purposes, you can roughly estimate taxes by applying your tax rate to the total money you received in the current year. Let’s say your down payment was $10,000 and you had two more payments of $1,000 each. The total is $12,000, and out of that you can expect to pay between $2,000 and $5,000 in taxes.
The key thing to remember is: with owner-financed rentals, you will only owe Uncle Sam a portion of what you collected from the buyer. The money you have not yet received is not yet taxed. Pretty fair.
Owner-financing flip properties.
Not so with flip properties! There is no “installment sale” option when selling flips. Even though you only received a small portion of the total money upfront – mainly the down payment – the IRS taxes you as if you already received the whole amount! Yes, you are being taxed on the money you have not yet received. Yes, it is ridiculously unfair. And yet, it is the law. In my earlier example, the tax you owe in the year of sale can easily be more than $12,000 that you received as the first year payments.
The key thing to remember is: with owner-financed flips, you can owe more money to the IRS in the year of sale than what you collected from the buyer. You can be upside-down!
It does NOT mean that you should never owner-finance flips. It means that you need to do your math carefully and make sure you collect large enough down payment to at least cover your first-year taxes – or be ready to foot the IRS bill out of your pocket.
Are there any solutions to this tax trap?
Yes, there are some. They are not simple however. If you want to learn them – we sell a recording of my advanced 4-hour class “Structuring Owner-Financed Deals for Tax Savings.”