So far in this series, we’ve been taking a look at options available to property owners who acquired their buildings more than 15 years ago.
These are the owners who have the most to gain from a disposition of their assets, but selling has serious tax implications and exchanging can add up to little more than kicking the tax can down the road.
Refinancing at today’s low rates can unlock equity for investment elsewhere, and for some, doing nothing at all is the best strategy. Today we’re taking a close look at another option: the Installment Sale.
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This option is really a hybrid solution to disposing of assets that have little or no debt at the time of the sale.
The owner of the property becomes a lender and finally gets to experience what it’s like to be the bank for a change. In an installment sale, the buyer and seller agree on a price, the down payment and the terms of a senior loan in the form of a promissory note in favor of the seller, secured by a 1st Deed of Trust on the property being sold.
The parties can agree on terms that suit one another without the restrictions or limitations imposed by conventional third-party lenders. The owner has the same opportunity to evaluate the creditworthiness of the borrower, and the collateral for the loan is an asset that he knows well, having owned it himself for many years.
In the event of a default, the former owner takes the property back through foreclosure and is then free to restart the process with another buyer. Many property owners see the installment sale as less risky than exchanging into another property because the asset securing the loan is well known to them. In this day of scarce supply, exchangers are often forced to buy assets in markets and of a type they are not as familiar with as their own properties.
Installment sales are particularly popular with investors who are looking to streamline and simplify their portfolios. As a lender, the former owner has no management responsibilities and none of the maintenance risk that he had as the owner. When the property is sold, all that risk becomes the new owner’s to bear, and buyers today are ready and willing to take it on just to get their hands on a property.
So, for property owners unwilling or unable to take on expensive items of deferred maintenance like roof and HVAC replacements, the installment sale is a good option because they are essentially replacing their rental income with loan payments that carry none of that risk.
In fact, the only significant risk is having to take the property back from a defaulting borrower at a value less than the remaining balance of the loan. This is very unlikely assuming a reasonable down payment was made when the property was sold.
But where does Mr. Taxman figure into the installment sale scenario? The answer to that one is interesting. Essentially, it’s a pay-as-you-go affair. Your accountant gives you the bad news, and then each year you pay a portion of your tax liability equal to the percentage of your gain that you receive.
So, if you accept a 20% down payment and carry the balance, you pay 20% of your total tax liability, plus tax on the principal portion of the loan payments in the same year. The tax must still be paid, but some find it more palatable to pay over time. Interest earned on the loan is taxed as ordinary income just as rental income would be.
If the idea of finding a nice check in your mailbox each month is appealing, then the installment sale might be just the thing for you. You will have to accept the idea that your yield will be fixed for as long as the loan is in play.
Also, the borrower will get the benefit of further price appreciation, but he will also be taking on all the other risk and responsibility that go with property ownership.
Coming Up Next
In Part 4 of this discussion on real estate strategy, we discuss Sale Leasebacks. Continue to Part 4 by clicking here.
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