Deadly tax trap: owner-financing flip properties

The fastest way to kill your new real estate business? Owner-financing flip properties.

To illustrate this deadly tax trap, I will give you an example. Andrew’s postcard marketing started to pay off. He got a call from Sheila, a motivated seller who just inherited her late father’s house. Per comps, the house can be sold above $90,000 after some minor work. Sheila, for her part, lives out of town and does not need the hassle. She will sell it for $60,000 that is still owed on the mortgage and walk away.

Andrew can put a quick $30,000 in his pocket – if he fixes the house and finds a retail buyer. However, Andrew does not have the money or credit to buy the house outright and fund repairs. He could wholesale the house to a rehabber, but Andrew (maybe, foolishly) does not want to give up the lucrative profit. Fortunately, Andrew quickly finds Lucas, an anxious buyer who agrees to take the house “as is” for $85,000 and fix it himself. This easily beats the modest assignment fee from wholesaling, and Andrew is happy.

Unfortunately, Lucas’s credit is poor, and he asks Andrew about owner-financing. Leaving aside the debatable wisdom of owner-financing to a bad credit buyer, Andrew has a bigger obstacle: paying off Sheila. Being a resourceful guy and having attended many real estate seminars, Andrew comes up with a creative solution: take the property subject-to from Sheila and flip it to Lucas on owner financing. To his delight, Sheila agrees.

This is how the math works out for Andrew. Lucas will pay him $5,000 cash up front, and the remaining $80,000 over 10 years. At 10% rate interest, it’s a little above $1,000 per month. Sheila’s father had 7 years left on his mortgage, and his monthly payment was just above $700. In other words, Andrew gets $5,000 cash right away, with at least $4,000 left after paying for paperwork etc. After that, he gets $300 cash flow per month for 7 years, and then $1,000 per month for 3 more years. All of that – for zero money out of pocket and hardly any work. Sweet!

Now, who would walk away from this juicy deal, may I ask? Answer: anybody with a basic understanding of IRS taxes.

Here is the deadly trap I was referring to: the IRS will tax Andrew on his entire profit immediately, even though Andrew will be receiving his money over the next 10 years (assuming Lucas pays as promised, of course.) Per IRS math, Andrew’s profit is $85,000 minus $60,000 equal to $25,000. Since this is a flip property and NOT a rental property, Andrews owes his regular income tax on it (commonly 25%) PLUS the self-employment tax which is Social Security and Medicare tax, roughly 15%. Together, the combined tax can be as high as 40%. Now figure 40% of $25,000 – it is $10,000! Yes, Andrew owes the IRS $10,000 right now, this year. His down payment, as you remember, was only $5,000. Where will he find the other $5,000 or $6,000 to pay the IRS?

Do couple more “great” deals like that, and now Andrew is in the hole for $30,000 owed to the IRS, with only $15,000 collected as down payments. He has absolutely nothing left to pay his bills, and he STILL owes the IRS $15,000. Plus interest and penalties to the IRS. Plus the cost of the inevitable divorce.

Please notice that we’re specifically discussing flip properties. If we were talking about rental properties, I would have totally approved owner-financing. When selling rental properties, an investor pays taxes only on the money he already received – a completely fair approach, known as an installment sale. Besides, self-employment tax would not apply to sale of rentals. However, selling flip properties with owner financing can be a deadly tax trap for a new investor. If you want to do it anyway, at least do your math and make sure you collect down payment high enough to cover IRS taxes.

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