Tax Aspects of Financing

November 1, 2025 Financing Traditional, resources, Tax No Comments

The Tax Aspects of Financing : how interest payments, debt structure, and property sales are treated for income tax purposes, particularly concerning homeowners and sellers who provide financing.

I. Homeowner Deductions (Mortgage Interest and Points)

The federal government employs tax incentives to encourage homeownership, primarily through the deduction of mortgage interest.

1. Mortgage Interest Deduction (MID): Interest accrued and paid on a mortgage secured by a principal residence or second home is classified as a personal use loan. This interest is deductible from the owner’s Adjusted Gross Income (AGI) as an itemized deduction (Schedule A), thereby reducing their taxable income.

2. Deduction Limits: The ability to deduct mortgage interest is capped by the principal amounts of the debt secured by the residences:

◦ Interest on balances up to $1,000,000 for purchase or substantial improvement mortgages is deductible.

◦ Interest on home equity mortgages (which fund personal or business purposes unrelated to the home) is deductible up to an additional $100,000 in principal.

◦ If a mortgage is refinanced, interest is only deductible on the portion of the new funds used to pay off the principal balance of the original mortgage.

◦ Interest paid on any portion of a mortgage balance exceeding the fair market value (FMV) of the residence is generally not deductible (primarily affecting home equity mortgages).

3. Deduction of Points (Prepaid Interest): Mortgage points are considered prepaid interest and may be deductible.

◦ For a purchase-assist mortgage on a principal residence, if points are paid by the buyer from separate funds or paid by the seller, they can be taken as a current deduction in the year paid. If paid by the seller, the buyer is deemed to have received cash back to pay the points.

◦ If the mortgage is secured solely by business or rental property, points must be deducted over the life of the mortgage (life-of-loan accrual).

◦ If permanent financing pays off a short-term balloon note, the points paid on the permanent loan may be immediately deductible if the permanent loan was considered “in connection with the purchase”.

II. Seller Financing and Tax Deferral (Installment Sales)

Seller financing, known as an installment sale or carryback financing, allows the seller to diminish the immediate tax impact of the sale by deferring profit reporting.

1. Profit Deferral: Profit taxes are paid only in the years when principal installments on the carryback mortgage are received. The interest income received on the carryback note is classified as portfolio category income.

2. Profit-to-Equity Ratio: To determine the taxable portion of each payment, the seller establishes the profit-to-equity ratio (the percentage of net sales proceeds represented by the total profit). This ratio is then applied to all principal received (down payment, monthly installments, and balloon payments) to calculate the portion taxed as profit.

3. Avoiding Debt Relief: To maximize tax deferral, the seller must structure the transaction to avoid debt relief. Debt relief occurs when the buyer assumes or refinances the seller’s existing mortgage, increasing the immediate portion of the down payment categorized as taxable profit.

4. AITD for Deferral: To entirely avoid debt relief when the property is encumbered, the seller must remain responsible for the underlying mortgage by using an All-Inclusive Trust Deed (AITD) or a land sales contract (a “wraparound” security device). This allocates a greater portion of the overall profit to the carryback note, thus deferring the tax.

5. Pledging/Modification: If a seller pledges (hypothecates) their carryback note as collateral for a loan, they trigger the reporting of profit allocated to principal equal to the amount borrowed. A seller may also intentionally modify an AITD to shift responsibility for the wrapped mortgage to the buyer, converting the debt to a regular note to engineer the timing of profit reporting to offset losses incurred in that tax year.

III. Interest Reporting on Carryback Notes (AFR)

To prevent sellers from avoiding taxes by setting a low interest rate (which increases lower-taxed profits) and a high sales price, the IRS mandates minimum interest reporting rules for carryback notes.

1. Applicable Federal Rate (AFR): Every carryback debt resulting from a credit sale has an Applicable Federal Rate (AFR) set by the IRS. The AFR dictates the minimum rate of interest the seller must report over the life of the note.

2. Imputing Interest: If the stated note rate is lower than the note’s AFR, the seller must impute (reallocate and convert) a portion of the note’s principal to interest for tax reporting purposes. This is a reallocation intended to shift profits (gains, taxed lower) into ordinary interest income (taxed higher).

3. AFR Calculation: The AFR selected depends on the purchase agreement acceptance date, the term of the note (short, mid, or long-term), and the payment schedule.

4. 9% Ceiling: For carryback sales below a specified inflation-adjusted threshold (e.g., $2.8 million in 2024), the minimum reportable rate is the lesser of the note’s AFR or 9%.

5. Accrual Threshold: If a note’s principal exceeds a set accrual threshold (e.g., over $4,246,200 in 2019), the seller must report interest income annually as it accrues, regardless of when payments are actually received.

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To simplify the dual nature of these tax consequences, consider the system as a financial seesaw.

The borrower is primarily concerned with the interest (the deductible weight) that lowers their taxable income.

The seller is primarily concerned with controlling the allocation between principal (the deferred weight, taxed later as lower capital gains) and interest (the current weight, taxed immediately as higher ordinary income).

Tools like the AITD or AFR rules dictate exactly how this weight distribution is calculated and reported.