Creative Financing = Creative Tax Headaches

A client called today to have our lawfirm engage in a discussion with his CPA as to tax ramifications for “subject to” sales of homes.    For those of you who have never considered using “creative financing” to sell your home or buy a home, a “subject to” means the buyer takes over the seller’s mortgage obligation but the obligation and the liability for the seller remains in tact.  Below is our opening discussion:

“Dear CPA

Your tax clients  face the age old problem – how to sell a house on which they  can’t find a buyer who wants or is able to pay enough to pay off their mortgage.   Other than Short Sale of the home, which the homeowners have already ruled out for various reasons, the several major options for selling the home are:

1. Rent with an Option to Purchase.    This technique has three main problems for your client:  (a)  it can still leave landlord with too much maintenance responsibility, (b) Landlord may have to pay tax on  rental income; (c)  the home physically depreciates and tax basis goes down and we are just kicking the can down the road when the tax consequences for selling could be even worse.
2. Selling the home by a “subject to” assumption, i.e., not paying off the existing mortgage of the Seller, is another option. We can add various layers of additional security on top of the basic transaction such as requiring the buyer to give us a “pocket deed” or and “escrow deed” and recording a wrap around deed of trust against the title.   Problem #1:   this sale violates the Due on Sale clause in the mortgage and is the most transparent technique that can use.   Title will clearly be in the name of a new homeowner at the courthouse, on the  tax bills that go to the lender, and on the insurance policy invoices that go to the lender.   The frequency of raising red flags to the lender makes this technique uncomfortable for many Sellers.
3. Use a “land trust” or a “Land contract” to accomplish #2 but use some legal camouflage to keep the lender from having it thrown into their face that you have violated the Due on Sale Clause. Also, repossession can be cheaper and quicker than in #2.

Whether we do 2 or 3, buyers always want to claim some deductions and in your tax client’s case he wants to make sure he doesn’t owe any income tax for the monthly payments being made by his Buyer to his mortgage company.

Problems:

1. The Seller’s Mortgage company continues to issue the 1099 or 1098 in Seller’s name and SSN.
2. The general rule for the IRS is that the BUYER must be : (a) on title; and (b) on the mortgage . . . in order to claim a deduction.    In #2 & #3 technically they are on title but still not “on the mortgage”.

The way we have been handling this for the past 20 years or so, and I’ve had no negative feedback from past clients, their mortgage lenders, or their CPAs, is that  we include a provisions like this one somewhere in the legal documents:

‘For and in consideration of the commencement of payments hereunder on or after the closing of equitable title hereunder, by the Purchasers, the payment of the sum of One Dollar ($1.00) cash in had paid, and other valuable consideration, the receipt of which is hereby acknowledged, the Seller does hereby bargain, sell, give, grant, convey, transfer, set over, and assign to the Purchasers all of Seller’s rights, title and interest in and to any tax deductions associated with the ownership of the property or the payment of periodic installments thereon, including the right to claim a deduction for the interest and real estate taxes from the date of closing on equitable title forth. Seller agrees to provide a copy of all statements or annual summaries of interest and principal paid on the first deed of trust mortgage to Purchasers on or before March 30th for the immediately preceding year, together with a statement acknowledging any interest paid by PURCHASER to SELLER under the terms herein for the repayment of SELLER’S equity. Purchaser and Seller agree to report all interest deductions and interest income consistently with such summary which shall be prepared in accordance with the Amortization Schedule provided by the underlying lender identified in Section 2 (B) above, or assigns. Seller agrees to generate and provide new end of year tax statements, 1099’s, and other forms for Purchaser’s interest and related home ownership tax deductions as necessary to supplement those of the lender which may be inconsistent herewith. Purchasers acknowledge that Sellers and/or Seller’s agent have made no representation with regard to IRS recognition of the tax deductions and that there is no warranty from Seller as to same’.

Basically, unless the parties and their tax advisors find an easier way to handle the deal to pass the tax deductions and liability for taxes to the buyers, then they all agree that the Seller will continue to be a “conduit” for taxes, i.e., Seller gets the 1099 every January from the lender, and creates a mirror image of the 1099 to give the Buyer.    Presumably it should be a wash to the seller and ultimately the buyer can claim deductions for payments made to the Seller as Buyer’s mortgage company.

It’s not a perfect world, but like our current complicated tax code, it does = job security for tax professionals.  That does, by the way, exclude this firm!

Charlie