If you’ve disposed of your house or any other asset and you’ve helped finance the purchase on a sell-refinance mortgage, you will also have to declare any money earned through this sale. Because there are a lot of potential buyers who will not qualify for receiving a loan from banks, seller financing is often accepted by sellers who wish to receive income regularly. But, Wells Fargo Bank states that both the purchaser and vendor have obligations with respect to interest income tax, or any deductions relating to such a transaction.
What is seller financing?
Seller financing, which is also referred to as owner financing, is the case when the seller of a property agrees to extend credit to the buyer for the purchase of the property rather than the buyer obtaining a loan from a bank or a lending institution. To put it simply, the seller becomes the lender and the buyer shall repay the seller in a series of payments, most often with interest. Such an arrangement can work wonders for both parties, more so if the buyer is unable to get financing or the seller is in a hurry to sell the property without the hassle of securing a mortgage.
As in the case of normal lenders, in a seller-financed mortgage the seller retains the title to the house until the very last penny is paid off the loan. The buyer also makes regular payments that include principal and a certain percentage as interest like any other conventional mortgage. Both the seller as well as the buyer have to include the interest aspect of the payment cycle to the IRS due any tax considerations for the two parties.
Reporting Interest Income as the Seller
As the seller, you are responsible for reporting any interest received from the buyer in your federal tax return, in particular, the addition of interest being income to your Schedule B (Form 1040 or 1040-SR), which is for purposes of listing interest and ordinary dividends among others. You will also be required to furnish the name, address, and social security number (SSN) of the buyer on the Schedule B form. This is of utmost importance as the IRS requires that to confirm the interest income that you are presenting n reporting to them with interest deduction of the buyer, the buyer’s details are provided for clarifications.
The buyer as well SSN on your repayment can attract $50 penalty. In case the buyer with holds the social security number, you should still ask for it, in writing. You should have a copy of the seek the number portion, in the event you lose the number, the IRS may require evidence that you made the effort to obtain the number. Besides that, if for example, the buyer will claim the interest paid on their tax return, the IRS will also check if the buyer reported the same amount of interest paid to the seller.
What the buyer needs to do
For the buyer, the interest portion of their payments may be deductible, just like the interest paid on a traditional mortgage. The buyer can generally deduct the interest if the loan is secured by the property, and the property is their primary or secondary residence. The buyer will report the interest paid on Schedule A (Form 1040) if they itemize their deductions. The amount deducted should match the interest income reported by the seller, and the buyer will also need to provide the seller’s SSN on their return.
Original issue discount (OID) and other complications
Seller-financed mortgage deals may present a number of unique tax issues that also apply when settling the debt for the property and in particular original issue discount (OID) and accrued interest. OID arises where a loan is made at a discount with respect to its actual face value. In this instances such OID shall be treated as interest by the seller for tax reporting purposes and an offsetting deduction claimed by the buyer in most cases.
Further, where a buyer makes a payment after its due date and incorporates accrued interest, the seller is also required to report the accrued interest as part of income earned. Also, this interest can be deducted by the buyer where the mortgage interest deduction is available to him/her.
For further clarification on these particular situations, please check IRS Publication 550, which is dedicated to investment incomes and expenses, and provides additional guidance on how to report income earned from sеller-financed mortgages, debts, and their applicable interest. In addition, the 2023 Instructions for Schedule B clarify the process of reporting interest income, and highlight some of the errors most commonly made in this regard.
Potential penalties
If you fail to report the interest income correctly or do not include the buyer’s SSN, the IRS may impose penalties. As previously mentioned, the penalty for failing to provide the buyer’s SSN is $50. Additionally, underreporting your income can result in further penalties and interest on the taxes owed. The IRS takes underreporting of interest income seriously, as it often leads to discrepancies between the seller’s and buyer’s tax returns.
Final note
Seller financing can be an advantageous option for both buyers and sellers, but it comes with specific tax reporting obligations. As a seller, you must report any interest you receive on Schedule B and provide the buyer’s name, address, and SSN. The buyer may also deduct the interest if they meet the requirements for mortgage interest deductions. Ensuring proper documentation and compliance with IRS rules will help you avoid penalties and keep the process smooth for both parties involved.
For more detailed instructions and guidance on how to handle specific situations, consult IRS publications and the Schedule B instructions.
