Seller Financing – a Solution to the Jimmy(ie) Problem
One of my clients, Jimmy, came to see me the other morning.Â He owns a property free-and-clear worth $225,000.00.Â He bought it 10 years ago for $100,000.00.Â He has an interested buyer.Â They have preliminarily agreed to a discounted price of $175,000.00, but the buyer needs 100% seller-financing.
The problem?Â Theyâre fighting over the terms of the seller-held note.Â Jimmy is offering a 7-year interest only balloon note at 10%.Â The buyer is balking and theyâre stuck.Â Jimmy needs my help.
I explain that the interest rate on the note is not the only problem.Â Jimmy has a potential tax problem as well.
I suggest that if they bump the price up to $210,000.00 and lower the interest rate to 4.5%, it will be much better for both parties.
Jimmy chokes on his donut.
Thereâs a yummie old-fashioned ice cream stand around my house.Â Every time I take my girlfriend and our kids there, however, we fight in the car.Â I like to eat my ice cream with jimmies on it.Â The kids, however, always tell me not to embarrass them by ordering jimmies.Â Instead, Iâm supposed to order sprinkles.
Iâm so confused by this when I go up to the little window to order, I always end up stumbling on myself,
âYes, uh, I would like a vanilla cone. Â And, uh, can you, uh, Â throw those sprinkly jimmie things on there as well.â
Am I committing a confectionary faux pas?
Whenever you convey a property with seller-financing, you must allocate the interest rate and sales price based on both: 1) what the buyer will agree to and can afford; and 2) what best suits your tax needs.Â Â Just agreeing on price and a reasonable interest rate is not enough – you must carefully calculate income, affordability and taxes if you want to craft a win-win transaction.
To use the above example, if the seller and buyer were to agree on the initial terms Jimmy offered, the end result would look like this:
- Jimmy would pay $54,125.00 in federal taxes*.
- Buyer would be paying $1,458.33 per month, and $297,500.00 total for property and loan interest.
However, if we restructure the deal to a $210,000.00 purchase price, and offer financing at 4.5% instead:
- Jimmy would pay only $39,652.00 in federal taxes*.
- Buyer would be paying only $787.50 per month, and $276,150.00 total for the property and loan interest
By properly allocating sales price and interest rate, weâve 1) made the property much more affordable for buyer; and 2) legally manipulated the tax rate on income for the seller.Â Even though the purchase price is higher, buyer wins because:
- He pays $21,000.00 less for the property in the long run
- He pays $700.00 less per month on the loan
- He gets a higher basis in the property (therefore less taxes when he sells)
Seller wins because:
- He gets $15,000.00 in tax savings, potentially more if marginal rates go up which, in this economy, seems likely
- He ends the stalemate – buyer now willing to close
- Buyer default risk much lower because carry costs on loan have been cut in half
The key to success in negotiating these deals is having a good understanding of the difference in tax rates between ordinary income and capital gains income (thereâs other tax considerations, but thatâs for another day).Â Ordinary income is taxed at 30-some% (I used 35% for the above example), while capital gains income is currently taxed at 15%.Â Thus, income on sales price is taxed at 15%, and income on note interest is taxed at 35%.
Jimmyâs buyer is back at the negotiating table, and weâre hoping to close later this month.
There seems to be no consensus as to where these terms came from, or which one is correct.Â Some say âjimmiesâ is a term unique to New England, but Iâm not from New England, so there goes that theory.
After 5 minutes of extensive internet research on this topic, I got bored and gave up.
I did, however, find something very helpful on Wikipedia – in the Netherlands, sprinkles are known as hagelslag.Â So to avoid any further embarrassment for the kids, I will no longer call them jimmies or sprinkles, but hagelslag.Â I can now order with confidence and conviction:
âYes, madam, if you please.Â I would like a chocolate-vanilla twist doused with hagelslag.â
Now THAT sounds delicious.
Tilâ next time, Jeff
*At $175,000.00, taxes are:
$75,000.00 (gain on property [$175,000.00 – $100,000.00 basis]) x 15% = $11,250.00
$122,500.00 (interest payments) x 35% = $42,875.00
Total taxes = $54,125.00
At $210,000.00, taxes are:
$110,000.00 (gain on property [$210,000.00 – $100,000.000 basis]) x 15% = $16,500.00
$66,150.00 (interest payments) x 35% = $23,152.50
Total taxes = $39,652.50
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