From any lender’s point of view, being able to have interest earn an after-tax yield that is in excess of the long term inflation rate can create significant compounded profits over time. Sellers often carry back financing in order to be able to sell faster; with greater after-tax profit either from higher rates of interest or from higher than market prices. Conversely, borrowers seek to avoid the ruinous effects of compounding interest and to shelter income – whether in the form of rent or gain – to the maximum extent possible from being taxed.
When conventional financing terms are used to fund transactions, neither buyer/borrower or seller/lender realizes as much profit as they might. Conversely, creative financing can enable both of them to realize a high return with more safety. It makes it possible to distribute tax deductions, timing of payments, costs of interest, cash flow, and ultimate gain between the parties in the ways that suit them best. Thus, both seller and buyer can wind up with more after-tax, inflation-hedged profit than they would have been able to realize had they been content to use conventional financing approaches. In many cases, increased profits result from decreased taxes on income and gain.
How might parties resolve what might seem to be opposing interests in a transaction? Let’s start with sellers who provide the financing on property they sell: Suppose they were to start thinking of profit in terms of “investment yield” rather than “interest”; how might that change the way they did business?
To simplify this illustration, we’ll say that a new free and clear house is being sold whose basis is $100,000. Suppose that the seller were willing to carry back $100,000 in the form of a secured mortgage note. Its terms would include 10% interest-only, payable at $833.33 per month, with a 5-year balloon payment. For the next 5 years both principal and interest on this note would be vulnerable to discount from face value caused by inflation over the period. And each interest payment would be taxed as ordinary income in the seller’s tax bracket. The result would be that, in terms of purchasing power and present value, the seller would wind up with less than the full face value of his note, even though the income tax code would require him to pay taxes as if there had been no inflation.
In the same transaction, the buyer would have a depreciable basis equal to the full amount of the debt, less the value of the land beneath the home. In most markets, paying 10% interest at $833.33 per month, plus taxes, insurance, management, maintenance, marketing, advertising, etc. would result in average negative cash flow to the buyer which could be as high as $200 per month. If this were his only negative cash flow rental, it would be fully deductible, but if he already had $25,000 in excess rental losses, it would not be deductible, but would have to be accumulated until final disposition of the property. How might creative financing be used to improve this situation for both parties?
Suppose, instead of selling the foregoing property and financing $100,000 for ten years with 10% interest-only terms, a seller simply net-leased the property to a buyer for rent equal to 5% of the $100,000 value per annum, or $416.67 per month. He’d couple this with a 5-year Option to buy at $100,000 plus half the annual inflation rate. If inflation were at a compound rate of 10% per year, after ten years, the seller would have received a total of $50,000 tax-sheltered net rent. Operating expenses would be borne by the lessee. Tax on the final payment of $127,628 could be avoided with a tax-free exchange. In the worst case, lower capital gains rate would apply. Assuming a $100,000 basis, in the 28% bracket, conventional financing would have yielded $149,294 after taxes. The lease/Option would have yielded $177,627. So, a “Lessor/Optionor” receiving un-taxed rents will have achieved a higher net after-tax/profit than he would have merely by selling the property on an installment contract. And it would have been inflation-hedged.
