Is Seller Financing Right for Your Next Transaction?
The commercial real estate market has been steadily improving since the 2008 financial crisis. While traditional financing is readily available, seller financing may be another viable option for many investors. Here’s what you need to know.
Using seller financing
In seller-financed transactions, the seller generally gives the buyer a secured loan to finance part of the property’s purchase price. Seller financing advantages include:
- Expanding the pool of qualified buyers;
- Fostering greater flexibility when negotiating loan terms; and
- Increasing the chances of producing an outcome that meets both parties’ needs.
A seller-financed mortgage loan is secured by a lien on the property. A seller-financed mezzanine loan is secured by a pledge of ownership interests in the purchasing entity. Sellers might use this type of arrangement to obtain cash to pay for operations or investor redemption requests. A seller can also choose seller financing to raise capital for other business ventures or to generate liquidity for the overall portfolio.
Reviewing seller risks
Sellers must be cautious when entering into such transactions. First, sellers must ensure that they are qualified to become a lender. Reviewing their organizing documents, any joint venture, fund or upper-tier debt agreements and applicable regulatory requirements should help sellers determine if they are allowed to make and hold loans. If needed, sellers can amend some documents to make them eligible to lend.
Sellers must comply with all applicable lending laws, including those related to state licensing, debt collection and securities. They should also assess whether they possess the needed capabilities to originate and service loans. Finally, sellers must determine if the property is appropriate for this type of arrangement. A financially robust property will produce optimal results for the buyer, seller and any third-party lender. However, a property with many vacancies may not generate the returns needed to allow the buyer to pay off its obligations to the seller and lender, let alone reap a profit.
Another consideration is to be sure that any current loan on the property gives the seller the right to prepay without incurring a penalty. The cash proceeds from the sale should be adequate to pay off the existing loan.
Additionally, transactions involving third-party lenders will likely place the seller in the position of a subordinate lender. However, a seller in these circumstances might be able to command a higher interest rate because of its increased risk.
Finally, once a buyer is found, the seller must conduct thorough due diligence to confirm that the buyer is creditworthy. The seller will need to review the buyer’s financial statements, credit history, tax returns and similar records. Sellers should also request banking and business references.
Considering tax effects
Seller-financed transactions have some potentially vexing tax implications. If, for example, the seller is a real estate investment trust (REIT), it must determine whether the loan constitutes a “qualifying asset” that generates “qualifying income.” A seller-financed loan could jeopardize the seller’s status as a REIT under the Internal Revenue Code (IRC) if the loan is not properly structured.
The IRC’s original issue discount (OID) rules can also come into play if the loan’s redemption price exceeds its issue price. If OID does enter the picture, the seller must recognize interest income, and the buyer must recognize interest expense, based on economic accrual. Under certain circumstances, a seller might be required to pay interest on the deferred capital gains tax liability typically enjoyed under the IRC’s installment sale provisions.
Real estate investors should take the time to review any available seller financing. Address the issues discussed in this article with your financial and legal advisors before making a final decision.
Introducing the Opportunity Zone Tax Incentive
One provision of the Tax Cuts and Jobs Act (TCJA) was designed to encourage economic growth in low-income areas. This new tax break allows investors to defer—or even eliminate—their capital gains taxes on investments in “Opportunity Zones.” Late in 2018, the IRS issued proposed regulations that answer some questions that real estate investors have asked about these tax incentives.
What’s the benefit for investors?
More than 8,700 communities in all 50 states, the District of Columbia and five U.S. territories have been designated as qualified Opportunity Zones. Investors can form private qualified opportunity funds (QOFs) for development and redevelopment projects in the zones. The funds must maintain at least 90% of their assets in qualified Opportunity Zone property, including investments in new or substantially improved commercial buildings, equipment and multifamily complexes, as well as in qualified businesses.
Investments in the funds can bring some impressive tax benefits. Investors may defer short or long-term capital gains on a sale if they reinvest the gains in a QOF. The tax will be deferred until the fund investment is sold/exchanged or December 31, 2026, whichever comes first.
After five years, an investor will enjoy an increase in tax basis for the investment equal to 10% of the original gain. As a result, the investor will pay tax on only 90% of that gain. An additional 5% in basis is added two years later, further trimming the taxable portion of the original gain. When an investment is held in the QOF for at least ten years, appreciation from the purchase date on the QOF investment is completely tax-exempt. In order to take advantage of the full 15% basis increase, investors would need to invest by December 31, 2019. However, a 10% basis increase is still available, as long as the investment is made by December 31, 2021.
What are the relevant rules?
The IRS proposed regulations cover several areas:
- Qualifying Gains
Under the proposed regulations, only capital gains (for example, gains from the sale of stock or a business) qualify for deferral. Investors can defer tax on almost any capital gain up to December 31, 2026. For pass-through entities that have gains, the rules generally allow either the entity or the partners, shareholders or beneficiaries to defer.
- 180-Day Timing Requirement
To qualify for deferral, taxpayers must invest in a QOF during the 180-day period that begins on the date of the sale that generates the gain. For amounts that are deemed a gain by federal tax rules, the first day of the period generally is the date that the gain would otherwise be recognized for federal income tax purposes. For partnership gains that the entity does not defer, a partner’s 180-day period generally begins on the last day of the partnership’s taxable year, which is the day the partner otherwise would be required to recognize the capital gain. If a partner is aware of both the date of the partnership’s gain and its decision not to elect deferral, the partner can begin its own period on the same date as the start of the entity’s 180-day period. Similar rules apply to other types of pass-through entities.
- Expiration of Opportunity Zone Designations
The proposed regulations address questions related to the fact that Opportunity Zone designations expire at the end of 2028, when some gain deferral elections may remain in effect. For example, will investors still be allowed to make basis step-up elections after ten years for QOF investments made in 2019 or later? The proposed regulations permit the election to be made until December 31, 2047. The latest gain subject to deferral would occur at the end of 2026, so the last day of the 180-day period for that gain would fall in late June 2027. A taxpayer deferring such a gain would satisfy the ten-year holding requirement in late June 2037. The IRS explained that the extra ten years are provided to avoid situations where a taxpayer would need to dispose of a QOF investment shortly after reaching the milestone simply to obtain the tax benefit, even though the disposal is disadvantageous from a business perspective.
It is possible the proposed regulations will undergo some significant changes before they are finalized, and IRS guidance on additional related topics is yet to come. Until final regulations are issued, taxpayers can rely on the proposed regulations as long as they apply them consistently and in their entirety.
Sidebar: Spotlight on qualified opportunity funds
The proposed regulations comprise more than just rules for investors in Opportunity Zones. They also tackle several issues related to the qualified opportunity funds.
For example, the proposed rules exempt land when determining whether a purchased building in an Opportunity Zone has been “substantially improved” (defined as doubling the building’s basis). Improvement is assessed solely by additions to the adjusted basis of the building. If, for example, a QOF buys a $1 million property, with $750,000 for the land and $250,000 for the building, it must invest only $250,000 to improve the building.
QOFs also are permitted to invest in qualified Opportunity Zone businesses if “substantially all” of the business’s leased or owned tangible property is qualified Opportunity Zone business property. The proposed regulations specify that “substantially all” means at least 70% of the leased or owned tangible property.
Among other matters, the proposed rules cover self-certification of QOFs and valuation for purposes of determining whether the QOFs are maintaining 90% of their assets in Opportunity Zone property.