Interest vs. Principal - Posted by dave

Posted by Tim (Atlanta) on September 27, 2001 at 13:44:26:

Yes, you might be negatively affected on cash flow. Does the market rent cover the cost of the property? Also, if you are paying 30% above market, are you planning on holding on to the property and hope for appreciation? What happens if you need to sell this property before the appreciation kicks in? You would be stuck with a house that is over leveraged.

I would definitely pass on this one. I like 30% below FMV, not above. If you can get him down to FMV at the 4% you menitoned, then you can look at the deal. Just be sure that the property cash flows.

Interest vs. Principal - Posted by dave

Posted by dave on September 27, 2001 at 13:35:40:

I have a seller who wants 30% above market value for his property, but he will take back the loan and he said he is very negotiable on the terms of the loan. I am trying to negotiate an interest rate of around 4%. I will try to balance the interest rate against the price I wanna pay, but I am wondering, do I pay taxes differently on the amount I pay in pricipal vs interest. Or are there any other ways that I will be affected negatively by this sort of deal.

IRS Imputed Interest - Posted by David Krulac

Posted by David Krulac on September 27, 2001 at 21:06:28:

nice name!
The IRS is way ahead of you. Since interest received,
(like if you’re the seller) is always ordinary income it is taxed at ordinary rates up to 39.6%. On the other hand capital gains, the profit from selling your property, is taxed at 20% for most people. (owner occupied is an exception and can be up to $500,000 tax free, but that’s another story.)

So some people decided to charge high prices for their properties and low interest rates on owner financing to possible move income from the 39.6% rate to the 20% rate. The IRS caught on and started the imputed interest rate, which I think is around 6% now, but don’t quote me. so on any deal where you receive less than 6% the IRS will recompute the interest rate as if it were 6% and take the appropriate tax bite.

Re: Interest vs. Principal - Posted by Dave T

Posted by Dave T on September 27, 2001 at 17:21:00:

To answer your first question, you do NOT pay taxes on either principal or interest payments that you make. Since I suspect this was not your real question, let me say that generally speaking, mortgage interest you pay is deductible but the principal payments you make are never deductible.

Now, your second question relates to the drawbacks of this deal. You don’t tell us what you will do with the property if you buy it, so I can’t get too specific.

Let’s assume that you intend to hold the property for rental income. Let’s also assume that you agree to give the seller a 30% premium over market value for his property, but he has to agree to 100% owner financing at 0% interest for 30 years.

For the sake of illustration, let’s say the property is worth $100K but the seller wants $130K. If you agree to the inflated price and if the seller agrees to your financing terms, then your monthly payment on this property is only $361.11 per month (130000/360). If you can rent this property for $650 per month, do you think your cash flow would be about $150 each month after operating expenses and mortgage payment?

After seven years, you will have paid the loan balance down to $100K while pocketing $12600 in cash flow. If you also assume that the property appreciates at a constant rate of 5% per year, at the end of seven years your property will be worth over $140K.

Now let’s also assume that you sell the property for $140K and net $130K after selling expenses. You pay off your private mortgage and have $30K left in your pocket. That gives you $12600 in cash flow, plus a $30K payday when the property is sold, for a total return of $42600 on your investment (before taxes of course). Not bad for no money down.

On the other hand, if you agree to the inflated price and also agree to a 4% interest rate, your 100% financing will cost you about $611 every month. Your monthly cash flow practically disappears, and your back end profit on the sale drops to around $19K.

While I usually don’t look at properties that are overpriced, great terms on the sale could still make the deal work for you. I realize that I make some optimistic assumptions here too. After all, the rents might not rise as fast as the taxes and insurance increases, operating costs might be higher is later years as major repairs are required, and high tenant turnover could introduce an intolerable vacancy rate to the mix.

Re: Interest vs. Principal - Posted by dewCO

Posted by dewCO on September 27, 2001 at 17:04:33:

At 30% above makret I’d say maybe no down payment and 0% interest for a term of 10 years. Geez there must be something really incredible about tis property for you to even be thinking about buying over market (do you get mineral rights too or something?), when most markets are getting SOFT. The saying is, “You make your deal going in.” This deal wouldn’t seem to fit that criteria.

On second thought, this doesn’t even fit the “you either get price or terms” theory. Don’t know that there are terms enough to cover this at over market. You won’t even be able to get a refi without mortgage insurance until the property appreciates by 40% or more. Yikes!

Tell the seller “Oh, uhuh, really funny, now here’s the deal…”. This person is not motivated (just looking for a sucker) I’d wager, and you should be looking for MOTIVATED sellers.