What is the minimum rate that must be charged for owner financing of a mortgage?

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Request for Question Clarification by denco-ga on 11 Sep 2005 19:16 PDT

Howdy smallbusinessjim-ga,

A reminder of the "Important Disclaimer: Answers and comments provided on
Google Answers are general information, and are not intended to substitute
for informed professional medical, psychiatric, psychological, tax, legal,
investment, accounting, or other professional advice."

I have taken this prior question of yours into account for the following.
http://answers.google.com/answers/threadview?id=560785

Also, this area of taxes can be pretty complicated, so you really need to
get a Certified Public Accountant (CPA) involved to draw up such a complex
arrangement to avoid any problems.

I am working on a few assumptions, such as you wanting the deal to be with
as few complications as possible, such as "gift tax" or "below-market" tax
issues. This April 1998 issue of the "CPA Journal" summarizes IRS (Internal
Revenue Service) Code section 7872.
http://www.nysscpa.org/cpajournal/1998/0498/News_Views/NV9.htm

"Also covered by section 7872 are below-market gift loans where the foregone
interest is a gift. These loans typically occur between family members or
friends ...
...
Clearly the IRS has broad authority under section 7872 to treat most
below-market loans as resulting in interest income to the lender at
the applicable
Federal rate."

The bottom line is that if you have a below-market loan, which appears to
include a loan in the form of a mortgage, then the IRS "adjusts" the interest
rate to the current Applicable Federal Rates or AFR.  This rate can be found
on the IRS web site by searching for: "adjusted federal rates" and here is
the link for the September, 2005 rates.
http://www.irs.gov/irb/2005-36_IRB/ar07.html

"This revenue ruling provides various prescribed rates for federal income
tax purposes for September 2005 ..."

The above link provides a chart that is complicated to use, but this article
by Patricia T. Henssler, C.P.A. as presented on the "Henssler Financial Group"
web site and titled "No Such Thing as an Interest-Free Loan" presents what
appears to be an easier, simpler method of figuring out the lowest rate you
possibly can use.
http://www.henssler.com/radio/041902/tax-content.asp

"In the case of a gift loan or demand loan (no stated term for maturity) the
IRS provides a simplified method of computing the foregone interest. This is
called the 'blended annual rate' and can be used to compute the interest on
the loan for the applicable year."

So, if the transaction is set up with a "demand loan," that is, a loan that
is payable on demand, then it appears you can use the "blended annual rate."
A search on the IRS web site on: "blended annual rate" gives us that rate.
http://www.irs.gov/irb/2005-27_IRB/ar10.html

"Section 7872(e)(2) blended annual rate for 2005 [...] 3.11%"

I don't if the above rate has to be adjusted every year to the current year's
blended annual rate, etc.

For some "light" reading, you should check out IRS publication 535, at least
the part that covers "Interest." 
http://www.irs.gov/publications/p535/ch05.html

"If you receive a below-market gift loan or demand loan, you are treated as
receiving an additional payment (as a gift, dividend, etc.) equal to the
forgone interest on the loan."

As this appears to be a very complicated issue, I have to repeat that you
really want to get a CPA involved.  A CPA might find flaws with my analysis
or look at the whole thing and find it to be a trivial problem.

However, if the above gives you enough information to at least provide you
some jargon to use with a CPA, or enough general information to get you on
the right track, please inform me as such, so I can post this as an answer.

Thanks!  denco-ga - Google Answers Researcher

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Clarification of Question by smallbusinessjim-ga on 12 Sep 2005 07:55 PDT

Thanks, please post this answer.  There is a lot to get through but it
certainly is a push in the right direction.

Howdy smallbusinessjim-ga,

Greatly appreciate you accepting this as an answer.

A reminder of the "Important Disclaimer: Answers and comments provided on
Google Answers are general information, and are not intended to substitute
for informed professional medical, psychiatric, psychological, tax, legal,
investment, accounting, or other professional advice."

I have taken this prior question of yours into account for the following.
http://answers.google.com/answers/threadview?id=560785

Also, this area of taxes can be pretty complicated, so you really need to
get a Certified Public Accountant (CPA) involved to draw up such a complex
arrangement to avoid any problems.

I am working on a few assumptions, such as you wanting the deal to be with
as few complications as possible, such as "gift tax" or "below-market" tax
issues. This April 1998 issue of the "CPA Journal" summarizes IRS (Internal
Revenue Service) Code section 7872.
http://www.nysscpa.org/cpajournal/1998/0498/News_Views/NV9.htm

"Also covered by section 7872 are below-market gift loans where the foregone
interest is a gift. These loans typically occur between family members or
friends ...
...
Clearly the IRS has broad authority under section 7872 to treat most
below-market loans as resulting in interest income to the lender at
the applicable
Federal rate."

The bottom line is that if you have a below-market loan, which appears to
include a loan in the form of a mortgage, then the IRS "adjusts" the interest
rate to the current Applicable Federal Rates or AFR.  This rate can be found
on the IRS web site by searching for: "adjusted federal rates" and here is
the link for the September, 2005 rates.
http://www.irs.gov/irb/2005-36_IRB/ar07.html

"This revenue ruling provides various prescribed rates for federal income tax
purposes for September 2005 ..."

The above link provides a chart that is complicated to use, but this article
by Patricia T. Henssler, C.P.A. as presented on the "Henssler Financial Group"
web site and titled "No Such Thing as an Interest-Free Loan" presents what
appears to be an easier, simpler method of figuring out the lowest rate you
possibly can use.
http://www.henssler.com/radio/041902/tax-content.asp

"In the case of a gift loan or demand loan (no stated term for maturity) the
IRS provides a simplified method of computing the foregone interest. This is
called the 'blended annual rate' and can be used to compute the interest on
the loan for the applicable year."

So, if the transaction is set up with a demand loan, that is, a loan that
is payable on demand, then it appears you can use the blended annual rate.
A search on the IRS web site on: "blended annual rate" gives us that rate.
http://www.irs.gov/irb/2005-27_IRB/ar10.html

"Section 7872(e)(2) blended annual rate for 2005 [...] 3.11%"

I don't if the above rate has to be adjusted every year to the current year's
blended annual rate, etc.

For some "light" reading, you should check out IRS publication 535, at least
the part that covers "Interest."
http://www.irs.gov/publications/p535/ch05.html

"If you receive a below-market gift loan or demand loan, you are treated as
receiving an additional payment (as a gift, dividend, etc.) equal to the
forgone interest on the loan."

As this appears to be a very complicated issue, I have to repeat that you
really want to get a CPA involved.  A CPA might find flaws with my analysis
or look at the whole thing and find it to be a trivial problem.

Looking Forward, denco-ga - Google Answers Researcher

Good answer.  Well Researched and detailed.

A very good answer. I don't disagree with any of the points. And,
especially, check with a CPA (especially one with real estate
experience) to help guide you. Just a couple of extra thoughts:

The question was about "the minimum rate that must be charged." There
is no minimum rate that must be charged; it's just that if you charge
less than the guidelines suggested above the IRS might come after you
for the imputed interest. Of course you want to avoid this,
but--technically and practically--there's no minimum rate that must be
charged.

Second, a good CPA will be able to provide guidance on how to
structure a deal so that the effective rate is as low as you want,
while still remaining on safe ground vis-a-vis the IRS. Keep in mind,
for instance, that balloon mortgages and these relatively new "teaser
rate" mortgages are perfectly legal (albeit dangerous if the borrower
doesn't know what he/she is doing).

In short, don't mentally lock yourself into a "minimum rate." Figure
out what interest rate works, then structure the deal so that you're
accomplishing the same end result.

Thanks for the kind comments and the 5 star rating, smallbusinessjim-ga.

Looking Forward, denco-ga - Google Answers Researcher