This article discusses the impact of rising interest rates on sellers seeking to offer carryback financing arrangements.
Interest rates rise from historic lows in 2022
Real estate professionals and their clients are watching interest rates with concern in 2022. Mortgage interest rates have already increased significantly in the first two months of the year, with the Federal Reserve (the Fed) promising more increases ahead.
Beyond the immediate impact of rising interest rates on home prices, higher rates are also spilling over into other facets of real estate, including carryback arrangements.
Applicable Federal Rates (AFRs) are set by the Internal Revenue Service (IRS) for carryback sellers to impute and report income at the minimum interest when the note rate on the carryback debt is a lesser rate.
In other words, AFRs determine the minimum interest yield reportable on carryback financing.
Carryback financing for tomorrow’s buyer’s market
When mortgage credit tightens, the definition of a “qualified” buyer becomes more restrictive. In these economic conditions, a seller hoping to locate a buyer amenable to the seller’s asking price needs to consider seller financing.
In a buyer’s market, characterized by less buyer competition and decreasing home values, sellers seeking to stand out may consider offering seller financing.
Seller financing is also known as:
- an installment sale;
- a credit sale;
- carryback financing; or
- an owner-will-carry (OWC) sale.
Seller financing occurs when a seller carries back a note executed by the buyer to evidence a debt owed for purchase of the seller’s property. The amount of the debt is the remainder of the price due after deducting:
- the down payment; and
- the amount of any existing or new mortgage financing used by the buyer to pay part of the price.
On closing, the rights and obligations of real estate ownership held by the seller are shifted to the buyer. At the same time, the seller carries back a note and trust deed taking on the rights and obligations of a secured creditor.
For buyers, seller carryback financing generally offers the benefits of:
- a more flexible down payment;
- competitive interest rates;
- less stringent terms for qualification and documentation than imposed by lenders; and
- no origination costs.
Beyond appealing to a wider range of homebuyers seeking a lower interest rate or lower qualification requirements, there are benefits to sellers, as well.
The seller, with a reportable profit on a sale, is able to defer payment of a substantial portion of their profit taxes until the year in which principal is received. When the seller avoids the entire profit tax bite in the year of the sale, the seller earns interest on the amount of the note principal that represents taxes not yet due and payable.
To combat this shift in earnings from interest income to profits on installment sales, which reduces the overall tax on the entire transaction, the federal government set a floor rate for minimum interest reporting on carryback notes — denoted by the AFR. Minimum interest rates limit the extent to which taxes can be reduced, properly called tax avoidance.
If the seller does not carry a note payable in future years, they will be cashed out and pay profit taxes in the year of the sale (unless exempt or excluded).
Higher AFRs impact carryback sellers
A lender or a carryback seller does not need to charge any rate of interest at all, in which case the rate of interest entered is zero.
However, the carryback seller will report interest income at an imputed interest rate, the AFR for the note, when the rate the seller charges is lower than the AFR. When interest is imputed, the principal amount of the note is reduced and allocated to interest for the seller’s tax reporting purposes only. The borrower and the note are unaffected by the seller’s handling of the taxes. [26 United States Code §483; see Real Estate Finance Chapter 52: Interest reporting on a carryback note]
Much like other rates, AFRs are on the rise in 2022. For example, the long-term (nine+ year) AFR is 1.61% in March 2022, up from 1.44% at the end of 2021. Similarly, the short-term (three or less year) AFR is 0.74% in March 2022, up from 0.25% at the end of 2021.
As the Fed raises their benchmark rate — which it plans to initiate first in March 2022, and again later this year — expect AFRs to continue to increase.
Related article:
Super-charged inflation has the Fed re-thinking their interest rate strategy
When a carryback note is executed, the AFR is fixed and does not vary over the life of the note. Thus, carryback sales will only be impacted by higher interest rates going forward. However, as the market begins to turn sideways in 2022, carryback sales will only become more common once the market shifts to favor buyers.
Lacking the support of 2021’s record-low interest rates, additional government stimulus or a jobs recovery, California home prices are expected to decrease in the second half of 2022. Home prices will be further checked by the additional inventory anticipated to arrive following the 2021 expiration of the foreclosure moratorium and rise in forbearance exits. Once price cuts pick up steam and sellers become more desperate, they will once again reach for carryback financing to appeal to more buyers. Real estate professionals can get ahead of the competition by refreshing their knowledge of seller financing today.
Watch AFR movement — and other interest rates impacting real estate — at firsttuesday’s Current Market Rates page.
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well written article!