What Is a Carry Back in Real Estate?

Fundamentals of a Real Estate Carry Back

A real estate carry back, often referred to as seller financing or owner financing, is an arrangement where the seller of a property directly provides a loan to the buyer for a portion of the purchase price. This method allows the seller to act as a lender, and the buyer becomes the borrower, creating a direct financial relationship between the two parties. This can be particularly useful when traditional bank financing might be difficult to obtain or when both parties seek more flexible terms.

This financing structure involves two primary legal documents: a promissory note and a security instrument. The promissory note is the buyer’s formal written promise to repay the loan to the seller. It details the principal amount borrowed, the agreed-upon interest rate, and the specific schedule for payments, such as monthly installments.

Accompanying the promissory note is a security instrument, commonly a deed of trust or a mortgage, which secures the loan against the property. This document grants the seller a lien on the property, providing a mechanism for recourse if the buyer fails to make payments as agreed. Should a buyer default on their obligations, the security instrument allows the seller to initiate foreclosure proceedings.

The promissory note defines the financial terms of the debt, while the security instrument provides the seller with collateral. While a carry back can cover the entire purchase price, it often finances only a portion, with the buyer providing a down payment and sometimes securing a separate loan from a traditional lender for the remaining balance.

Structuring a Real Estate Carry Back Agreement

The specific terms and conditions governing a real estate carry back are outlined within the promissory note and the corresponding security instrument. These documents define the principal loan amount, which is the portion of the property’s purchase price the seller is financing.

The agreement also specifies the interest rate the buyer will pay on the loan. This rate can be fixed or adjustable and is a factor determining the total cost of the financing. A detailed payment schedule is also established, indicating the frequency of payments, such as monthly or quarterly, the amount of each payment, and the overall amortization period for the loan.

The loan term defines the total duration of repayment. Some carry back agreements may include a balloon payment, a large, lump-sum payment due at the end of the loan term. Default provisions outline what actions by the buyer constitute a default and the seller’s available remedies, such as acceleration clauses or the right to initiate foreclosure.

The agreement should also address any prepayment penalties, which are fees the seller might impose if the buyer repays the loan early. If there is a primary mortgage from a traditional lender, a subordination clause defines the priority of the seller’s lien (the carry back) relative to the primary mortgage. The agreement must clarify who is responsible for ongoing property taxes and insurance premiums during the loan term.

Tax Considerations for Real Estate Carry Backs

Real estate carry back arrangements present specific tax implications for both the seller and the buyer. For the seller, interest received from the buyer on the carry back loan is generally taxable as ordinary income. This income needs to be reported on the seller’s annual tax return, on Schedule B of Form 1040.

The principal portion of the payments received by the seller is often treated for capital gains purposes under the installment sale method. This method allows sellers to report the gain from the property sale as payments are received over time, rather than recognizing the entire gain in the year of the sale. Sellers use IRS Form 6252, “Installment Sale Income,” to report this gain, spreading the tax liability across multiple years.

If the interest rate on the carry back loan is significantly below market rates, the Internal Revenue Service (IRS) may apply Original Issue Discount (OID) rules, which could impute a higher interest rate for tax purposes. This ensures that the interest component is adequately recognized, even if not explicitly stated in the agreement.

For the buyer, the interest paid on the carry back loan may be deductible, similar to interest paid on a traditional mortgage. This deduction is available if the property is a primary residence and the interest qualifies as qualified residence interest. Buyers should consult a tax professional to determine the deductibility of their interest payments.

The full purchase price of the property, including the amount financed by the seller through the carry back, establishes the buyer’s cost basis in the property. This cost basis is used for future tax calculations, such as determining capital gains or losses when the buyer eventually sells the property. The cost basis includes the purchase price plus certain acquisition costs, and it can be adjusted over time by improvements or depreciation.