Seller Carry Back: How It Works, the Risks, and the Taxes
A seller carry back is a loan you, the seller, make to your buyer for part of the purchase price. The buyer gets most of the money from a bank, pays some cash down, and signs a note to you for the gap, usually secured by a second deed of trust or mortgage behind the bank. You are paid over time, and the gain in that note is taxed as you collect it under the installment method (IRC §453).
It can close a deal that would not close otherwise. It is also the riskiest way to seller-finance, because you are second in line. This page covers how a carry back works at closing, why it is dangerous for sellers, how to protect yourself, and how it is taxed, with numbers. For buildings and other investment property, see seller financing commercial real estate.
What a seller carry back is
"Seller carry back," "carry back loan" and "seller second" all mean the same thing: the seller carries a note for part of the price. The difference from full seller financing is who else is lending.
| Seller carry back | Full seller financing | |
|---|---|---|
| Bank loan | Yes, usually the largest piece | None |
| Your lien position | Usually second | First |
| Share of price you finance | A slice | Most of the price |
| Share of your gain that is deferred | Small | Most of it |
| Your risk | High: you are behind the bank | Moderate: you are first |
Both are installment sales under §453. For the full-financing version, see seller financing taxes.
How it works at closing: an example
Simple example, all numbers illustrative. You sell a small rental building for $800,000.
- The buyer's bank lends $560,000 (70%) and records a first deed of trust.
- The buyer pays $80,000 down (10%).
- You carry back $160,000 (20%) on a 5-year note, $32,000 of principal a year plus interest, secured by a second deed of trust.
- Your adjusted basis is $300,000 and your selling expenses are $40,000.
At closing you receive $640,000 in cash: the bank's $560,000 and the buyer's $80,000. You hold a $160,000 note.
The tax math. Installment basis = $300,000 + $40,000 = $340,000. Gross profit = $800,000 - $340,000 = $460,000. With no debt assumed, the contract price is $800,000, so the gross profit percentage is $460,000 / $800,000 = 57.5%.
| Year | Principal received | Taxable gain (57.5%) |
|---|---|---|
| 1 (closing) | $640,000 | $368,000 |
| 2 | $32,000 | $18,400 |
| 3 | $32,000 | $18,400 |
| 4 | $32,000 | $18,400 |
| 5 | $32,000 | $18,400 |
| 6 | $32,000 | $18,400 |
| Total | $800,000 | $460,000 |
The point most sellers miss: the bank's money is a payment to you in the year of sale. A carry back of 20% of the price defers only about 20% of the gain, here $92,000 of $460,000. If your goal is to spread a large gain, a small carry back does very little. You take most of the credit risk of a lender for a small share of the tax benefit.
If the building was a rental, the depreciation you took comes out of the gain first, as unrecaptured §1250 gain taxed at up to 25% (Reg. §1.453-12), and any §1245 recapture on equipment or cost-segregated parts is taxed in year one regardless (§453(i)). Interest on the note is ordinary income each year.
Why carry backs are risky for sellers
The autocomplete question "why are seller carry back loans dangerous for sellers" has a real answer. Five of them.
1. You are second in line. If the buyer stops paying the bank and the bank forecloses, the foreclosure can wipe out your lien. To protect it, you may have to cure the buyer's bank loan with your own money, or bid at the sale. Either way you are putting in cash to protect a note.
2. The buyer has little equity. In the example, the buyer owes $720,000 on an $800,000 building. A 10% drop in value, plus selling costs, leaves nothing behind the bank for you. Your "security" is only as good as the equity above the first loan.
3. Default is slow and expensive. A foreclosure takes months, and a bankruptcy filing freezes it with the automatic stay (11 U.S.C. §362). In a Chapter 11, the court can change your note's rate and term.
4. State law can limit what you collect. In California, for example, a seller who carries back part of the purchase price generally cannot get a deficiency judgment against the buyer (Cal. Code Civ. Proc. §580b). If the property is worth less than what is owed, the property is all you get. Other states have their own rules; ask a local real estate attorney.
5. You get the property back in whatever shape it is in. Deferred maintenance, unpaid property taxes, lapsed insurance, empty units. And if you do take it back, the repossession rules put gain back on your return (§1038). See what happens if the buyer defaults.
There is also the opposite risk. If the buyer refinances in year two and pays off your note, you get your money, and all the remaining gain is taxed that year. For a small carry back that is usually fine. It just means the deferral was temporary.
How to protect yourself
You cannot remove the risk, but you can shrink it. Work with a real estate attorney on the documents; these are the terms to discuss.
- A bigger down payment. Cash in the deal from the buyer is the best protection you have. It is equity that sits between the bank's loan and your note.
- A recorded deed of trust or mortgage securing your note, not an unsecured promise.
- A personal guaranty from the buyer's owners if the buyer is an entity.
- Know the bank's terms. Get a copy of the first loan. Understand whether it permits a second, what it requires of you, and whether you will receive notice if the buyer defaults on it.
- Cross-default. Make a default on the bank loan a default on your note.
- Due-on-sale. If the buyer sells, your note is paid off.
- Insurance and taxes. Require proof of hazard insurance naming you, and proof that property taxes are paid.
- Late charges and default interest set out clearly in the note.
- A short term. A 3 to 5 year carry back limits how long you are exposed, at the cost of a balloon the buyer must refinance.
- Underwrite the buyer. Credit, experience, the property's cash flow after both loans. The bank did its homework on its loan; do yours on yours. For a broader checklist, see is seller financing a good idea.
- A servicing company. Let a third party collect, track taxes and insurance, and send year-end statements.
Negotiating the note itself (rate, amortization, balloon, prepayment): seller financing note terms.
How a carry back is taxed
A carry back is an installment sale. The rules:
- Year of sale: the buyer's down payment and the bank loan proceeds are payments received. Multiply by the gross profit percentage.
- Later years: each principal payment on your note is taxed at the same percentage.
- Interest: ordinary income every year, reported separately. If the note's rate is below the applicable federal rate, part of the principal is recharacterized as interest (§§483, 1274). See seller financing interest rate and the AFR.
- Recapture: §1245 recapture is taxed in year one in full (§453(i)).
- Your old loan: if your own mortgage is paid off at closing from the buyer's funds, that is also a year-one payment (Temp. Reg. §15a.453-1(b)(3)(i)).
- Reporting: Form 6252 for the year of sale and every year after until the note is paid. The IRS rules are in Publication 537.
Selling the note later. Note buyers usually pay less than face value. Selling the note is a disposition under §453B: your gain is the amount you receive minus your basis in the note, and your basis is the unpaid balance times (1 minus the gross profit percentage).
Simple example: $128,000 is left on the note after one payment. Basis in the note = $128,000 x (1 - 0.575) = $54,400. You sell the note for $110,000. Gain = $110,000 - $54,400 = $55,600, reported that year with the same character as the original sale. The $18,000 discount reduces your gain, but you receive less money.
Borrowing against the note counts too. For sales over $150,000, the proceeds of a loan secured by the note are treated as a payment on it (§453A(d)).
Carry back vs full seller financing vs a structured sale
| Carry back (second) | Full seller financing (first) | Structured installment sale | |
|---|---|---|---|
| Who pays you over time | The buyer | The buyer | An assignment company, usually funded by a fixed annuity it owns |
| Security | Second lien | First lien | None; you are an unsecured creditor |
| Buyer default risk | Highest | Moderate | None (buyer is released at closing) |
| Early payoff | Possible | Possible | Not possible |
| Gain deferred | Only the carried slice | Most of it | The structured amount |
| Commission | None | None | Built into pricing |
| Legal footing | Settled | Settled | No IRS ruling specifically approves it |
A structured installment sale takes the buyer's credit out of the picture: the buyer pays in full with a bank loan, and the deferred portion is paid by an assignment company on a fixed schedule. The trade-offs are an unsecured claim, locked payments, a lower rate and an open legal question. Details: seller financing vs a structured sale.
If your existing loan stays in place under the new note, that is a wraparound mortgage.
Bottom line
A seller carry back can bridge a gap between the bank's loan and your price, but you take a lender's risk from second position and defer only the slice you carry. A real down payment, a recorded lien, a personal guaranty and a short term can all reduce the risk, and it is worth pricing in what a default would cost you. To see the payment, interest and tax each year, use the seller financing calculator.
Questions to ask your CPA
- How much of my gain is deferred by this carry back, and how much is taxed at closing?
- Is any of my own loan being paid off at closing, and how does that change year one?
- How much §1245 recapture and unrecaptured §1250 gain is in this sale?
- Does the note's rate meet the AFR for its term?
- If the buyer pays off early or I sell the note, what is my tax?
- If I have to take the property back, how does §1038 treat it?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.