Tax Deferral on Vendor-Take-Back Mortgages – What You Need To Know

Posted on 15. Sep, 2010 by in General

Courtesy of Navaz Murji, www.realaccountant.com

There are tax advantages of a vendor take back mortgage. Unfortunately, to explain this to a seller can be a challenge. A Vendor Take Back Mortgage (VTB) allows the seller to defer a portion of their profits on their property, excluding their principal residence. The maximum amount of deferral is the lowest of:

1)   20% of the profit from the property in each of the years on a cumulative basis. That means in year 1 the maximum deferral is 80% of the profit, year 2-60%, year 3-40% and year 4-20%

2)   It is a prorate portion of the monies you have collected from the sale. That means at the end of each year – amount of VTB outstanding at the end of the year / proceeds from the sale of the transaction X profit on the transaction

Why should a seller use this? It helps to manage your tax brackets. Sometimes when you sell a property, it will take you to a maximum tax bracket. If you are coming up for retirement, it would be a good idea to have your accountant to run up the numbers for you.

Hint: This is the seller’s tax return that is impacted by this transaction. If you are a buyer, you will have a hard time because accountants do not like to advise their clients to hold a second mortgage, though they do not have the tools to understand the transaction.

The vendor can only defer a portion of the Capital Gains taxes if he takes a vendor take back mortgage.
 

How does this work?  A detailed example

Well, you can elect to defer the taxes on the ratio of the portion of monies collected to the total capital gains over a maximum of 5 years with 20% of the profit in each year.

Let’s walk through an example. Say you bought a property for $100,000. This property was not your primary principal residence and hence, you have to pay taxes on the capital gains. You sell the property for $250,000. You take back a mortgage of $150,000 repayable in 10 annual payments of $15,000 each.

In summary:

Cost is:                                    $ 100,000

Selling Price is:                         $ 250,000

Capital Gain is:                         $ 150,000

Initial Proceeds are:                  $ 100,000

Vendor-Take-Back:                             $ 150,000

1/5 of Capital Gain is:               $   30,000

Annual Payment is:                            $   15,000

The amount of capital gains you can defer and have to take into income in each of the years is as follows:

In the year when you sell, you can defer lower of:

a)      $150,000    /  250,000  x  150,000             =    $90,000

VTB    / Total Proceeds X Capital Gain = Deferral

b)      $150,000 (Capital Gain)           x 80%                   =    $120,000

Therefore, in year one, the vendor’s deferral will be $ 90,000 and the vendor has to report $60,000 in capital gain (only ½ of this is taxable).

In year 2, the deferral shall be the lower of:

a)      $135,000    /  250,000  x  150,000             =    $81,000

VTB    / Total Proceeds X Capital Gain = Deferral

b)      $150,000 (Capital Gain)           x 60%                   =    $90,000

In year 2, the vendor has to report $9,000
($90,000 Balance to report – $81,000)

In year 3, the vendor has to report:

a)      $120,000    /  250,000  x  150,000             =    $72,000

VTB    / Total Proceeds X Capital Gain = Deferral

b)      $150,000 (Capital Gain)           x 40%                   =    $60,000

In year 3, the vendor has to report $21,000 ($81,000 – $60,000)

In year 4, the vendor has to report:

a)      $105,000    /  250,000  x  150,000             =    $63,000

VTB    / Total Proceeds X Capital Gain = Deferral

b)      $150,000 (Capital Gain)           x 20%                   =    $30,000

In each of years 4 and 5, the vendor has to report $30,000.

This is a senior tax strategy and is for the benefit of the seller (whom will be holding the mortgage). Seek professional help when advising your VTB mortgage holder on any tax advice.

For more information please contact the author:

Navaz Murji, CGA

#203, 2849 North Road, Burnaby, B.C. V3J 1R6, 
Phone:  604-415-0808, 
Fax:  604-415-0802

E-mail:  navaz@realaccountant.com   Website: www.realaccountant.com

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