In this blog post, we're going to cover something called IRS Form 1098.
This form comes into play for anyone who is selling properties via owner financing, and more specifically,
- If owner financing is “in the normal course of the seller's trade or business”.
- If the seller is receiving $600 or more in interest payments from an individual borrower in each fiscal year.
Keep in mind, you don't necessarily need to be a bank or a hard money lender for seller financing to be “in the regular course of your trade or business”. Any person or entity that receives $600+ of interest payments (such as real estate developers, house flippers, land flippers, loan servicers or certain collection agents) from an individual borrower will most likely be expected to file form 1098 each year.
Why is it Necessary?
The whole purpose of IRS Form 1098 is to ensure that borrowers are able to claim the appropriate tax write off from the interest they've paid to their lender(s) each year. When a lender submits a 1098 to the IRS and the borrower each year, it helps both parties verify how much interest expense can be claimed by the borrower when they file their annual tax return.
In other words, when you submit a 1098 form to the IRS, it's just another way of telling them,
“Yep, this borrower paid me $_____ of interest this year.”
When the IRS receives this kind of cross-reference from lenders, it's much easier for them to verify that a borrower is telling the truth when they claim to have paid a certain amount of interest in a given year.
Disclaimer: Before we get much further into this, please be aware that I am not an attorney or a CPA and the information in this article should not be interpreted as legal or financial advice. Everything you read here is based on my own conclusions after reading the IRS Instructions for Form 1098 (and given how convoluted these instructions are, it's entirely possible that a CPA or attorney will have a different opinion than me). Be sure to cross-check this information with a tax professional as it relates to your specific situation before you move forward.
Here’s the good news:
- If you're receiving interest from a corporation, partnership, trust, estate, association or company (other than a sole proprietor), you do not need to file Form 1098.
- If you receive less than $600 in interest payments from your borrower each year, you do not need to file Form 1098.
- If the interest you receive is not “in the course of your trade or business” (i.e. – if you're financing the sale of your former personal residence, or for a one-time, non-recurring type of transaction), you do not need to file Form 1098.
- If the security for the loan is NOT “real property” (i.e. – land and anything built on it, growing on it or attached to it), you do not need to file Form 1098.
- If you are enlisting the help of a loan servicing company to assist in the collection of payments and/or if you're paying a CPA to handle your accounting and tax-related issues, they will most likely handle the annual filing of any/all 1098 forms for you (however, you'll want to verify this assumption with them).
There are a few other exceptions on who doesn't need to worry about Form 1098, but these are the most common. Read the full instructions for Form 1098 at the IRS website for specific details.
Here’s the bad news:
If the transaction doesn’t fall within one of these exceptions, the IRS will most likely expect you to file Form 1098.
As I was reading the Instructions for Form 1098, there were two questions that came to mind:
IRS Form 1098 is also known as a “Mortgage Interest Statement” and the instructions repeatedly refer to “mortgage interest”. If my seller financed properties aren't secured by a “mortgage” per se, but are secured by a land contract (which functions differently from a mortgage, because the deed doesn't transfer to the buyer until after the loan is paid in full)… does this requirement still apply to me?
Luckily (or unluckily for me), the IRS took the time to clearly define what is meant by the word “Mortgage”. See here…
As I interpret this – if the loan is secured by the property you're selling (i.e. – if you're able to repossess the property in the event of the borrower defaulting on the loan), then the IRS most likely considers it to be a “mortgage”.
Another phrase that comes up repeatedly throughout the instructions is this,
As a real estate investor who occasionally sells vacant land with seller financing, at what point are these deals considered to be “in the course of my trade or business”?
Does this come into play after one deal? Three deals? Five deals? One Hundred Deals? Where's the line? How can I know when I DO and DON'T need to worry about this?
After talking with a CPA and a few attorneys, the general consensus I got was that ultimately, if you're doing two or more of these deals in a year – the IRS can potentially make a case that you're working as a “Dealer” (which means it's in the course of your trade or business) and once you get into this territory, you'd better be filing your 1098s.
Of course – there are always exceptions, and the true definition is anything but straightforward. There have been many court cases where the IRS disagreed with tax payers about whether or not they were considered “Dealers” or “Investors” – so even though it's not always a clear line, if you have ANY inclination that you're flirting with Dealer status, your best bet is to err on the side of assuming you need to do this.
How to Complete IRS Form 1098
To complete the filing process, you will need to order blank copies of IRS Form 1098 and IRS Form 1096. These forms need to be printed with a very specific type of paper and ink, and while it's possible to reproduce these documents from home, it's usually a lot easier to just order these forms from the IRS.
The forms are free and the IRS will send them to you by mail, usually arriving within about a week. It takes less than a minute to order. Here's the link.
Note: If you are filing more than 250 of these 1098 forms, you are required to file electronically (but you'll probably want to engage the services of a CPA or loan servicing company well before you get to that point).
The Filing Process
In order to complete the 1098, you'll need a few key pieces of information, including the Payer's/Borrower's social security number.
If it wasn't already completed at the time of closing the transaction, ask the seller to complete IRS Form W-9. When this form is completed, signed and dated, it will provide you with all the information you'll need (including their SSN) to complete the 1098 and 1096 appropriately.You can find IRS Form W-9 here. This video explains how the W-9 works…
When you've got the information you need, it's time to fill out the 1098.
In my case, I'm typically the seller in these types of transactions, so I would list myself as the “RECIPIENT/LENDER” and the buyer would be listed as the “PAYER/BORROWER” on both the 1098 and the 1096.
In this example, the property is a vacant lot without a physical address, which is why I drew a line through Box 8 and listed the county name and parcel number in Box 9 – as explained in the Instructions for Form 1098. If it had been a common single family home, I could have just entered the physical street address of the property in Box 8 and then left Box 9 blank.
When I've got both the 1098 (Copy A) and the 1096 complete, I would mail both forms to the IRS. If you're not sure which address to include on the pre-addressed envelope, check the instructions on IRS Form 1096. This is what it said on the 2016 version of this form:
As I'm filling out the 1098, there will also be a “Copy B” (which should be sent to the Payer/Borrower) and “Copy C” (which is for the Recipient/Lender to keep). Here's what I would send off to the Borrower.
And here's what I could keep in my files.
Pretty simple stuff – right?
What Happens If You Fail to File Form 1098?
Let's say you miss one of these forms and fail to file a IRS Form 1098 for one of your seller financed deals. Will something bad happen to you??
If you fail to file a 1098 form, the IRS can technically start issuing penalties starting at $250 per failure to those who don't follow through with this requirement (that is, if they ever find out about it).
For this reason, if you're going to handle your loan servicing in-house (and if it's clearly in the normal course of your trade or business), you'll want to make sure you're doing at least one of the following:
- Hire a competent CPA or accountant who will catch this requirement and make sure it's getting completed at tax time each year.
- Enlist the help of a loan servicing company that will handle this requirement each year automatically.
- Use a service (like this one, for example) that will help you calculate the interest paid on your loans each year. It won't necessary handle the entire task, but it should at least help simplify the process to some extent.
Historically, I've used a loan servicing company for the bulk of my seller financed deals AND my accountant has always caught this requirement for each loan I have on the books, so it has never been a problem for me – but it could easily become an issue if you don't have some checks and balances in place to catch this each year.
Make sure someone is paying attention to this item if/when it becomes a requirement – and you should be just fine. 🙂