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October 17, 2023
Last Updated : June 20, 2024

Tax Implications Behind ‘Subject-To’ Financing & Similar Strategies

What is “Subject-To” Financing?

Subject-To is a strategy where an investor purchases a property but leaves the existing mortgage in place. The buyer pays the seller an agreed-upon amount, which is the difference between the sales price and the existing loan. After taking ownership of the property, the buyer takes on the responsibility of making the mortgage payments to the seller, who in turn pays their lender.

Why Subject-To Investing?

Subject-To allows investors to effectively lock in lower interest rates. If someone bought a property at a 2.8% rate and had to sell for whatever reason, the new buyer could take over that property and the mortgage with its locked-in low rate. This saves the investor from having to secure a new loan at the current high rates, making deals more viable in today’s market.

Who Are the Sellers in Such Deals?

Motivated sellers are often the key players in these transactions. Reasons can range from divorce and job loss to bankruptcy and other financial strains. For these sellers, Subject-To can be an appealing quick exit strategy, even if they have little to no equity.

Tax Implications

One of the most frequently asked questions about Subject-To investing is, “Who gets to deduct the mortgage interest?” The answer is the buyer, who is now making the mortgage payments. They get to claim the mortgage interest deductions, while the seller, who may still receive the 1098 mortgage interest form, must work out the mechanics to assign this benefit to the buyer.


Another common question is about depreciation. If executed correctly, the buyer, who is now the legal owner of the property, gets to depreciate it. Bonus depreciation can also be claimed as applicable.

Risks Involved

  • The Due-On-Sale Clause

Almost every mortgage has a due-on-sale clause, which means that transferring ownership without settling the loan can lead to the bank calling the loan. If this happens, both parties could be in trouble.

  • Contractual Agreements

It’s vital to have a well-crafted contract outlining who will pay and when, to provide a legal fallback should one party fail to hold up their end of the bargain.

Subject-To investing can be a powerful tool for real estate investors in today’s challenging interest rate environment. However, like any investment strategy, it comes with its share of risks and tax implications. Before diving in, consult with your tax strategist and legal advisor to ensure you cover all your bases.

Podcast Transcript

Tom: Before we just jump into exactly what Subject 2 is, it’s kind of important to understand what’s going on with interest rates so you kind of understand why this strategy has become so popular again. Unless you were living under a rock for the last year or so—and I don’t believe you were—you know that interest rates are rapidly increasing, or have already rapidly increased. In fact, I’m looking at my screen today; I’m recording this as of October 11th. Okay, interest rates—if you have a credit score between 740 and 759—interest rates on a 30-year fixed are 8%. It’s over 8% now.

Brandon: Can you believe that? That’s insane! It’s stayed at high rates too. That’s, I think, what’s worrying everybody, especially over the next 12 months, is that do they sustain at these levels, or do they come back down a little bit?

Tom: Yeah, we don’t know. I just read the headline. I was looking into this before: mortgage rates are as high as they’ve been in over 20—I think 23 years—which is crazy. And you know, it’s really interesting. Last year, or two years ago in 2021, I was looking at a property that I’m kicking myself, of course, for not buying. I could have gotten an interest rate on it at 2.8%—was like 2.83%, something stupid low—and I was just like, you got to be kidding me. And now, mortgage rates have shot up to almost above 8% in some cases, and it’s extremely painful, extremely painful. And it’s causing a lot of deals to not pencil out for a lot of investors.

Brandon How does that impact Subject 2? What is Subject 2, I guess, first off, and why is this relevant, right?

Explaining Subject 2

Tom: So, basically, Subject 2 is when you buy a property from somebody, but they still carry back the mortgage they originally had. So, in other words, typically how this works—and I can give an example—is you would basically pay them the…you don’t have a purchase price that you’re going to agree upon, and then there’s going to be the loan that the buyer has, or the seller has—excuse me, the original owner—and you’re going to pay them the difference between the sales price and the existing loan, and you’re going to take possession, you’re going to take ownership of the property. They’re going to convey the deed to you, and now you’re going to own the property, but they’re going to keep their mortgage. And now you’re going to pay them, right? You’re going to pay them the mortgage payments, and then they’re going to pay their lender. And this allows you to basically, effectively lock in that interest rate. So, say someone did buy that property at 2.8%, right, and they have to sell their property for whatever reason, and here you are, your savvy real estate investor, and you’re coming in, you’re like, “You know what? Let’s do the Subject 2.” Okay, you do the Subject 2 arrangement, and now you basically take ownership of the property. Now you’re paying their mortgage at that 2.8% interest rate, rather than you having to go to the bank and get a new loan at 8%, let’s say, which is, you know, extremely favorable. 

Brandon: As an investor, got it, got it, got it. So you can buy property and effectively still get low rates, like if you can buy property from people with low rates. But who would be a seller in something like this? Why would I sell you my property with this type of arrangement?

Tom: Yeah, I mean, there’s probably going to be some, as they say in the real estate world, and everybody knows this at this point, I think, you listen to this show, is there’s motivated sellers out there. There’s reasons for people to sell. There’s divorce, there’s other extenuating circumstances, maybe you lost a job, maybe you have other things going on, maybe you’re filing for bankruptcy for some reason. I don’t know, there could be a million and one reasons why someone would want to sell their property, and perhaps you’re their best option, right? You’re not going to see everybody wheeling and dealing this strategy. It’s one of those things you kind of have to work out and figure out, you know, your marketing as an investor, who you’re targeting for this strategy. But there’s like communities of people out there doing this right now. And the reason why we’re doing this episode today is because got asked at least five or six times already that I could remember recently about how taxes work in an arrangement like this. So there’s people out there; they’re doing this, happening right now in the tax investor Facebook group, there’s been a few people, and the Insiders Community, there’s been a few people. 

Brandon: So, how do taxes work in this type of arrangement? 

Tom: So first, the biggest question that we’ve gotten so far was: who gets to deduct the mortgage interest, right? The seller is paying their mortgage, the buyer is paying the seller to pay the mortgage, right? So who ultimately gets to deduct it? So, long story short, the person who’s paying the mortgage should deduct it. So, in other words, the buyer is going to be able to deduct the interest. Now, I happened to speak to a tax professional about the mechanics behind this recently because I was just like, “Okay, how mechanically, you know, the seller is going to be receiving Form 1098, the mortgage interest form, from their lender.” And, uh, long story short, there’s some mechanics—we’re not going to talk about the mechanics—you can go ahead and ask your tax professional to handle that, but ultimately, you, the buyer, deduct the interest, and the seller would not, in this case.

Brandon: The seller’s got to somehow assign the interest to the buyer, right?

Tom: And that’s, and that’s, that’s handled on the back end, there form stuff.

Brandon: Now, what if the seller takes the deduction, though?

Tom: That’s a good question. That’s a good question. There could be some issues there. I mean, one first, like I guess let’s back up. The risk of this, right? There’s a risk of Subject 2. So, most mortgages have something called a “due-on-sales clause,” right? And the due-on-sales clause basically says that if you convey ownership to somebody else, in other words, you sell the property, you have to close out the loan, right? You have, that’s how most transactions work, you sell a property, you take the sales proceeds, you pay off the loan you had, but if you keep that loan, you violate the due-on-sales clause, then the bank could potentially call that loan, and you’d have to pay that loan. So there’s a risk there; you have to be very careful on how you do this. And, you know, we’re not going to go through how to do Subject 2 on this podcast. If you want to go look into that, you Google it, there’s people out there who will teach you how to do Subject 2 transactions. However, just letting you know from a tax perspective, you, as the buyer, you get to deduct the interest. 

Brandon: Okay, I guess that makes sense. Um, what are some other issues that we got to worry about, like who gets depreciation? 

Tom: That’s another common question we get. Do I get to take bonus depreciation on the property if I buy a property subject to? The bottom line is in a Subject 2 transaction, if you execute it correctly, you are now the owner of the property, as if you bought it in any other way. So now, you would start to be able to depreciate the property, like, because now you took ownership of the property, just like you bought it in a regular transaction. 

Brandon: What happens if the lender does call the note?

Tom: Well, then you both could be in, uh, a bit of a pickle, as they would say, right?

Brandon:  Because the seller would have to pay the note off if the note’s called, which means that they would ideally work with the buyer to come up with the cash, but if the buyer doesn’t have the cash, I guess the buyer loses the property, and the seller gets a foreclosure on their record.

Tom: Basically, I just read an article on this, preparing for this, and yeah, that’s basically one of the risks is using this, or wraparound mortgage, which is a very similar strategy, except with a wraparound mortgage, the sell actually, like, wrapping a mortgage around their existing mortgage. So, in other words, they’re giving you the mortgage in a wraparound mortgage, but it’s the same issue: if the bank finds out about this, and they call the loan, well, someone has to pay that loan off, otherwise the bank is foreclosing on the property, right? And yeah, that’s the risk; that’s one of the biggest risks of this type of transaction, is that the bank finds out that you sold the property, and that they call the loan, and now you and the buyer, or you and the seller, someone has to come up with the money to pay that bank.

Brandon: Is it more risky, do you think, for the seller or for the buyer? Because the buyer, I guess, would lose equity in any additional, you know, improvements that they made, whatever cash they’ve infused into the deal, but the seller, they’re the ones that get the, like, the knock on their record, right?

Tom: I think it depends, right? Because I think it depends on who carries the most risk. Because think about it: as a seller, you’re still responsible for that mortgage, right? You still have to pay that mortgage. So depending on what the balance is, that could be a risk for you. As the buyer, to your point, how much equity do you have into the deal? How much cash did you put into that deal? That’s what you have at risk, right? So I think both sides do carry risk. You know, if the seller has a very low mortgage, say 20 grand, I’m just throwing out a really low, stupid number here, and the buyer has like 200 grand of equity, somehow that happens, well, then the buyer, in that case, has stands more to lose, and the seller has less to lose. So, it definitely depends. I guess it also depends on the contract, too. I mean, I would presume that the contract itself would stipulate what happens in this type of an event, right?

Tom: Yeah, the way you kind of create these deals is you want to have a contract between you and the seller, or you and the buyer, depending on which side of the transaction you’re on, about who’s going to pay and when, and all that good stuff. So that if one of you defaults or one of you fails to execute your side of the contract, at least you have some type of legal recourse against the other party. Now, that doesn’t eliminate risk. Just because you have a contract, of course, does not mean that it’s risk-free. But that’s how it kind of works. 

Brandon: So, can we go back to the seller question? I know we—we’ll circle back to taxes here in a second—but the one thing with Subject 2 that I’ve never been able to understand, and this is probably because I run an accounting firm, not like a wholesale business or a flip business or a large-scale rental business, and I’m sure if I was in the weeds, I would have the answer to this question, but why would somebody sell under this scenario, like, why not just cash your equity out? And maybe this is recency biased because, you know, the markets run up so much that I feel like everybody’s got pretty significant equity. But like, why would you do this versus just sell?

Tom: Yeah, I’m, I’m be honest, I don’t have a good answer for you, you know. We just—I think we’re going to bring somebody on at some point to actually talk about Subject 2, like, in the actual strategy itself, but, uh, yeah, I, I don’t know why people would be doing this outside of the fact that they’re in a bind, and the buyer that’s helping them do such a transaction is perhaps one of their only options.

Brandon: I think, I think that you just hit on it. I mean, I just Googled it, right? And the first thing that popped up was, “Selling Subject 2 allows the buyer to purchase your house quickly,” meaning I’m in need of cash, even if it needs some repairs, or has little to no equity. So I think that my, my potentially very green opinion here is just that this is probably for sellers who need to move quickly, they need to liquidate quickly, they don’t have much equity, and they just need to, they’re just done with it and want to cash out. And maybe this is a really quick way to do it. You know, I could see, I could see you doing this with some properties that aren’t performing and stuff, but even then, you still have the note, you know, associated with your name, so it still hurts you for future financing purposes. But I know that there’s a lot of people that do Subject 2 really successfully. It’d be a lot of fun to sit down with somebody and ask them all these questions.

Tom: Well, well, here’s, here’s a scenario. Humor me for a second, right? So you’re an owner of a property, the property has a lot of issues with it. You are digging yourself a hole. A very sophisticated flipper comes in and says, “Look, I see you have an issue. Maybe you can’t sell the property because there’s not that many buyers who want to buy the property with all these issues.” And you have a flipper coming and say, “Look, I can easily fix this. This is not a problem for me. Here’s the deal.” Give you, and the seller is just like, “Look.” The flipper, to being a savvy real estate investor, comes and says, “You know, I can close in 10 days,” right? Doing this, and now that’s a really attractive offer to a seller who might not want to have anything else to do with this property and just wants out.

Brandon: Yeah, that’s a good point. That’s a good point. I could see it even on the landlord side, because for the landlord, it’s great because you probably could structure win-wins now in today’s interest rate environment, because the landlord knows that they’re going to get a lower interest rate. So I could see, I could see it working on properties that are distressed. Yeah, interesting. Okay, well, back—sorry, everybody—back to the tax piece. What else do we need to know about taxes related to Subject 2?

Final Thoughts on Taxes

Tom: Well, believe it or not, there’s not that much else to know. Um, those are the two major tax questions. But I, the reason why we’re doing this podcast today is because people ask and want to give people clarity on how these things work. So again, you know, from a tax perspective, who gets to deduct the interest? The buyer ultimately gets to deduct the interest. What if you’re doing a wraparound mortgage? How does that work? Well, in that case, the buyer will deduct the interest they pay. The seller will report the interest that they receive as interest income on Schedule B. Alright? The seller will then generally issue a Form 1098 to the buyer because now they basically have—they have a mortgage. And then the seller will deduct the interest on Form 4952. So that’s generally how it works with a wraparound mortgage. And then, the other major question: can you claim bonus depreciation? Yes. When you buy the property, it’s as if you bought it in any other transaction. So if you can claim bonus depreciation, if it’s eligible for bonus depreciation under a normal transaction, you will be able to use bonus depreciation there too. You’ll be able to deduct all your expenses as if it were a normal rental property. The point here, the bottom line, is it’s not that complicated from a tax perspective.

Brandon: Yeah, so it’s just like, from a tax perspective, like analyzing or reporting any other rental property, you get all the deductions, depreciation included. You can cost bonus depreciate it, ‘cuz you own it, right?

Tom:  Exactly, exactly. The lender is a little bit different, right? And that’s just what you have to be aware of. That’s, that’s the biggest thing, right? And look, I’m not sitting here, um, saying people should or should not use this strategy. It’s been around since at least the 80s, when I did some looking into it. The tax law around it, that was dating back to the 80s, and it’s been around. And now, you haven’t heard about it too much over the last few years because interest rates have been so low, it’s not really been needed. But now that interest rates have shot up so quickly, there’s been a resurgence, and people are actively using it. So there you have it, and the tax—how it’s dealt with from a tax perspective.