Cash Offer Versus Seller Financing and the Prepayment Penalty
Mr. Jung owns a four-unit residential building that he bought eight years ago for 900,000,000 KRW. After depreciation, his adjusted basis is 640,000,000 KRW, including 260,000,000 KRW of depreciation taken. An existing mortgage of 520,000,000 KRW at 4.8% fixed carries a 2% prepayment penalty on the outstanding balance if repaid before the next reset in 10 months. He lists at 1,250,000,000 KRW. Offer A is 1,180,000,000 KRW cash, 25-day close, 3% earnest money, seven-day inspection, buyer preapproved. Offer B is 1,260,000,000 KRW with 20% seller financing-252,000,000 KRW at 5.5% interest-only for five years with a balloon-and 1,008,000,000 KRW cash at a 45-day close; the buyer has a 680 credit score and no landlord experience. Selling costs are 3% commission plus 8,000,000 KRW closing costs. Assume depreciation recapture is taxed at 25%, remaining gain at 20%, and no state tax. Mr. Jung needs at least 300,000,000 KRW net cash within 60 days to buy a replacement property.
1. Compute the approximate after-tax net cash at closing for each offer, including mortgage payoff and prepayment penalty. Show your steps.
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Offer A: selling costs are 3% of 1,180,000,000 = 35,400,000 KRW plus 8,000,000 = 43,400,000 KRW. Mortgage payoff is 520,000,000 + 2% penalty (10,400,000) = 530,400,000 KRW. Cash before tax = 1,180,000,000 - 43,400,000 - 530,400,000 = 606,200,000 KRW. Gain = price minus adjusted basis minus selling costs = 1,180,000,000 - 640,000,000 - 43,400,000 = 496,600,000 KRW. Tax = 25% recapture on 260,000,000 = 65,000,000 KRW, plus 20% on the remaining 236,600,000 = 47,320,000 KRW; total tax = 112,320,000 KRW. After-tax cash = 606,200,000 - 112,320,000 = 493,880,000 KRW.
Offer B: selling costs are 3% of 1,260,000,000 = 37,800,000 + 8,000,000 = 45,800,000 KRW. Payoff is still 530,400,000 KRW. Cash at closing before tax = 1,008,000,000 - 45,800,000 - 530,400,000 = 431,800,000 KRW. Total gain = 1,260,000,000 - 640,000,000 - 45,800,000 = 574,200,000 KRW. Recapture tax is again 65,000,000 KRW. Remaining gain is 314,200,000 KRW. Under an installment sale, the gross profit ratio is 314,200,000 ÷ 1,260,000,000 = 24.94%. Gain recognized on the 1,008,000,000 cash received is about 251,400,000 KRW; tax at 20% = 50,280,000 KRW. Total current tax = 65,000,000 + 50,280,000 = 115,280,000 KRW. After-tax cash = 431,800,000 - 115,280,000 = 316,520,000 KRW, with about 62,800,000 KRW of gain deferred to the note payments.
2. Compare the risk and liquidity of the two offers. Which better meets Mr. Jung's 60-day need for 300,000,000 KRW?
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Offer A produces about 493,900,000 KRW of after-tax cash at closing and carries little financing risk. The buyer is preapproved, the close is in 25 days, and the seller can use the proceeds immediately for the replacement property. Offer B produces only about 316,500,000 KRW of after-tax cash at closing and leaves 252,000,000 KRW tied up in a note. The note pays 5.5% interest-only, or about 13,860,000 KRW per year, but the principal is not liquid until the balloon. The buyer has a 680 credit score and no landlord experience, so collection and refinancing risk are real. If the buyer defaults, Mr. Jung may have to foreclose on a four-unit building, which is slow and costly.
Both offers technically clear the 300,000,000 KRW need, but Offer B clears it by only about 16,500,000 KRW before any prorations, repair credits, or vacancy loss. That is too thin a cushion for a 60-day purchase deadline. Offer A better meets the need despite the lower price. Offer B's higher price is mostly a promise of future payments, not current cash. Mr. Jung should compare the note's present value, not just the face amount; at a market discount rate for a 680-credit borrower, the 252,000,000 KRW note is worth materially less than face value.
3. If Mr. Jung wants to pursue seller financing, what conditions should he negotiate and what risks should he explain?
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He should demand a larger cash down payment and a smaller note, such as 30% down or a 200,000,000 KRW maximum note. He should increase the interest rate to compensate for the credit risk, require a personal guarantee from the buyer, keep a first lien on the property, and prohibit any junior financing without consent. The note should include a due-on-sale clause, late charges, a default interest rate, and a right to accelerate on a missed payment. Shorten the balloon to three years or require a refinance commitment with documented lender preapproval. Require the buyer to provide rent rolls, a property-management plan, and proof of reserves. Escrow the note servicing with a professional servicer.
Explain that the 2% prepayment penalty is due now because the existing mortgage will be paid off at closing; the penalty is 10,400,000 KRW and reduces cash. Explain that the installment sale defers tax only on the note portion, not on the recapture, and that the deferred gain is not eliminated. If the buyer defaults, Mr. Jung may get the property back with a tax basis problem and legal costs. He should also confirm that the replacement purchase can close with the smaller cash proceeds from Offer B. If he needs certainty for the 60-day deadline, Offer A is the cleaner choice.