How Do Capital Gains Taxes Work on Seller Financing?

Question

A friend is considering selling a duplex purchased at the bottom of the market. They're not interested in a 1031 Exchange, they want to sell and be done with investment properties.

They are not opposed to seller financing. How do capital gains taxes work when you hold the note?

@Natalie Kolodij @Linda Weygant @Amanda Han @Steven Hamilton II

Linda Weygant · Answer

Great question.

If you sell and hold the note, the capital gains are spread over the life of the note. (Note the Depreciation Recapture occurs all in the year of title transfer and is not spread).

With some smart planning and a really good understanding of future income sources and amounts, you can possibly push the capital gains down to $0 since there is a 0% tax bracket available when all income sources are down below certain dollar amounts.

Interest Income is taxed separately outside of the gain, but would be included for purposes of calculating total income (in order to get that gain down into the 0% bracket)

Linda Weygant · Answer

Um.  yeah.  Maybe they will.

(Points to my designation in my header)

Natalie Kolodij · Answer

While those who weren't tax pros were chiming in...

Linda came in and provided the correct answer based on her years of experience as....Drum roll.......A CPA

Linda Weygant · Answer

Writing out the if/then logic loops on this would likely take the better part of the rest of my day.  Your best bet is to get with a tax expert and pay for some of their time to explain how this all flows together.  (Not me - my dance card is full for tax season).

I **think** @Natalie Kolodij may have some time available during tax season and I know she knows this strategy pretty well and she can probably outline it for you.

However, this is NOT something YOU should be doing for the sellers.  It's good for you to know the basics and understand that this exists, but your sellers absolutely need to be consulting with their own tax advisers when it comes down to actually negotiating the details of a deal like this.  There are way too many pitfalls in this for people not to make sure that every consideration has been considered by a professional whose job it is to consider them.

Mindy Jensen · Answer

A bit more info: He purchased it around $35k or $50k. They'll see capital gains around $210k so not insignificant.

@Linda Weygant your advice was hugely helpful to them. Thank you!

Basit Siddiqi · Answer

@Mindy Jensen mentioned that her friend brought the house at the bottom of the market hinting that the purchase price is low and there is a lot of appreciation.Her friend will pay tax on depreciation recapture on year of sale. Still vague how much that is since all we know that it was purcahsed in the bottom of the market.However, the good thing is that the tax related to the capital gain will be spread over the life of the installment agreement.In addition, the friend would be reporting interest income on an annual basis.To answer your question - No, tax on capital gain will be not be due in full on the tax return.

Jay Hinrichs · Answer

this is why i loved buying and flipping land so much.. no recapture ... just gain and interest..  recapture i dont like LOL..

Linda Weygant · Answer

No, your understanding is not correct.

1.  Tax paid in year of title transfer on Depreciation Recapture

2.  Tax paid on interest income over the course of the payment period.

3.  Capital Gain tax paid in the year of sale on the down payment as well as in subsequent years on the principal received over the payment period.

This is not a "no tax" transaction, it's a spreading of the capital gain over the payment period.

Sometimes, if you structure it properly, you can end up paying zero tax if and only if your total income is such that you can qualify for the 0% capital gains tax bracket.  It's not automatic and it's not a slam dunk.  It requires very careful planning and a complete and total understanding of the seller's other income in the future years and how to get things structured.

Scott P. · Answer

@Basit Siddiqi and @Linda Weygant have stated what my closest associate experienced, selling on contract (which i think is the same as "holding the note") meant for him that the Buyer started getting the depreciation and he got to immediately pay a lot of tax since he'd depreciated for so many years prior.  I understand  @Jay Hinrichs like of buying and flipping just the land ;-)

Thomas J. · Answer

Do a lease with purchase option instead of seller financing and you won't pay the gains until the sale goes through.  The IRS cares not that you lent the buyer the sale price.

How Do Capital Gains Taxes Work on Seller Financing?

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