Sell a rental house w/ owner financing and pay 0% capital gains?

Question

I am hoping that a CPA might respond to this post.

I'm going to sell a rental house via owner financing and I'm playing around with various loan amortization schedules to settle upon loan terms where I wouldn't pay any capital gains taxes on the sale. The buyer is flexible and has already agreed in principal to basic terms. A 420k sales price w/ 15% down, 6 yr loan @ 1% interest, yearly payments, would mean that my Form 6252 yearly payments would be around 62k and w/ a gross profit % of 75%, the yearly capital gains would be about $45700. Other income would only be about $6000, for a total income of roughly $51700. HSA deduction and standard deduction would give me taxable income of around 35k. In this scenario, as I understand it, I would pay $0 in federal income taxes for six years while living off the yearly payments. Why a 6 yr loan? I'm 54 and retired and this could get me nicely to 59 and 1/2.

Am I correct? Any tax pro comments would be appreciated!

I'd appreciate it if replies stick to the topic, which is taxes.

Thanks!

Jack Martin · Answer

@Sigurd Panke consider the advice by @Basit Siddiqi before you commit to a seller carry.  The inflationary environment alone is a compelling reason to own or have ownership interests in real assets.  A loan is static and will be negatively impacted by inflation.

If you are seeking favorable tax treatment upon the sale look to a 1031, or better yet, an investment in a property wherein bonus depreciation can be used to shelter your gains. If you are not familiar with bonus depreciation, do yourself a favor and spend a few hours reading up on the power of that strategy.

In particular, with an investment into a property wherein a high degree of its value from "land improvements" you may be able to shelter 100% of your gains.  Mobile home parks, RV parks, golf courses, and cemeteries are all examples of those.  The reason for this is that a large portion of the value of the property is allocated to land improvements, rather than a building.  100% of that portion of the property's value allocated to land improvements can be taken as a passive loss in the year the property was acquired.  That means significant tax shelter for investors in those kind of properties.

Additionally, when the property is exited in the future, recapture occurs at a maximum rate of 25% so in most cases that will create additional tax arbitrage for investors.

All the best,

Jack

Basit Siddiqi · Answer

depreciation recapture is taxed at the lower of your marginal tax rate or 25%

The risk of not getting paid, not having access to the capital now, inflation make this not a good deal. Almost better off paying the tax.

People also forget about state taxes which you may have to pay for.

Sigurd Panke · Answer

I appreciate the comments Basit and Jack, and if I were in another scenario, your advice would make way more sense than the seller financing scenario that I laid out. The reason I'm interested in it is that I'm 54, not working, and living off the sale of a personal residence from a couple years ago. That money will run out soon, and I have this rental house that could provide me w/ a tax free income stream of $60,000 - $70,000 per year for the next 5-6 years, after which I would access my IRAs and pensions and live off those.

I want to divest myself of my real estate, not continue to invest, so 1031s aren't of interest to me. This is all about living for the next 5 years and basically being retired from here on out

Selling w/ owner financing would save me about $80k in federal and state taxes and selling expenses, and I would be making another $10k or so in interest, so I would be netting $410,000 on the house price of $400,000 rather than $320,000. $90k for the hassle and risk of owner financing is a compelling number.

Sigurd Panke · Answer

I've only taken 11k or so of depreciation, and all of that is unrecaptured Section 1250 gain and is taxed as ordinary income in the year of sale. However, because the 11k of depreciation and the amount of my other ordinary income is less than the sum of my HSA deduction and standard deduction, I will pay no income tax on it, as I understand it.

I think that some years ago you had to pay 25% tax on your unrecaptured Section 1250 gain no matter what, so people have it fixed in their heads that you're going to pay it, and there's lots of misleading websites out there still saying that you're going to get taxed 25% depreciation recapture, but I think the IRS changed it somewhere along the line and that is no longer completely accurate, as discussed here:https://www.taxcpe.com/blogs/news/recaptured-and-unrecaptured-real-estate-rental-section-1250-gain and here: https://forum.thetaxbook.com/forum/discussion-forums/main-forum-tax-discussion/28485-is-the-schedule-d-tax-computation-worksheet-flawed

Wayne Brooks · Answer

A portion of what you receive will be apportioned to depreciation recapture, so you’ll pay ordinary income tax on that amount.

Sell a rental house w/ owner financing and pay 0% capital gains?

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