Tax implications for seller financing to my current tenant

[JD Martin]

Good afternoon all!

One of my tenants that I've had for several years is interested in purchasing the home that he's currently living in (he's rented two different homes from me). They've been good tenants but don't have any real means to qualify for buying the house in the traditional sense. He asked me about financing the home for them. 

I'm trying to figure out what the potential tax implications are here. Let's assume we would do a straight 30 year amortized mortgage. From what I can gather, whatever they pay in interest during the year I would declare as interest income on my taxes (and issue them a 1098?). I am less clear on when I do my depreciation recovery (that year of the sale?), and how capital gains would factor into the equation. I assume that I don't actually have to pay the capital gains until the principal repayment exceeds my cost basis, which on an amortized loan would be quite awhile (assuming they don't refinance and pay me off altogether). At that point am I declaring capital gains based on what I've brought in, and paying based on that? For example, say my basis is $100k and I'm selling the property for $250k. On an amortized basis it will be about 13 years before we hit even. Every year after that would be an increased amount of gains until year 30. Do I pay taxes on the incremental gain each year? 

Is there anything else (from a tax perspective) that I'm missing? I own the property free and clear so the only annual deductions have been maintenance, repairs, taxes, depreciation. 

Thanks!

[Michael Plaks]

@JD Martin

I know you want a simple answer, but there is none in this case.

First, we will need to determine whether this owner financing constitutes a sale. This depends on how the deal is structured and what rights and responsibilities you retain vs what you transfer to your current tenant. It also partially depends on your local law. And it's not black and white in most cases. Yes, I know.

Assuming it is a sale, your approach is not how it works. Every payment, including down payment and monthly payments, will have 3 parts: taxable interest, taxable capital gain and tax-free return of basis. You will not have to recapture depreciation in the year of sale, it will be baked into the 3-component payments. The mechanics are too tedious to explain.

If it's not considered a sale, it's even more complicated.