Filing Income Taxes With Note Income

5 Replies

Looking for help on seller financing my primary residence (of 2 1/2 years) when I move out later this year. I have an FHA loan, and have renovated the kitchen.

I am trying to figure out how to structure the deal to make the most sense for income tax purposes.


I assume I still claim mortgage interest deduction on my loan. 

1. Is this the only tax deduction I can claim? 

2. Does depreciation come in to play with deals that are seller financed?

3. How do I handle the income? 

4. What is the difference between note income and rental income?

This is just a starting point, so if I am missing information that would allow some tax professionals, and/or seller financing experts to help answer my questions please let me know - google searches on this subject don't yield great results so any and all help/direction on this matter would help me tremendously.

First, you really want to discuss this with an experienced accountant.  None of us really know your full situation and there may be something that matters.

1) You're still paying the mortgage, so, yes, you deduct that interest.

2) No.  You no longer own the property, so no depreciation for you.  If the buyer is using it as a rental, they could take depreciation.

3) Its ordinary income.   Reported as interest income.  But this is where things are really tricky.  Some of the money you receive is the return of your basis.  No tax on that.  Some is the gain on the sale (sales price less selling expenses less basis).  That's capital gain.  Since it was your primary residence the two of five year exemption may apply and you might avoid capital gains tax on all or part of the gain.  Then there's the interest income of the loan you've made.  That's ordinary income.  

4)  Well, they're both cash.  Both are, in the end, taxed as ordinary income.  However, rental income gets very favorable tax treatment (depreciation, specifically) that can reduce the taxable income.  Interest income is just that.  Same as from a bank account.  No special treatment there.

Realize you are violating the due on sale clause in your existing mortgage.  That gives the lender the right, but not obligation, to call the note.  But it does create a significant risk for you and the buyer.

If this is the one and only deal you do like this I don't think you will get caught under Dodd-Frank or the SAFE act.  But you want to discuss this with an attorney and be sure.

Thanks a million @Jon Holdman! You answers were very clear. So clear that I have more questions now :-)

I was trying to avoid being a landlord. Based on your response, it may be in my best interest to rent it out to benefit from depreciation. My capital gains would not exceed more than 50-75K so I am not worry about tax on that end.

Question: I realize you're not a tax professional, but can you elaborate on the basis and how I would figure out the difference. Specifically regarding the comment you made about "some of the money you receive the return of your basis..."

I am trying to estimate what the offset would be if I collected on a note that would be for $170-180K with 9-10% interest rate.

The whole issue of violating the due on sale clause is about as clear as mud. So many investors do different things that they believe makes them exempt from the due on sale clause in creative financing deals. 

Question: Does putting a subject to deal in a trust really provide protection from the due on sale clause?  If so, could you elaborate on how so.

Last Question: Why would I be less likely to be caught under the Dodd-Frank or SAFE act if this is my one and only wrap/sandwich deal?

Thanks again!

Let me take a stab at those in reverse order.

You really do want to consult with an attorney that's knowledgeable about Dodd-Frank and other lending issues.  @Bill G. may have some input, too.  It is my understanding, after a modicum of research recently, that if you do only one such deal in a 12 month period you have quite a bit of leeway.  If you do two or three, some more requirements come into play.  If you do more three in 12 months you're fully covered by these laws.

There is NO WAY to provide protection against the due on sale clause.  Trusts MIGHT let you hide what you've done, but they offer no protection.  The standard version of this clause has exemptions for transfers to family members and leases that are three years or less.  But an actual sale (subject to or a wrap), a land contract, an option, or a lease longer than three years typically all violate the due on sale clause.

Say you paid $100K for a house and has $2000 in closing costs that can be applied to the basis.  Your basis for the property is now $102K.  A few years later you make some capital improvement that costs you $25K.  Now your basis is $127K.  Now you sell it for $180K and have $14K in closing costs for a new from the sale of $166K.  Your basis is not taxable, so subtract that.  That leaves you with $39K in taxable gain.  If it was a property you occupied for at least two of the five years immediately before the sale closed you can shelter $250K of gains as a single taxpayer, $500K married filing jointly.  So, you would not actually have any taxable gain at all.  

Now, consider that you sell that property with a owner carried note of some sort.  And lets say you collect $18K in interest and that the buyer pays  you off before the year ends.  Now you have an additional $18K in income.  That's ordinary income.

Now, if the buyer continues to pay you over some years, then the money you receive in the first year is some combination of return of your basis, gains and interest.  I've not had to deal with it, so I don't understand the details of how this is sorted out.

Had that been an investment property, that $39K of gain would have been taxable as capital gains.  But the situation would have been more complex.  You would have been taking depreciation.  Say you owned it five years and had a total of $20K in depreciation on the original purchase and another $10K of depreciation on the $25K improvement.  So you have a total of $30K in depreciation.  When you sell, your basis is not $127K as in my example above.  Instead its $127K - $30K = $97K.  Now you have $69K in gains.  That gain gets divided into two parts.  First, the amount of gain up to the depreciation taken (or allowed, if you didn't actually take it all, I know of no reason why you would do that) is subject to tax on unrecaptured depreciation.  That's your ordinary tax rate but is currently capped at 25%.  Then you would pay long term capital gains tax on the remaining gain.  That's currently 15%.

So, I strongly encourage you to sit with a knowledgeable accountant and work through the different scenarios.

Now, if you do decide to turn that property into a rental, be very aware of that three year limit.  If you rent it for three or more years and then sell you lose that exemption for homeowners.  So if you sell and close that sale three years and one day after the day you moved out, the gain becomes fully taxable.  Close three years from the day you moved out and its not.  One of my co-workers had exactly this happen to him.  Rather than face that big tax bill, they moved back in.  After living there two years they will move out and sell.

I think Jon nailed it; And, the only thing to add is that your basis as a % of the sale price, then that percentage determines the % of principal that is allocated to the basis, the excess is a gain on the sale.

The buyer in an installment sale needs to be prepared to refinance the loan (or sell it) to meet any demands, if they can't it falls to the seller to pull the rabbit out of the hat.

I also suggest you not do what other investors do or have done, you need to see an attorney familiar with the current regulations. :)

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