Seller Financing Tax Implications for Seller

[Bryan Petrinec]

How is income from a seller-financed property treated from a tax perspective?  I am considering selling a property that has no mortgage on it through seller financing.  I know that if I were to sell it through a standard mortgage, there would be up to $250k of capital gains that would be tax free as a single person, 500k as a married couple.  

For sake of this example, assume I'm single, I'm selling a home for $500k that has a basis of $250k and forget about all the closing costs.  If I do this as a seller-financed deal, I would be getting P&I payments of $2500/month and the deal is a 30-year amortization with a 10-year term.  

I assume, and this is where I need clarification, that the principal in the monthly payment is tax free (repayment of capital) and the interest is treated as ordinary income just like most investments.  Then after 10 years, when there is a large ($200+k) payment or if the seller refinances before then.  Is that money then just considered as proceeds from the sale and not taxed since the overall capital gains were less than $250k?  Or is there some way this becomes ordinary income or has a long-term capital gains tax applied?  

I am interested in proceeding with this deal as seller financing, but I don't want to be hit with any unforeseen tax burden in 10 years or sooner when the buyer refinances.

Thank you in advance and yes, I will seek the advice of my CPA also.