Tax Reporting For Real Estate Note Holders...

When real property is sold, and a real estate note and deed of trust/mortgage are carried back by the seller as part or all of the purchase price of the property, the gain on the sale is reported on the seller’s tax return as an installment sale.

The amount of interest received each year by the seller or note holder must be reported on Schedule B of Form 1040.

This is a very simple process if the note holder has an amortization schedule for the loan, which summarizes the interest portion of each payment received.

A portion of the principal received each year must also be reported on Schedule D of Form 1040 (and supporting Form 6251 for Installment Sales). This is not as simple as the tax reporting for interest.

The total amount of the gain on the sale is called the realized gain. Realized gain is the net sales price less the cost. The amount of the realized gain that is reported each year on the note holder’s tax return is called recognized gain.

The amortization schedule shows the amount of interest and principal reduction for each payment, and the yearly totals.

For this example, we will assume that the cost of the property (cost basis) was $40,000. The realized gain is the sales price ($100,000) less the cost ($40,000) or $60,000.

A simple technique for properly computing the recognized gain for each year’s tax return, and thus avoiding tax problems, is to first compute the gross profit percentage which is the realized gain divided by the sales price.

In the example, this percentage is $60,000 divided by $100,000 or 60%.

In the example, the property was sold in December 2007. The cash down payment was $5,000 and no payments were received on the note in 2007 because payments did not start until January 2008.

The amount of the gain to report on Schedule D in the first year (2007) is 60% of the $5,000 down payment of $3,000. For 2008, the amount to report on Schedule D is 60% of principal received in 2008 ($649.02 from your payment records) or $389.41.

For the next year, 2009, the amount to report on Schedule D is 60% of principal received in 2009 ($209.90) or $425.94.

In our example, let's assume that the note holder sold the note after two years. Therefore, he also has to report the net amount he receives on the sale of the note in 2009.

The additional amount to report in 2009 is 60% of the remaining note balance of $93,641.04 or $56,184.62. Notice that the total of the four amounts reported ($3,000 + $389.41 + $425.94 + $56,184.62) is equal to the $60,000 realized gain that must be reported over the life of the note.

However, what about the discount? The note holder did not receive the entire remaining balance of $93,641.04 when he or she sold the note. The note holder receives $66,229.43 in our example.

In this case, the note holder takes the entire discount of $93,641.04 less $79,501.55 or $14,139.49 as a tax deduction thus reducing the amount to report on Schedule D in 2009 from $56,184.62 to $42,045.13.

Tax reporting for partial sales and split funded sales are somewhat more complicated than this example for a full sale.

You should consult your tax advisor for the tax reporting method for these types of sales.

If you have an amortization schedule for your note, the yearly principal paid the yearly interest paid are simply taken from the yearly totals shown on the amortization schedule.

Note: The above information is presented AS IS for informational purposes only. We are not tax attorneys or financial advisors.