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. 

[Account Closed]

Quote from @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!

 Something i would like to add: You probably don't want to seller finance the whole thing. Make sure they bring some equity to the deal, even if its only 5%. That way they are more invested to continue to make payments. 100% seller financing can be risky if the market changes and your upside down on it, and the owners stop paying. 

[Basit Siddiqi]

If your basis is $100,000 and your sales price is $250,000 then $150,000 / $250,000(60%) of each principal payment will be considered gain.

[JD Martin]

Quote from @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. 

 Thanks for the reply.

The structure would be just like as if I were the bank. The owner would be responsible for everything. The only right I would retain were the right of foreclosure should principal & interest payments not be made. We don't have any local laws here, just state laws. TN is a Deed of Trust state FWIW. The deal would be something along the lines of 3-5% down and financing at a fixed rate amortized over some period (probably 20-30 years). 

So just as an example: I would sell the house for $250k. I would finance let's say $240k for 25 years at 7.5%. That's a monthly payment of $1775 (which is pretty close to his current rent payment). Let's say my basis in the house is $75k (that's close). So far I've had about $27k in depreciation write off over 10 years. In year 1 I would collect about $17,900 in interest and $3,400 in principal. Using those numbers, just as an example, how would what I collected apply to my interest, basis refund and capital gains, and how does depreciation work there?

[JD Martin]

Quote from @Basit Siddiqi:

If your basis is $100,000 and your sales price is $250,000 then $150,000 / $250,000(60%) of each principal payment will be considered gain.

 Thanks Basit! So in year 1, using my numbers just above this, I'm collecting $3400 in principal repayment. That means that my overall capital gains (my basis is actually close to $75k) would be $175,000/$250,000, which is 70%, so $2380 of that principal repayment would be taxable at whatever my level is - do I have that right? 

If you know, how does depreciation recapture figure into this? Michael says that it becomes part of the 3-tier application of the payments received by my former tenants. So far I've had about $27k in depreciation write off over 10 years or so. 

[Melanie P.]

This deal is truly not worth doing. Either continue renting to them or sell the place for cash, but doing financing for someone the banks have already determined is not creditworthy is not a good use of your time. This will be an ongoing headache for 30 years (or until you foreclose) without any of the upsides you're used to. The monthly payment isn't going to get bigger, all kinds of crazy taxes to get out of the real estate eroding the payments you do receive every year and no opportunity to participate in appreciation. 

Tell the tenants to contact you when they have financing pre approved and are ready to discuss price.

[Michael Plaks]

Quote from @JD Martin:

So in year 1, using my numbers just above this, I'm collecting $3400 in principal repayment. That means that my overall capital gains (my basis is actually close to $75k) would be $175,000/$250,000, which is 70%, so $2380 of that principal repayment would be taxable at whatever my level is - do I have that right? 

If you know, how does depreciation recapture figure into this? Michael says that it becomes part of the 3-tier application of the payments received by my former tenants. So far I've had about $27k in depreciation write off over 10 years or so. 

Yes, $2,380 will be taxable capital gain. It will all go towards depreciation recapture until your entire $27k depreciation is recaptured. After that, it becomes long-term capital gain. The rates depend on your overall tax bracket each year.

[JD Martin]

Quote from @Michael Plaks:

Quote from @JD Martin:

So in year 1, using my numbers just above this, I'm collecting $3400 in principal repayment. That means that my overall capital gains (my basis is actually close to $75k) would be $175,000/$250,000, which is 70%, so $2380 of that principal repayment would be taxable at whatever my level is - do I have that right? 

If you know, how does depreciation recapture figure into this? Michael says that it becomes part of the 3-tier application of the payments received by my former tenants. So far I've had about $27k in depreciation write off over 10 years or so. 

Yes, $2,380 will be taxable capital gain. It will all go towards depreciation recapture until your entire $27k depreciation is recaptured. After that, it becomes long-term capital gain. The rates depend on your overall tax bracket each year.

 Thanks! That's super helpful - so essentially until I clear the depreciation recapture everything that's not part of the basis repay is going to at 25% or above, depending on where my overall bracket falls. That at least allows me to do some rudimentary calculations on tax implications.

[Michael Plaks]

Quote from @JD Martin:

Quote from @Michael Plaks:

Quote from @JD Martin:

So in year 1, using my numbers just above this, I'm collecting $3400 in principal repayment. That means that my overall capital gains (my basis is actually close to $75k) would be $175,000/$250,000, which is 70%, so $2380 of that principal repayment would be taxable at whatever my level is - do I have that right? 

If you know, how does depreciation recapture figure into this? Michael says that it becomes part of the 3-tier application of the payments received by my former tenants. So far I've had about $27k in depreciation write off over 10 years or so. 

Yes, $2,380 will be taxable capital gain. It will all go towards depreciation recapture until your entire $27k depreciation is recaptured. After that, it becomes long-term capital gain. The rates depend on your overall tax bracket each year.

 Thanks! That's super helpful - so essentially until I clear the depreciation recapture everything that's not part of the basis repay is going to at 25% or above, depending on where my overall bracket falls. That at least allows me to do some rudimentary calculations on tax implications.

Yes, except the recapture rates. It's not 25% and never above. It's your regular bracket rate capped at 25%.

[JD Martin]

Quote from @Michael Plaks:

Quote from @JD Martin:

Quote from @Michael Plaks:

Quote from @JD Martin:

So in year 1, using my numbers just above this, I'm collecting $3400 in principal repayment. That means that my overall capital gains (my basis is actually close to $75k) would be $175,000/$250,000, which is 70%, so $2380 of that principal repayment would be taxable at whatever my level is - do I have that right? 

If you know, how does depreciation recapture figure into this? Michael says that it becomes part of the 3-tier application of the payments received by my former tenants. So far I've had about $27k in depreciation write off over 10 years or so. 

Yes, $2,380 will be taxable capital gain. It will all go towards depreciation recapture until your entire $27k depreciation is recaptured. After that, it becomes long-term capital gain. The rates depend on your overall tax bracket each year.

 Thanks! That's super helpful - so essentially until I clear the depreciation recapture everything that's not part of the basis repay is going to at 25% or above, depending on where my overall bracket falls. That at least allows me to do some rudimentary calculations on tax implications.

Yes, except the recapture rates. It's not 25% and never above. It's your regular bracket rate capped at 25%.

 Right - I meant that 25% would end up being my baseline, with the possibility of the interest payments being higher. I usually do a test run of my taxes in November so that I have time before 12/31 if I need to make any moves, so at least I know what I can count on at the bottom level, since I already know my bracket will end up being at or above 24% this year.