Filing Income Taxes With Note Income

[Brittani Gardner]

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.

[Jon Holdman]

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.