Seller in seller finance deal worries about capital gains

[Dave S.]

The situation is as such, Seller owes house free and clear Seller is offering me 100% seller financing I'm going through an attorney to get the mortgage note and all paperwork together. Will the seller be responsible for paying capital gains on the property in the tax year of closing???? Or when I go to refinance the property and he actually gets the funds? It's hard for me to believe that someone will be responsible for paying capital gains / taxes on money that they don't have in hand. Once the seller gets the funds (I.e I refinance him out) and he gets the money then he can get taxed on it. Up to that point the only taxable funds would be the income from my monthly payments?

[Nathaniel Busch]

In general, he shouldn't need to pay capital gains on the income until the principal is received on cash.

For example, he has basis of $50,000 in property and agrees to sell to you on seller financing for $100,000. His tentative gain is $50,000.

In year one, you give him a 10% down payment. He will be responsible for reporting 10% of his tentative gain ($5,000).

In year two, you make principal payments of $10,000 to him (which represents 10% of the total sales price). He would need to report another 10% of his total gain ($5,000).

And so forth.

In your example, if you would pay interest only then have the whole loan balloon when you can refi at a later date, he would delay paying the cap gains until he receives the cash at the time of the refi.

Of course, he would pay ordinary tax rates on the interest you would pay him.

This is called the installment method of reporting.