when do you start recognizing a capital gain when owner financing

Question

I am considering owner financing the sale of a building I own.  Will I owe cap gains as soon as I start getting payments or will I not owe cap gains until all of my basis is paid back?  Say it took 10 years to get back my basis, would I not pay any cap gains for the first 10 years?

Linda Weygant · Answer

You begin recognizing the capital gains when you receive the first payment.  Essentially, you figure out your up front gain, then recognize it a little bit at a time as the payments come in.

Brendan Hallissey · Answer

Thank for the responses. Yes the property is a rental that I have owned for about 3 years. Recapture should be minimal. The market in our area has been going up and I would like to cash in on that now because I fear what will happen if rates go back up.

Ashish Acharya · Answer

@Christopher Smith ,

You dont get taxed immediately.  There are many factor involved.

@Brendan Hallissey ,

is this the rental property that you are trying to sell?

If no, there might not be any gain and no depreciation recapture

If yes, how old is it?  Did you place it in service and depreciate it before 1986. If you did not, the depreciation recapture (unrecaptured 1250 depreciation)is not taxed immediately, rather it is taxed with each payment (First few payments - front loaded, see below).

Although, the capital gain will be recognized on yearly basis for 10 years.

The unrecaptured 1250 depreciation that is taxed at 25%  is not deferred for 10 years, but a front-loaded approach applies to the installment recognition of unrecaptured 1250 depreciation.

If yearly gain from an installment sale includes both unrecaptured Section 1250 gain (25% gain) and capital gain. The unrecaptured Section 1250 gain is reported before the capital gain.

You would be paying 25% on the first few installments gain rather than  ( 0 ,10, or 20% capital gain - whichever applies to you)

To answer your second question:  It is complicated but simply stated:

Gain will be recognized when you repossess the house because you received few payments before default.

More complicated answer if you are interested:

if you repossess the property, a special mandatory rule may apply.  Generally, you will recognize all interim installment payments as gain(on top of what you had already recognized before with each payment before default). But this gain you have to recognize is limited by the original gross profit ratio. The gain that is limited by the ratio is used to adjust the basis. Ordinarily, the limitation on total gain does not apply, which results in your's tax basis in the repossessed house being the same as when the property was sold (increased by any expenses incurred in repossessing the property).

Dont worry about this, If you will repossessed the house, you have to get a CPA.  He/She will do this.

Brendan Hallissey · Answer

Thank you for your responses. I was hoping I could delay the tax hits to be in a few years to coincide with an expected lower income and end up owing no cap gains because income will be in the 15% bracket.

Michael Plaks · Answer

@Brendan Hallissey

Short answer to your initial Q.

Each of your payments, including the down payment, is split into 3 parts:

• interest (taxed)
• principal return (tax-free)
• capital gain (taxed)

So, in effect, you start paying capital gain taxes right away, but it is spread over 10 years, using your example.

To your follow-up question about a default down the road: forget about it. :)  The tax consequences in such event will not make any sense to you, even if I tried to explain. You will have a very strange tax hit when you repossess. But eventually, over the lifetime of this property, everything will even out. I second @Ashish Acharya: don't try handling a default without a tax accountant.

Michael Plaks · Answer

@Christopher Smith

You were incorrect. Depreciation recapture is NOT taxed immediately. It is part of the capital gain and is spread over the owner-financed period.

I don't want to dive deep into technicalities, but your mistake is very common and 100% justified. Recapture is indeed taxed immediately, but what we deal with is not really depreciation recapture, but an "unrecaptured Section 1250 gain" - a very different animal, despite an almost identical name.

Ashish Acharya · Answer

You are absolutely right. We should just reply with general laws to all the questions here. Thanks. Peace

Christopher Smith · Answer

What I provided were the general instalment sale provisions and they were in fact correct as stated.

Of course every situation has it's own facts which may deviate from the general rule for which we could go on all day about ad infinitum. So your comment on many factors adds nothing other than a declaration of the utterly self evident.

Brendan Hallissey · Answer

what would happen in the event of a default and you never fully realized the gain? Could you get that tax back?

Christopher Smith · Answer

After recapturing any depreciation previously taken (taxed immediately), then the remaining gain is recognized ratably with each payment. This assumes you fully qualify for instalment sale reporting.

when do you start recognizing a capital gain when owner financing

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