Under Section 1041 of the Internal Revenue Code, transfers of property between spouses (or former spouses, if incident to divorce) are generally treated as gifts for tax purposes, meaning no gain or loss is recognized on the transfer. However, the monthly payments and interest you receive under the land contract may have different tax implications.
- Interest Payments: The IRS requires that interest income be reported as taxable income. If the land contract specifies an interest rate, that interest is taxable to you as the seller and deductible by your husband (if the property is used for business or investment purposes). If no interest rate is stated or if it is unreasonably low, the IRS may impute an interest rate, often using the Applicable Federal Rate (AFR) as a benchmark.
- Principal Payments: The principal portion of each payment is not taxed as income but is treated as a return of your basis in the property. If the sale qualifies as an installment sale under Section 453, you may need to calculate the gross profit percentage to determine the taxable portion of each payment. This percentage is the ratio of your gross profit (sale price minus your adjusted basis) to the total contract price.
Determining Interest vs. Principal: The IRS requires clear documentation to distinguish between interest and principal in each payment. Typically, the land contract should outline the payment breakdown. If it doesn't, you may need to allocate payments based on a reasonable interest rate and the remaining balance of the contract.
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