sold a rental house with seller financing and I am receiving interest only for the first three years and then a balloon payment

[jbesrtt1230]

I sold a rental house with seller financing and I am receiving interest only for the first three years and then a balloon payment. For income tax purposes when do I report the capital gain - when the balloon payment is received?  Will I report only interest income for the first 3 years?

Thank you.

[Critter-3]

Oh boy ... I hope you got enough of a down payment to cover the recaptured depreciation if not you are going to be unhappy with your bottom line on the form 1040.

For the installment sale form 6252 you will enter all payment received at closing and during the year ... so if all you got was the interest then that is all that will be reported on the form 6252.  In the rental section go slowly to indicate the sale and the disposal of all the associated assets.  I highly recommend you either seek local professional assistance   OR   upgrade to the LIVE option for one on one guidance  if you do not feel you understand what is going on. 

[AmeliesUncle]

You have a choice. 

(1) You can report it in the year of the sale.  But if you have a large gain, you will have a large tax bill and may not have the money to pay the taxes.

(2) As Critter noted above, report it as an Installment Sale.   If you do that, in your case you will only pay taxes on the interest that you receive.  You will pay taxes on gain based on when you receive the payments for the 'principal' (in your case a balloon payment).

@Critter-3   Most likely there won't be any tax besides the on the interest.  The gain based on the depreciation of a rental property is "Unrecaptured Section 1250 Gain".  That is NOT immediately taxable with an Installment Sale (unlike depreciation "recapture" of other depreciable property).

[Critter-3]

@AmeliesUncle   As I remember when teaching this subject those practice problems on which enough first year payments were not enough had large tax bills they could not avoid ... 

 https://thismatter.com/money/tax/installment-sales.htm

If the installment sale was of depreciable property, then the depreciation recapture is taxed in the year of the sale; only the capital gain is reportable on the installment method. ... Instead, interest earned on the installment payments is reported as interest income on Form 1040, U.S. Individual Income Tax Return.

Installment income from the sale of rental property or of a business is figured on Form 6252, Installment Sale Income, then transferred to Form 4797, Sales of Business Property. An election is made to report the entire gain in the year of the sale by reporting the sale on Form 8949, Sales and Other Dispositions of Capital Assets or Form 4797 or both, but not on Form 6252.

If the installment sale was of depreciable property, then the depreciation recapture is taxed in the year of the sale; only the capital gain is reportable on the installment method. The depreciation recapture is figured in Part III of Form 4797 and is reported as ordinary income in Part II of that form, and is also used in Part I of Form 6252 to calculate the gross profit percentage.

The gain portion of the annual payment does not include interest, which is taxed as ordinary income to the seller. Instead, interest earned on the installment payments is reported as interest income on Form 1040, U.S. Individual Income Tax Return. The allocable gain of each annual installment payment is reported on Form 6252, then the installment income is transferred to Schedule D, Capital Gains and Losses.

[AmeliesUncle]

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@Critter-3 wrote:

If the installment sale was of depreciable property, then the depreciation recapture is taxed in the year of the sale;

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As I noted above, the tax based on the gain of the depreciation of a home (Section 1250 property) is NOT "recapture".  It is "Unrecaptured Section 1250 Gain", which is NOT taxed in the year of the sale.

[Carl]

Hopefully you got all your legal ducks in a row. Based on my personal knowledge of the first hand experience of others with a seller financed loan, the probability you will foreclose on the sale in the first 2 years is 95%. Chances you will foreclose in the first 5 years is 100%. So be ready for a tax nightmare that I can assure you will require professional help - especially if your state taxes personal income.