Tax implications of offering an interest-only owner financed loan when selling a house

[kritter-k]

I plan to sell a house that I allowed my deceased parents to live in rent free. I never took any depreciation or claimed any other tax break for the house. I’m considering offering an interest-only owner-financed loan with no prepayment penalty to expedite the sale, and I’d like to know the tax ramifications.

For example, assume the listing price is $430K and I offer to finance the house at 5.5 percent with $140K required as a down payment and the balance due within 5 years. Would the monthly interest-only payments I’d receive be taxable as regular income each year? And would the down payment be taxable as capital gains in the year in which the house sale closes (2025), or would the capital gains for the down payment plus the rest of the principal not be taxed until the loan was paid off? Also, are there any other tax implications of doing this?

[Vanessa A]

Yes.  The monthly interest only payments would be taxed as income income as your ordinary income tax rate. 

Yes, the down payment would be capital gains (assuming your parents lived there more than 12 months so it is a long term asset) in the year you make the deal.  Unless you opt out of the installment sales method, you would report the gain on the portion of the sale made each year.  You would deduct your basis on a prorated basis from the sale each year as well.  

So if your basis in the house was $200k and you sold the house for $430k with a 5 year term, your profit on the house would be $230k. Your profit percentage would be 53% (230,000/430,000) so 53% of your $140k down would be taxable profit. 

The rest of the principal would be taxed in the same way in the year you received the payments.  

There are not really any other tax implications for doing this, other than increasing your income each year which does result in higher taxes.  However, depending on the profit received each year, depending on your other income, you may end up with a lower year over year capital gains tax rate than you would if you claimed the sale all at once.  

Installment Sales Pub 537

 

[kritter-k]

What impact would not having any profit from the sale have? The house is a long-term asset in a community property state, and my husband died a year ago. Because of the 100% step-up in cost basis I should receive for the house due to his death, plus the cost of improvements we made to the house, I shouldn’t owe any capital gains taxes. Would offering owner financing interfere with getting the step-up in basis?

[Vanessa A]

No. The stepped up basis is only based on the death of the spouse.  There is not an income component to it so the interest would not affect this. 

If you had no gain on the sale, you would still need to report the sale to show you don't have a gain. 

[kritter-k]

So I think you're saying I'd still pay income tax on any interest I receive each year, which makes sense. But how would I claim the step-up in basis and show that I had no gain if I received the down payment in one year and the balance up to 5 years later? Would I have to opt out of the installment sales method so that I could report the entire sale all at once in the first year to show I have no gain?   

[Vanessa A · Accepted solution]

Correct.  You will have to pay income tax on any interest regardless of a gain, loss or no profit or loss on the sale.  The interest is treated separately.

You can choose to opt out of the installment method which would make it easier if you have no gain to report the sale in the year it is sold.