Tax Consequences of Owner Finance

[NCREI]

Another question on owner financing (hypothetical example)...

If I rent a house to a tenant for $1000/month and have a mortgage with a principle of $100 and interest of $600, for tax purposes I've made $400 minus other expenses for that month.  20 years later the same house is still renting for $1000/month with a principle payment of $600 and an interest payment of $100, for tax purposes I've made $900 minus other expenses for that month, right?

Now, if I sell a house using a land contract to someone so that the payment to me is $1000 and I have an underlying mortgage where I'm paying principle of $100 and interest of $600, what is my income for tax purposes?  How about when the principle of my mortgage is $600 and interest is $100?  I'm so confused on how owner financing is taxed I can't even clearly ask the question.  Sorry.  Thanks for your insight.

[Dave T]

If I rent a house to a tenant for $1000/month and have a mortgage with a principle of $100 and interest of $600, for tax purposes I've made $400 minus other expenses for that month.  20 years later the same house is still renting for $1000/month with a principle payment of $600 and an interest payment of $100, for tax purposes I've made $900 minus other expenses for that month, right?

In theory, you are correct.  In practice, assuming a 30 year mortgage, you will have only paid a little less than half of your original loan balance in 20 years.  So, your $700 monthly payment will be more evenly divided between interest and principal.


Now, if I sell a house using a land contract to someone so that the payment to me is $1000 and I have an underlying mortgage where I'm paying principle of $100 and interest of $600, what is my income for tax purposes?  How about when the principle of my mortgage is $600 and interest is $100?  I'm so confused on how owner financing is taxed I can't even clearly ask the question.  Sorry.  Thanks for your insight.

If you are only looking at the interest income you receive from the loan to your seller and the interest payment you are making on your underlying mortgage, the rule is:

                 Net Interest Income = Interest Income - Interest Expense

The formula does not change whether your interest payment (expense) is $600 or $100. 

[NCREI]

Net Interest Income = Interest Income - Interest Expense

Ahhh...  Now I understand.  I was thinking that principle received would be considered income but using the formula above makes sense.  Thank you!!

[Dave T]

Well, if you want to talk about the principal balance, you only look at the payment you receive from your buyer. 

The principal payment you make on your underlying mortgage is increasing your equity in the property, but it is not a deductible expense.  The principal you receive from your buyer is divided between return of basis and profit.  Only the profit part is taxable income. 

Maybe an example will help.  Let's say you buy a house for $125K which you use as a rental.  You put $25K down and finance the rest at 6% fixed for 30 years.  After two years, your tenant asks you if you will sell him the house.  You both agree on a $150K sale price.  The buyer gives you $15K and you "finance" the balance of the sale price on a contract for deed at 8% on a 30 year amortization with a balloon payment in three years. 

The difference between the interest that you are paying on your 6% mortgage and the interest your buyer is paying you on his 8% loan is taxable to yoiu as ordinary income (at whatever your tax bracket rate is).   Because you are receiving your interest income over three years, only the actual amount of NET interest received during the tax year is reported on your tax return each year.

Since you used the property as a rental for two years, you were allowed two years of depreciation.  Let's say your depreciation basis was $80K (you can't depreciate the cost of the land) and you took $5800 in depreciation expense during your holding period.

Unrecaptured depreciation is taxed at 25%, so when you sold the property, the first $5800 of principal received is taxed as unrecaptured depreciation.  Principal received beyond the first $5800 is deivided between profit and a return of basis.  Only the profit is taxed as a capital gain at whatever capital gains rate applies to you when you receive the income.

Does this help?

T

[NCREI]

Dave T. -

Yes, this helps.  In fact you're a step ahead of me, already answering what would have been a follow-up question on how capital gains is handled.  Thank you!