Saturday, February 18, 2012

Installment sale of real estate

There are a few things to consider if you make an installment sale of a former home.
If you have no mortgage, you may want to owner-finance the sale.  If you still owe on a mortgage, you can still owner-finance it with a "contract for sale" or "land contract."  The advantages are that you can avoid brokerage fees and a lot of other expenses and you can collect both principal and interest over 20 or 30 years.   Also, if any part of the sale is taxable, you can spread the taxable gain over the life of the mortgage rather than paying it all in the year of the sale.  You will probably need to pay an attorney to prepare the documents.

I had a home I later sold.  I had taken some depreciation deductions for a home office while I lived there.  Later, I rented the house and took depreciation on the entire house.   While it was rented, I paid off the mortgage I owed, then sold it to the tenant who had been renting it and gave him a warranty deed.

I sold it late in the year, so the taxable percent of the principal he paid was fairly small.  I had sold it for a little more than it had cost me, and my cost basis was further reduced by the depreciation I'd taken.   When I prepared my tax return, I somehow ignored  Section 121 which exempts the gain on the sale of a home that you had lived in for at least two of the last five years preceding the sale.   It made very little difference on the first year but in future years, it would become increasingly important.

So I filed an amended return to set the record straight.  I got a small refund--not enough to justify filing the amended return for the sake of the refund.  However it would make a lot of difference over the years as more and more of the payment would become taxable as he reduced the balance of the mortgage. 

The only part of the principal that I had to pay tax on is the percentage attributable to the depreciation I had taken for the home office and for the period rented.  By spreading it over the life of the mortgage, it will be fairly small each year since the total depreciation was not a high percentage of the cost of the house. 

If I had not reported it on the installment basis, the tax on the gain would have been significant in the year of the sale.  In some cases a large gain could exceed the total amount collected on the installment sale especially if the sale took place in December.

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