You decided to sell your property with owner financing to get a better price and close faster. But what are the tax consequences?
There are several tax issues that can affect both sellers and buyers in owner financing deals. If these are not handled properly, you could face penalties, interest charges, or worse — possibly having to start over with the IRS questioning your entire transaction.
FOR SELLERS
The Good News – Capital Gains
Here’s the biggest benefit: you don’t have to pay all your capital gains taxes upfront. Instead of writing a huge check to the IRS in the year you sell, you can spread those taxes out over the years as you receive payments.
For example, if you were to buy a rental property for $300,000 and sell it for $600,000 with owner financing, your gain is $300,000. In a regular cash sale, you would owe capital gains tax on the full $300,000 that year. With owner financing, if the buyer pays you 20% the first year, you only pay tax on $60,000 of the gain.
The Catch – Interest Income
It’s very important to remember that you must charge reasonable interest — at least what the IRS calls the “applicable federal rate;” otherwise, the IRS can declare part of your principal payments as interest, which gets taxed at higher ordinary income rates instead of lower capital gains rates.
Every month when you get the payment from the buyer, part goes toward principal, and part is interest. The interest portion gets added to your regular income and taxed accordingly.
The Immediate Hit – Depreciation Recapture
If you claimed depreciation on the property while you owned it, you likely will have to “recapture” some of that depreciation in the year of sale. This usually cannot be spread out like capital gains.
Annual Reporting
You need to file Form 6252 every year to report the installment payments you receive. The interest goes on Schedule B. If the buyer lives in the house, you must report their name, address and Social Security number to the IRS.
Annually you will have to send the buyer/borrower Form 1098-E showing how much interest they paid to you.
FOR BUYERS
Interest Deductions – Usually
The good news is that the buyer/borrower typically can deduct the interest you pay, just like a regular mortgage. This works whether it is your home or an investment property.
For rental properties, you can also depreciate the building like any other investment property purchase.
You Are Now the Property Owner
Once the deed transfers to you, property taxes and insurance are your responsibility. Some sellers will require you to pay these through an escrow account so they know you are keeping up with the obligations. Why? Because the property is their security if you stop making payments.
Watch Out for Alternative Minimum Tax
If you are in a high tax bracket and paying substantial interest, you might trigger the Alternative Minimum Tax, often referred to as AMT. This can reduce or eliminate your interest deduction benefits.
KEY ISSUES TO ADDRESS
Record Keeping
Both parties need to track every payment and know how much goes to principal versus interest. If this is not recorded properly, you will have problems with the IRS.
Both parties may want to consider using a loan servicing company to handle the payments and provide proper documentation to avoid problems later.
Regulation
There are certain laws and regulations governing owner finance transactions, and it is wise to consult an attorney to ensure that you are compliant with any applicable regulations.
Loan Structure
The loan must look like a real loan to the IRS. If the terms are too favorable or the documentation is not done in a professional manner, the IRS might say it is not really a loan, which can destroy your tax benefits.
Foreclosure Complications
If the buyer defaults and you must foreclose, there is a new set of tax issues. The buyer might owe taxes on the debt you forgave. You might be able to claim a loss, but there are limits.
ADVANCED STRATEGIES
1031 Exchanges
It is possible to combine owner financing with a like-kind exchange, but this can get complicated. You will need professional help to structure this properly.
Large Transactions
If your total installment obligations exceed five million dollars ($5,000,000), you will owe interest to the IRS on your deferred capital gains tax. This reduces the benefit of spreading out the payments.
Next Step
The bottom line is that owner financing tax rules are complex and the penalties for getting them wrong are severe. The complex transaction between capital gains, depreciation recapture, interest income, and various IRS elections requires expert guidance.
If you’re considering owner financing, consult with an attorney, such as the Lonergan Law Firm PLLC, for guidance.
Gaylene Rogers Lonergan
Real Estate and Title Attorney
Lonergan Law Firm, PLLC
12801 N. Central Expressway, Suite 150, Dallas, Texas 75243
(214) 503-7509
grogers@lonerganlaw.com | LonerganLaw.com
© Gaylene Rogers Lonergan and Lonergan Law Firm, PLLC, 2025. All rights reserved. This article is provided for educational reasons exclusively and is not meant to be construed as legal advice. The Lonergan Law Firm, PLLC, will represent you only after being retained and that agreement is made in writing.
