You used owner financing to sell your property in order to earn more and close the deal faster. Are there any tax consequences?
Both buyers and sellers can be affected by several tax issues related to owner financing. Obviously, each one needs to be handled properly. Otherwise, there could be interest charges, penalties or other problems, such as the IRS questioning your transaction and requiring you to begin the process all over again.
IMPLICATIONS FOR BUYER/BORROWERS
Interest Deductions
A buyer/borrower in an owner finance transaction typically can deduct the interest paid, just like a regular mortgage. This is true whether the property is used as a home or an investment property.
Buyer/borrowers can also depreciate rental buildings like any other investment property purchase.
New Responsibilities as the Property Owner
The buyer/borrower is responsible for paying the property taxes and insurance once the deed is transferred to him/her.
Some sellers require them to make these payments through an escrow account so they can be sure the obligations are being met because, after all, the property is their financial security if the buyer/borrower stops making payments.
Alternative Minimum Tax
The Alternative Minimum Tax may be triggered if the buyer/borrower is in a high tax bracket and paying a substantial amount of interest. This situation can reduce or even eliminate the interest deduction benefits.
IMPLICATIONS FOR SELLERS
Capital Gains Benefit
Sellers are not required to pay all the capital gains taxes upfront. Rather, they can spread the tax payments to the IRS over the years as payments are received from the buyer.
Charge the Right Amount of Interest
The seller is required to charge a reasonable interest, which the IRS dubs the “applicable federal rate.” Failing to do so means the IRS can declare a portion of the principal payments as interest, which is then taxed at the higher ordinary income rates rather than the lower capital gains rates.
Each month that a seller receives a payment from the buyer/borrower, part of it goes toward principal and part is considered interest, which is then added to the seller’s regular income and taxed accordingly.
Depreciation Recapture
Sellers likely will be required to “recapture” some of the deprecation in the year of the sale if they claimed depreciation on the property while owning it. This amount usually cannot be spread out like capital gains.
Annual Reporting
To report the installment payments received, sellers must file Form 6252 every year. The interest is listed on Schedule B. They must also report to the IRS information about a buyer who lives in the house, including the name, address and Social Security number.
As the seller, you are required to send the buyer/borrower Form 1098-E, which lists the amount of interest they paid to you that year.
KEY ISSUES FOR BOTH PARTIES
Record Keeping
Every payment should be tracked by both parties, detailing the amount paid to principal and to interest. The IRS will come calling if these are not recorded properly.
A loan servicing company may be a good option for both parties to consider for the purposes of properly handling payments and reporting and providing the necessary documentation.
Legal Implications
As in every area of real estate transactions, certain laws and regulations govern owner finance. A real estate attorney can provide the information necessary for both parties to be compliant.
Loan Structure
A properly executed owner finance loan is a real loan, and it must appear as such to the IRS. This means that if the documentation is not professional or if the terms are too favorable, the IRS may not consider it a proper loan. This in turn can significantly impact tax benefits.
Complications with Foreclosure
There are additional tax issues when a buyer/borrower defaults and the seller forecloses on the property. It may be possible to claim a loss, but there are limitations.
ADDITIONAL STRATEGIES
1031 Exchanges
If you choose to combine owner financing with a like-kind exchange, you most likely will need professional help to structure this complicated process.
Large Transactions
You will owe interest on deferred capital gains tax if your total installment obligations are greater than five million dollars ($5,000,000). Unfortunately, this reduces the benefit of spreading out the payments.
NEXT STEP
Owner finance tax rules are complicated, and the penalties for not following them are serious. The complex transaction between capital gains, depreciation recapture, interest income, and various IRS elections requires professional guidance.
If you are considering using owner financing as a buyer/borrower or seller, 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.
