Federal Income Tax Seller-Financed Interest Requirements
The difference between the sale price and the price originally paid for the property is a taxable capital gain or loss. When a seller finances the purchase, the tax on the gain is spread over the life of the loan. Interest received on the loan is also subject to income tax.
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Capital Gain on an Installment Sale
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When seller-financed property is sold at a gain, the installment method must be used for reporting the gain unless the seller opts out of this method. Generally, it is more advantageous for a buyer to delay payment of the tax on gain until the money is received.
Installment Method of Reporting Gain
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The installment method treats each payment as a combination of return of investment, profit on the investment and interest. The seller reports the profit portion of the payments made in a year as capital gain on Schedule D and the interest income on Schedule B. The return of investment portion of each payment is not taxable.
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Unstated Interest Rules
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In cases in which no adequate stated interest is specified, the buyer may be required to treat a portion as interest income. The unstated interest rules do not apply when the total payments on the loan are less than $250,000. Internal Revenue Service Publication 537 offers more details about when the rules apply and how to calculate the adequate interest.
Capital Loss on an Installment Sale
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When property is sold at a loss, the capital loss must be claimed in the year of the sale. If there are insufficient capital gains to fully offset the loss, they may be carried over to future years according to the standard rules for loss carryover. The rules concerning unstated interest apply, potentially reducing the capital loss and resulting in positive interest income over the life of the loan.
Sale of a Main Home
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The purchaser of a main home will be able to deduct the interest portion paid each year from his income taxes. The name, address and Social Security number of the buyer must be listed on the seller's income tax return. Unstated interest rules do not apply to a sale of a main home.
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References
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