Many sellers opt to sell their property on a land contract or a contract for deed. These arrangements allow you to, in essence, act as the lender and turn your property into a long-term stream of income. They also allow you to spread out the principal that you receive, which lets you avoid receiving a large lump sum of money all at once which could be subject to capital gains tax.
Down Payment as Income
Most sellers who sell on a land contract request some down payment from the buyer of the asset. A down payment is a good idea because it ensures that the buyers have some "skin in the game" and helps to reduce the risk that they will walk away from the property if a problem occurs. Unfortunately, the IRS treats capital payments as depreciation recapture, taxed at 25 percent, rather than capital gains, taxed at 15 percent, then as tax-free repayment of existing capital. For example, if you sell a building for $1 million, for which you paid $800,000 and took $100,000 in depreciation, your basis would be $700,000. If the buyer on the contract gave you a $200,000 down payment, you would pay $25,000 in tax on the $100,000 of recaptured depreciation and $15,000 in tax on the $100,000 in capital gains, based on the rates in effect for the 2011 tax year.
Interest Payments as Income
The IRS taxes interest payments as regular income. To calculate them, apply the marginal tax rate for your income and filing status. Taking the example of the $800,000 land contract in Section 1, if you were to use a 6-percent interest rate and 30-year amortization, you would collect $47,733 in interest in the first year. At a 28-percent marginal income tax rate, you would owe $13,365 in taxes.
Principal Payments as Income
The principal payments you receive on your land contract, whether they are part of the buyer's monthly payments or come in the form of a large balloon payment at the end of the contract, are taxed in the same way as the down payment. Continuing with the example of the $1 million sale and $800,000 contract, it would take about 98 months to collect $100,000 in principal payments, all of which would be taxed at the long-term capital gains rate which, as of publication, is 15 percent. Any principal payments after the first $100,000 would be tax-free.
1031 In Lieu of a Land Contract
Land contracts allow you to turn real estate into income streams, but you will end up paying all of your capital gains and recapture taxes. You can also do a 1031 tax-deferred exchange where you sell your real estate and use the proceeds to buy more investment real estate. If you buy a passive property that requires little or no management, you can enjoy the cash flow and ease-of-ownership benefit of a contract but, at the same time, avoid paying any capital gains tax.