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For Sale by Owner News and Articles

For Sale by Owner Articles • - Seller Financing

Tax Considerations When a Seller Carries Back Paper

By Sandy Gadow
When a seller elects to defer receiving the sales proceeds on the sale of a principal residence, he may choose to "carry back the paper" or allow the buyer to sign a promissory note for a specified amount of the sales price. The seller may agree to receive this amount over two or more years in the future. By deferring the receipt of funds in the year the sale takes place, the sale may be eligible to qualify as an installment sale, and the seller may be allowed to use the installment method of accounting to defer reporting his gain on the property until he actually receives payment of the full sales proceeds.
What you can do under current tax law
Under current tax law, a seller in a traditional sales transaction may choose to take a tax exclusion on the gain of the sale of his primary residence up to $250,000 ($500,000 if married and filing jointly). This exclusion may be used every two years and the residence must be the seller's principal residence, not a second residence or rental property. A seller cannot exclude the gain on the sale of his home if, during the two year period ending on the date of the sale, he sold another home at a gain and excluded all or part of that gain. Since the seller cannot exclude the gain, it must be included as income. A seller is permitted to claim a reduced exclusion if he sold the home due to a change in health or place of employment.
When a seller chooses to sell his property carrying back the paper, reporting the sale under the installment method requires only that the seller report that part of the gain that he cannot exclude from income and only that portion that was received each year. The portion of the gain that must be reported should be listed on Schedule D (Form 1040). Installment reporting is permitted regardless of the amount of payment received in the year, even if the entire purchase price is received in a lump sum in a year subsequent to the sale year. There is no minimum or maximum amount of payment which must be received in the year of the sale. Sellers may receive more than 30 percent down and still use the installment method of reporting. Losses are not allowed to be reported in an installment sale.
The forms you need to fill out upon the sale of your home
Beginning in 1998, Form 2119, which was required to report the sale of a home, is no longer required. If the home was sold in 1998 or later, the sale now needs only to be reported on Form 6252 (to calculate the gain) and the taxable portion of gain received should be reported on Schedule D. Since most promissory notes usually consist of both principal and interest, the seller will be required to report the interest he receives as part of each payment separately as interest income on Schedule B (Form1040). If the buyer of the home uses the property as a main or second home, the seller must also report the name, address, and social security number of the buyer on either Schedule B or Schedule1(Form 1040A).
Calculating the "gross profit percentage"
Since using the installment method allows that only a portion of the amount received each year will be taxable, the seller may spread the tax on the gain over the period during which the installments are received. A figure called the "gross profit percentage" will determine the amount that is taxable each year. Form 6252 will allow you to calculate the gross profit percentage by dividing the contract price amount by the amount of gain realized. This resulting percentage will then be applied toward the payments made to you by the buyer. This percentage of the payment will then be reported on Schedule D.
Setting up an installment sale
It is recommended that an accountant or certified tax attorney be consulted before setting up an installment sale. The sales price may involve more than cash and it may involve the assumption of an existing mortgage. The amount realized on an installment sale includes the amount of cash received in addition to the fair market value of any other property received or to be received. If there is an existing mortgage on the property, then the buyer may either assume or take subject to this mortgage and it must also be figured into the sales price.
Certain types of sales transaction which are not allowed to be structured
There are certain types of sales transaction which are not allowed to be structured using an installment sales contract arrangement. Sales of property by a real estate dealer, sales or exchanges of marketable stock and securities, and sales or exchanges between husband and wife do not qualify for the installment method. Real estate held for investment has specific limitations as to when an installment method may be used. A qualified tax consultant can tell you if your specific sale will qualify.
There are many considerations and options for a seller wishing to carry back paper on his sales transaction. A seller should consult with his tax and legal advisors regarding his particular situation. Tax laws are changing rapidly, and there is talk that new legislation in regard to installment sales may be appearing sometime soon.
"This article is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the author is not engaged in rendering legal or accounting service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From a declaration of principles jointly adopted by a committee of the American Bar Association and a committee of publishers and associations."
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