Do I Pay Capital Gains on Owner Financed Property?
Understand how capital gains taxes apply to owner-financed property sales, including tax deferral strategies and key factors that influence your tax liability.
Selling a property through owner financing can provide steady income over time but also comes with tax implications. One key concern for sellers is how capital gains taxes apply when payments are received in installments rather than as a lump sum. Understanding these tax obligations helps avoid surprises and optimize financial outcomes.
The way capital gains are taxed depends on several factors, including asset classification, sale structure, and the portion of each payment representing profit versus interest.
Capital Asset Classification
How a property is classified for tax purposes determines how gains from its sale are treated. The IRS categorizes assets into different groups, with real estate used for personal or investment purposes typically considered a capital asset. This means any profit from the sale is subject to capital gains tax rather than ordinary income tax.
A primary residence may qualify for an exclusion under Section 121 of the Internal Revenue Code, allowing homeowners to exclude up to $250,000 of gain ($500,000 for married couples filing jointly) if they meet the ownership and use tests. Investment properties do not qualify and are fully subject to capital gains tax.
For rental or commercial properties, classification as a Section 1231 asset can provide tax advantages. If held for more than a year, gains are taxed at long-term capital gains rates, which are generally lower than ordinary income tax rates. Losses on these assets may also be deductible against other income.
Installment Sale Method
When selling a property through owner financing, the IRS allows sellers to report capital gains using the installment sale method under Section 453 of the Internal Revenue Code. This spreads the tax liability over multiple years, aligning tax payments with the receipt of proceeds rather than requiring a lump sum payment in the year of sale. By deferring taxes, sellers may reduce their overall tax burden if future income falls into lower tax brackets.
Each installment payment consists of three components: a return of the seller’s original investment (basis), capital gain, and interest. The taxable portion of each payment is determined by the gross profit percentage, calculated by dividing the total gain by the contract price.
For example, if a property is sold for $300,000 with a $100,000 basis, the gain is $200,000. If the buyer makes a $30,000 payment in a given year, and the gross profit percentage is 66.67% ($200,000 ÷ $300,000), then $20,000 of that payment is taxable as capital gain, while the remaining $10,000 is a nontaxable return of basis.
Certain sales, such as those involving publicly traded securities or dealer property, do not qualify for installment reporting and must recognize the full gain upfront.
Principal vs. Interest Allocation
When receiving payments from an owner-financed sale, the IRS requires a clear distinction between principal and interest. The principal portion represents the repayment of the property’s sale price, while the interest portion is taxable as ordinary income. The agreed-upon interest rate must meet or exceed the Applicable Federal Rate (AFR) set by the IRS to avoid imputed interest rules under Section 7872, which could result in additional tax consequences.
A higher interest rate increases taxable income in the form of interest, which is subject to ordinary income tax rates rather than capital gains rates. Conversely, lower interest rates shift more of each payment toward principal, deferring capital gains tax but potentially triggering IRS scrutiny if the rate falls below the AFR.
Buyers also have tax considerations. The interest portion of their payments may be deductible if the property is used for business or as a primary residence, subject to mortgage interest deduction limits under Section 163(h). Proper documentation, including an amortization schedule, ensures both parties report amounts correctly and avoid discrepancies in tax filings.
Depreciation Recapture
When selling owner-financed property used for rental or business purposes, depreciation recapture can create an unexpected tax liability. Under Section 1250 of the Internal Revenue Code, depreciation deductions claimed during ownership reduce the property’s adjusted basis, increasing the taxable gain upon sale. The IRS requires that the portion of gain attributable to depreciation be taxed as ordinary income, up to a maximum rate of 25%, rather than at lower capital gains rates.
For example, if a commercial building purchased for $500,000 had $150,000 in accumulated depreciation before being sold for $700,000, the adjusted basis would be $350,000 ($500,000 – $150,000). The total gain would be $350,000 ($700,000 – $350,000), but the first $150,000 of gain, representing prior depreciation deductions, would be subject to depreciation recapture tax at ordinary income rates, capped at 25%. The remaining $200,000 would be taxed as a capital gain.
Depreciation recapture applies regardless of whether the sale is structured as an installment sale. However, while capital gains tax is spread over time, the IRS requires that recaptured depreciation be reported in the year of sale rather than over the payment period. This can create a significant upfront tax burden, requiring careful planning to ensure liquidity for tax obligations.
Tax Rates for Gains
The tax rate applied to capital gains from an owner-financed property sale depends on how long the seller owned the asset before selling. If the holding period exceeds one year, the gain qualifies for long-term capital gains treatment, which is taxed at 0%, 15%, or 20%, depending on the seller’s taxable income.
For 2024, single filers with taxable income up to $44,625 (or $89,250 for married couples filing jointly) pay 0% on long-term gains. Those earning between this threshold and $492,300 ($553,850 for joint filers) are taxed at 15%. Any amount exceeding these limits incurs a 20% rate.
Short-term capital gains, resulting from sales of properties held for one year or less, are taxed as ordinary income, which can be significantly higher depending on the seller’s tax bracket. Additionally, high-income taxpayers may be subject to the 3.8% Net Investment Income Tax (NIIT) if their modified adjusted gross income surpasses $200,000 for single filers or $250,000 for married couples filing jointly. This surtax applies to capital gains and other passive income sources, increasing the effective tax rate on installment sale proceeds.