Chris Prefontaine explains how seller-financed real estate sales are taxed. The sale is recognized when the deed transfers, not at balloon payment. Each monthly principal payment is taxed proportionally: a $500,000 sale with $250,000 basis means 50% of each payment is taxable income. The primary-residence exclusion applies only if you owned and used the home two of the last five years.
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I'm buying the house from David for $500,000. His accountant tells him his basis is only $100,000. He's getting taxed on everything above that. So every time you send him a check for $2,000 towards the month that you're giving him, 80% of that is taxable.
Something that Brian had asked the seller that I didn't know is when do you declare the— in owner financing, when do you declare the home sold? Is it when the title transfers or is it at the balloon payment?
No, it's sold and transfers at the beginning. And when the deed transfers and the note gets created and all that, you own it at the beginning. It's sold.
So he has to essentially declare that as income even though he hasn't received full income for it?
No. Great question. So, okay, is this— this is his primary?
Yes.
If it's his primary, I'm wondering why he's concerned about Declaring income because as a single guy, is he single?
I assume so.
If he's single and he's filing, you know, one, no joint return, his $250,000 exclusion on the property, he's not making more than that on this property. What's this property price?
$285,000 is what he wants for it.
Yeah. So I don't think it's applicable to him unless he's— you're misunderstanding him or he's misunderstanding what's going on. Let me answer the question. Does everybody know how to answer that question? If it's not his primary and it is going to be taxed, let me go over that.
I think so. If it's not his primary, it'll be taxed when he receives his money, right? Monthly and throughout the year, right?
The proportion. Yes. Portion of that minus the basis. Yes, Dave. Exactly. Jessica, you don't need this for him, but let me say it, okay? Because that sparked it. Let's do this really simple. David has a house. He's selling it for $500,000.
He—
most sellers don't know what the basis is unless they're really financially savvy. But let's say his accountant tells him your basis, which is what he bought it for, less the depreciation every year that his accountant took, plus any improvements. That's the basis.
Sweet.
So, and then above that, he's going to get taxed on. So let's go back to the example. David's house is $500 grand. His accountant says your basis is $250,000, half. So if I structure $2,000 monthly principal payments with David, half of that payment is subject to capital gains every month. Not right away, Jessica, right? Pay upfront as he gets the money proportionate to what his accountant tells him is taxable. Was that not clear? Was that clear? That makes sense, guys?
It's clear to me, but I'm an accountant, so there you go. I'm gonna cheat on that one.
That's how you said it. So why did you say half is because basically it's what's over the $250,000? No, sorry, I used $250,000 kind of twice to change it, but it's nothing to do with each other. The basis was $250,000, which happens to be half of $500,000. That's all I was doing. Let's do it a different way to change up the numbers. I'm buying the house from David for $500,000. His accountant tells him his basis is only $100,000, 20%. He's getting taxed on everything above that. So every time you send him a check for $2,000 towards his— towards the month that you're giving him, 80% of that is taxable, subject to capital gains tax. David, does that make sense?
Yes, I think that sounds about right. Yeah. Okay. So he'll be paying capital gains on 80% of it.
If his basis was only $100,000.
If in that situation, yes. Yeah. Yeah.
I thought capital gains was if you've lived there less than 2 years or if you—
That is the other exception on the primary. You are correct. Sorry, I should have said that. Um, yes. Is he, is he less than 2?
He's been there for 3 and a half years.
Hmm, he may be past it then. No, there's 2, there's 2, Corey, because Mallory was on last week. Um, so they have to be there, uh, 2 out of 5. That's what Corey was just saying, right, Corey? Yeah, 2 out of the last 5.
Yeah, yeah.
But does that— there's another one. I think it's either less than a year or less than 2, and I'm drawing a blank. Mallory did it last week with me. In other words, are they so quick?
That's just the criteria.
Yeah, if you're less than 2 years.
That's just the 2 and 5 is just the criteria to be a primary resident. So, correct, if he— if his dad just passed this year and he took over this year, he wouldn't even be in the qualification as a primary at this point, you know what I'm saying? But he's been there 3 years, so it does qualify as a primary. That just gets back to the 80% of what he can qualify that he has to pay taxes on later, but it's only per the year. So if you only— if you give him $2,000, he's only paying the 80% of the $24,000 this year and then next year going forward. So, and that the, the transition on owner, uh, the A— the, uh, owner financing would stop that anyway as soon as it closes. So which would satisfy his criteria.
