When you sold your property with owner financing, you probably didn't pay tax on the whole gain that year. You paid it a little at a time, as the payments came in. Selling the note changes that. This article explains how, with a worked example.
I buy notes. I'm not a CPA, and this isn't tax advice. It's the plain-English version of the IRS rules, so you know what to ask before you sign anything.
Short version: Selling your note usually moves the rest of your deferred gain into the year you sell. The discount you take can lower that gain. Talk to your CPA before you close, not after.
How you've probably been paying tax so far
Most owner-financed sales are reported on the installment method. Instead of paying tax on the whole profit in the year of the sale, you pay tax on a slice of each principal payment as it comes in. The IRS covers this in Publication 537, Installment Sales. Your CPA reports it each year on Form 6252.
Two kinds of money come in with each payment:
- Interest. Taxed as regular income every year, like bank interest.
- Principal. Part of it is a return of what you paid for the property. Part of it is profit. Only the profit part is taxed.
The share of each principal dollar that counts as profit is called your gross profit percentage.
What happens when you sell the note
The IRS calls selling your note a "disposition" of the installment obligation. When you do it, you figure a gain or loss right then:
Gain or loss = what you sell the note for, minus your basis in the note.
Your basis in the note is the unpaid balance, minus the profit still built into it. Here's the formula from Publication 537:
- Take the unpaid balance.
- Multiply it by your gross profit percentage. That's the profit you haven't paid tax on yet.
- Subtract that from the unpaid balance. The rest is your basis.
A worked example
Say you sold a piece of land you'd owned for years.
| Detail | Amount |
|---|---|
| Sale price | $150,000 |
| What you had in the land (your basis) | $90,000 |
| Total profit on the sale | $60,000 |
| Gross profit percentage | 40% |
Years later, the buyer still owes $100,000. You decide to sell the note.
Step 1: Your basis in the note. 40% of $100,000 is $40,000 of profit not yet taxed. Your basis in the note is $100,000 minus $40,000, which is $60,000.
Step 2: Sell the note. A note buyer pays you $85,000.
Step 3: Your gain. $85,000 minus $60,000 = $25,000 of gain, reported in the year you sell.
Notice what happened. If you had kept the note, you'd have reported $40,000 of gain over the coming years. Because you sold at a discount, you report $25,000 now. The $15,000 discount came off your gain.
What kind of gain is it?
Per Publication 537, the gain generally keeps the same character as the original sale. If the original sale was a capital gain, like land you held for years, the gain on selling the note is usually capital gain too.
Things that change the math
Your situation may not be as clean as the example. Bring these up with your CPA:
- It was your home. If you lived there, part or all of the original gain may have been tax-free. Ask how that carries over to the note.
- It was a rental. Depreciation recapture is usually taxed in the year of the original sale, not spread out. That part may already be behind you. Ask your CPA to confirm.
- You're selling only part. A partial sale is taxed differently than a full sale and can be tricky. Get advice before you choose.
- Timing. Closing in December or January can put the gain in different tax years. That can matter if this year's income is already high.
- State tax. Ohio and Indiana both tax income. Your state return matters too.
What happens to the interest
Interest you received before the sale was already taxed each year. Once you sell, you stop getting interest, so there's no more interest income from that note.
Questions to ask your CPA before you sell
- What's my gross profit percentage on this sale?
- What's my basis in the note today?
- If I sell for this price, what's my gain, and how much tax is that?
- Would a partial sale or a different closing date save me money?
- Is there anything about this property, like it being my home or a rental, that changes the answer?
Bring your Form 6252 from last year, the closing statement from the original sale, and the quote from the note buyer. With those, a CPA can usually answer this quickly.
Frequently asked questions
Do I pay tax when I sell my owner-financed note?
Usually, yes. Selling the note generally makes the rest of your untaxed profit taxable in the year you sell, minus the discount you take.
Does the discount on my note lower my taxes?
Yes. Your gain is what you sell the note for, minus your basis in the note. A lower sale price means a smaller gain.
Is the gain on selling a note capital gain?
Generally, it keeps the same character as the original sale. If the original sale was a capital gain, the note sale usually is too. Confirm with your CPA.
What if I inherited the note?
Different rules apply. Read selling an inherited mortgage note.
Can I avoid the tax by keeping the note?
Keeping the note spreads the tax out over time. It doesn't make it go away. Whether that's better depends on what you'd do with the cash. Read should you sell your note or keep it.
Want real numbers to bring to your CPA? Get a free quote. There's no obligation, and it makes the tax conversation much easier.
Larry has invested in real estate since 2006 and has bought more than 300 mortgage notes. He runs LJH Investments, LLC, an Ohio company based in Madison, Indiana. More about Larry
This article is general information, not legal or tax advice. Laws change. Talk with your own attorney and tax adviser about your situation.