Ray always appeals to my (rather large) ego. Assuming that the property is “investment” propety, the seller pays capital gains taxes (with depreciaion “recapture rates” applied first, and then the lower capital gains rates) based on the following rough formula: ([down payment (in year 1 only) + principal payments] / total sales price). If the total principal payments in year one equal $40,000 (I’m too lazy to figure out the real number), the gain incurred in year one = $95k or $500k x 19% [150k + 40k]/1,000,000]. If the seller has dealer property (which gives rise to ordinary gain, as opposed to capital gain) or elects out of installment sales treatment, the $500k gain is all incurred in year one. A 1031 exchange does a much better job of defering taxes. The interest is ordinary income. Generally, the gain is deferred in the interest only scenario…but I could see an exception to that rule if certain annoying rules (Original Issue Discount, or OID rules) applied to the note…I’d have to think about that one.
My question revolves around how much capital gains tax is due and when is it due when it applies to seller financing deals. By the way Ray Alcorn says you have one of the best real estate law minds around and saying so may help me get my question answered.
Scenario: Sale Price and Value are $1,000,000. Basis is $500,000. Down Payment is $150,000. Loan scenarios a)Principal and interest at 7% over 20 years due in 10 or b)interest only for 10 years at 7%.
Does seller pay, in the taxes due for the year of sale, a)taxes on the entire gain regardless of financing($100,000 using 20%), b)taxes based only on the proportion of the down payment to the gain($30,000 based on the down payment being 30% of the gain $150,000/$500,000 and the total capital gains tax being @$100,000, or c)only $15,000 because the downpayment is 15% of the sale price, or d)something else.
Secondly, What is the rule for payment of capital gains on an installment sale? I assume the interest portion of the payment is taxed as ordinary income and the principal portion is taxed on some proportion to the gain? In the interest only scenario are capital gains taxes deferred until the principal is paid?
I look forward to hearing from you. Thank you in advance.
Have a good day.