Let’s say you sold your principal residence for a healthy profit a few years ago and took back an installment note from the buyer to cover part of the sale price. This is called a seller-financed installment sale, and they were fairly common in hot markets a few years ago.
Unfortunately, not all seller-financed transactions work out. If a deal falls through, what are the tax implications if you repossess the property and then resell it? Good question. The financial results might be favorable and the tax implications might be favorable too. On the other hand, the tax results may not be great, depending on your specific circumstances.
Payments Received Before Repossession
When you sold your former principal residence the first time, you probably collected a down payment and some interest payments on the installment note before the buyer bailed. Depending on the terms of the deal, you also might have collected some principal payments. If you sold the home for a profit, the gross profit percentage multiplied by the down payment and any principal payments count as potentially taxable gains. The gross profit percentage equals the total gain divided by the total sale price.
You were probably eligible to exclude (pay no federal income tax on) any such gains, thanks to the principal residence gain exclusion (see the right-hand box for the qualification rules). It allows qualified sellers to exclude some or all of the profits received from federal income tax.
In any event, you must report any interest received on the installment note as ordinary income taxed at your regular rate.
So far so good, but now you’ve repossessed the property and face new tax implications.
The general rule for real estate repossessions (from Section 1038 of the Internal Revenue Code) states that repossessing a property triggers taxable capital gain equal to the amount of cash you receive from the buyer’s down payment and/or principal payments before the repossession. As mentioned earlier, any interest collected on the installment note is ordinary income taxed at your regular rate (as opposed to lower-taxed capital gain).
Gain Exclusion Exception
A favorable exception to the general rule allows you to use the principal residence gain exclusion break to shelter gain on both the repossession and the resale as long as:
- The original sale qualified for the gain exclusion and
- You resell the property within one year after repossession.
If you pass these tests, you’re allowed to treat the original sale and the subsequent resale as a single transaction that took place on the original sale date.
Here’s how that could work to your tax-saving advantage.
Example 1: Gain Exclusion Break Is Available
You’re a married joint-filer. On February 1, 2008, you sold your principal residence for $600,000. The sales proceeds consisted of a $50,000 cash down payment and a $550,000 installment note payable to you. The note called for monthly interest-only payments until the note came due on January 1, 2013. At that time, the entire $550,000 principal balance was to be repaid. So this was a seller-financed installment sale with a balloon payment at the end.
Your sales costs were $25,000 and the property’s tax basis was $175,000. Based on the assumption that the buyer would make the $550,000 balloon payment as scheduled, you had an installment sale gross profit percentage of 66.667 percent ($400,000 profit divided by $600,000 sale price).
Assume the sale qualified for the $500,000 joint-filer gain exclusion because you and your spouse owned and used the property as your principal residence for years. The $400,000 profit would have been entirely federal-income-tax-free, and you did not have to report any taxable gain from the $50,000 down payment on your 2008 tax return or any taxable gain in 2013 if the balloon payment had been made as scheduled.
Unfortunately, the buyer made the interest-only payments for four years and a few months and then bailed. On September 1, 2012, you repossessed the property after incurring $15,000 in legal fees and other costs to do so.
Thanks to a resurgent real estate market, you were then able to resell the property on February 1, 2013 for $555,000 in a conventional sale. Assume you incurred $35,000 of selling costs on the resale.
Because the original sale qualified for the gain exclusion break and because the resale occurred within one year of the repossession date, you’re allowed to treat the two sales as one transaction that took place on the original sale date. Therefore, your gross sales proceeds are $605,000 ($50,000 down payment from the original sale plus $555,000 resale price). Your total selling costs are $60,000 ($25,000 from the original sale plus $35,000 from the resale). Your updated tax basis in the property is $190,000 (the original $175,000 plus $15,000 of repossession costs). The gain on sale is $355,000 ($605,000 gross sales proceeds minus $60,000 selling costs minus $190,000 basis). The $355,000 gain is federal-income-tax-free because it’s sheltered by your $500,000 joint-filer gain exclusion. Therefore, you do not need to report taxable gain from the resale on your federal tax return.
All in all, these financial and tax results are pretty good.
What If You Don’t Resell Fast Enough?
If you fail to resell the property within a year of the repossession date, the original sale, the repossession and the resale are treated as three separate transactions, which will sometimes (but not always) lead to less-favorable tax results.
Assuming the original sale qualified for the gain exclusion, the down payment and any principal payments received before the repossession are usually fully sheltered by your exclusion.
If you have gains on the separate repossession and resale transactions, the gain exclusion is only available to the extent you meet the timing rules as of the repossession and resale dates.
However, this is not as bad as it sounds, because the gain exclusion from the original sale reduces your gross profit and gross profit percentage, which effectively reduces or eliminates any later repossession gain or resale gain.
Examples 2 and 3 below illustrate how the reduced gross profit rule can work to your tax-saving advantage in a resale. The numbers in Examples 2 and 3 are based on following Worksheets A, D, and E in IRS Publication 537, Installment Sales. The tax code and related regulations provide no specific guidance on the scenarios presented in Examples 2 and 3, so Publication 537 is basically the last word in such situations.
Example 2: Tax-Free Gain from Resale More than One Year after Repossession
Same basic facts as Example 1, except this time assume the resale date is October 1, 2013, which is more than one year after the repossession date.
Therefore, the favorable exception explained in Example 1 is unavailable. As a result, the original sale, the repossession, and the resale are treated as three separate transactions for federal income tax purposes.
The tax results from the original 2008 sale are the same as in Example 1 — no taxable gain thanks to the gain exclusion privilege.
The repossession gain, the tax basis of the repossessed property, and the resale gain/loss are calculated as shown below. These calculations are based on a 0 percent gross profit percentage for the original sale, because the gain exclusion privilege made the entire $400,000 gain on the original sale tax-free.
Repossession Gain Calculation
Repossessed Property Basis Calculation
Key Point: In other words, the $565,000 basis is comprised of the $175,000 original basis plus $25,000 original sales costs plus $400,000 original excluded gain (which still increases your basis) plus $15,000 repossession costs minus $50,000 down payment received from the original sale.
Resale Gain/Loss Calculation
Key Point: The preceding outcome assumes you cannot characterize the loss as from an investment property sale instead of a personal residence. Even if you could, a special rule says your initial adjusted basis in the repossessed property for tax loss purposes cannot exceed its fair market value (FMV) on the date it was converted into an investment property. In this example, if the FMV figure was below $520,000 on the conversion date (it probably was), you wouldn’t have an allowable loss on the resale. (The special basis rule is intended to disallow the loss from a decline in value that occurs before the conversion date. But a further decline in value after the conversion can result in an allowable loss. Don’t forget that basis reductions from post-conversion depreciation can offset some or all post-conversion value decline.)
Example 3: Taxable Gain from Resale More than a Year after Repossession
Same basic facts as Example 2, except this time assume you sold the repossessed property for a whopping $700,000. You would have a $100,000 capital gain ($700,000 minus $35,000 selling costs minus $565,000 basis) that could not be sheltered by the gain exclusion privilege, because the home was not used as your principal residence at any time during the five-year period ending on the sale date. Your gain would be long-term gain, because your holding period for the repossessed property would include your ownership period before the ill-fated seller-financed sale and your ownership period after the repossession. The $100,000 resale gain must be reported on your Form 1040.
Key Point: The maximum federal rate on long-term capital gains can be as high as 20 percent, and you might also get hit with the 3.8 percent Medicare surtax on net investment income if your income is high enough.
Depending on your exact circumstances, the federal income tax results from selling your principal residence in a seller-financed installment sale deal, repossessing the property, and reselling it may be benign (as in Examples 1 and 2) or not (as in Example 3).
When repossession is looming, get your tax adviser involved as soon as possible. Careful advance planning often leads to better tax results.
© Thomson Reuters. Reprinted with permission.
Want tax answers? Give us a call or complete the following form.