You buy a property “subject to” an existing loan. You sell the property on an installment land contract or lease/option. What are the tax ramifications?
Part One – Determining Your Basis
Your tax basis is basically what you paid for a property. If you have a seller $2,000 and took a deed subject an existing loan of $189,000, your basis is $191,000. Basically, your basis in a subject to is cash paid to the seller, plus existing loan you are taking over. If you also paid money for back taxes and mortgage payments, that would also be part of your basis. So, if in the above example you paid $3,000 to the lender to cure the back payments, your tax basis is $194,000.
Part Two – Figuring Out Your Gain
If you resell the property for cash, the gain is easy to figure out -sales prices less your basis, less your sales costs (broker fees, closing costs, etc). If you resell the property on a lease/option, you haven't really sold it at all, since a lease/option is generally not considered a sale until the tenant exercises the option to purchase. During the period of the lease, you would be taking depreciation, so there's a recapture of that depreciation when you sell at 25%.
If you resell on an installment land contract (aka “contract for deed”), it IS a sale, even though title does not pass to the buyer. Thus, your gain is the sales price on the contract, less your tax basis. This is considered an “installment sale”, so your taxable gain is based on the cash received, plus any principal received in the year of sale. When the buyer pays off the balance of the contract, you have a gain in that tax year for the balance of principal received.
Part Three – The Interest
This part of the equation always gets people confused. In our example above, you bought a property from Sally Seller subject to the existing loan. You then sold it on a land contract to Barney Buyer. Who “owns” the property? For federal income tax purposes, there were two sales – from Sally to you, then from you to Barney. So Barney would be deducting the interest he is paying on schedule “A” of his federal income tax return as the “equitable owner”.
This appears confusing because you have the deed and Barney does not. It is also even more weird because Sally Seller's lender is sending a form 1098 for the annual mortgage interest to the IRS in Sally's name! Don't let that fool you… the basic rule of the interest deduction is that the person who has an ownership interest in the property, uses it as his principal residence, and actually makes the interest payments is the one who is entitled to the deduction. So, in this case, Sally Seller neither owns the house nor makes the payments – she does nothing. Barney Buyer is the “equitable owner”, which give him an ownership interest. And, Barney is also actually making the interest payments, which he can deduct.
One last part of the equation – the interest you are paying on the underlying loan. If you buy subject to and sell on a wraparound, you are collecting payments from Barney Buyer and continuing to make payments on Sally's underlying loan. The interest you pay is deductible as an offset (business interest) against the interest income you are collecting from Barney Buyer.