Taxes on Contracts for Deeds

A contract for deed, otherwise known as a land contract, is an arrangement in which the seller finances the purchase without the intervention of a third-party lender. This arrangement is convenient for buyers without access to credit, and for sellers who wish to expedite the transaction. A contract for deed transaction carries tax consequences for both buyer and seller.

In a traditional real estate transaction financed by a third-party lender, the buyer pays a lump sum and the seller realizes a capital gain if he sells the property for more than he paid for it, and if he did not use the property as a residence. In contract for deed transactions, however, the buyer pays in installments. Because of this, the seller realizes capital gains with each installment payment, because the portion of each installment that represents profit on the transaction is subject to capital gains tax. Capital gains are taxed at rates that are generally lower than ordinary income.

Under a contract for deed arrangement, the seller retains the title to the property until the buyer completes all payments. Nevertheless, the buyer is responsible for paying real estate taxes on the property, even though the tax is assessed against the seller. Since the buyer is the party who pays the tax, he may deduct it from his taxable income on Form 1040 if he itemizes his deductions.

In many states, the seller does not hold a legal mortgage on property subject to a contract for deed transaction, and he doesn't need to foreclose to reclaim the property if the buyer defaults. However, the IRS treats the buyer's installment payments as mortgage payments and allows him to deduct the interest portion of each installment from his taxable income, as long as he itemizes his deductions.

Different states apply different rules to buyer default. In the absence of special rules protecting the buyer, the seller has the right to immediately reclaim the property if the buyer defaults, without going through foreclosure procedures and without returning any of the buyer's accumulated equity to him. In this case, the seller realizes an immediate capital gain, equal to the capital gains portion of the total purchase price minus any capital gains already realized when the buyer paid installment payments. If the state requires the seller to return all or part of a defaulting buyer's equity in the event of default, the seller's liability for capital gains tax is proportionately reduced.