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George Saenz, the Tax Talk columnistTaxes on a rental property sale

Dear Tax Talk,
I recently sold a rental property with some creative financing. I am carrying a 20 percent second mortgage with a balloon payment due in five years. How do I, or where do I, claim this on my tax return? I really don't see anywhere on IRS forms to allow this, so I do not have to pay taxes on the full amount. Help. I'm sleepless in Michigan.
-- John

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Dear John,
You can rest easy: You do not have to pay tax on money you did not receive. When a seller provides financing, he has entered into what is called an installment sale for tax purposes. An installment sale allows a nondealer to ratably report gain over the period of collection. A dealer is someone who regularly sells property out of inventory such as a developer, retailer or wholesaler. Installment-sale rules only apply if you are not a dealer. An installment sale is a sale of property at a gain where you receive at least one payment after the tax year of the sale. A loss is reported in full in the year of sale. Installment sales are discussed in Publication 537.

Form 6252 is used to report gain on an installment sale. On Form 6252 you will determine your gross profit, contract price, gross profit percentage and installment-sale income.

Each payment on an installment sale usually consists of the following three parts:

  • Interest income (you must have adequately stated interest).
  • Return of your adjusted basis in the property.
  • Gain on the sale.

In each year you receive a payment, you must include the interest part in income (Schedule B of Form 1040), as well as the part that is your gain on the sale (for a rental property, use Form 4797 and for an investment property, Schedule D). You do not include in income the part that is the return of your basis in the property. Basis is the amount of your investment in the property for tax purposes.

For example, suppose you sell for $100,000 a 3-year-old investment condo that cost you $54,000. You receive $80,000 down, plus a note for $20,000 at 6 percent, interest only, due in five years. Your selling expenses are $6,000 and there was no mortgage on the property. Your gross profit is $40,000 or 40 percent ($100,000 less $54,000 cost and $6,000 selling expenses). Of the $80,000 that you received, 40 percent is capital gain, so you would report on Form 6252 $32,000 in gain and carry that amount through to line 11 on Schedule D.

Because $48,000 of the $80,000 is a return of your basis, it is not taxable. You would report the $100 a month in interest that you receive every tax year on Schedule B (6 percent of $20,000 is $1,200 a year or $100 a month). During the five years you do not receive a principal payment, you would not need to file Form 6252. In the fifth year you would file Form 6252, completing lines 1 through 4 and part 2 to report the $20,000 of which $8,000 would be taxable and $12,000 would be a return of principal.

If you sell a property with a mortgage or one that has depreciation, the computations are a little more complex, so you may want to consult a CPA.

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.'s corrections policy -- Posted: Feb. 15, 2006
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