Potential Tax Trap in Seller Carry-back Financing of a Principal Residence

For sale by owner sign in front yard with Bike in background next to a house. Seller carry back financing.


The seller can exclude a portion of the gain on the sale of a principal residence if the seller meets certain minimum requirements.  The main requirements are an ownership test and an occupancy test.  The seller must own the principal residence for at least two years and the seller must have occupied the residence for at least two out of the five years prior to the sale.  This allows the seller to rent the property for a portion of the time prior to the sale.  The gain that can be excluded from income is up to $500,000 for a married couple or $250,000 if the owner is single.

The current market conditions in the Bay Area make it unlikely a seller will provide seller financing as an inducement to sell their property.  There may be situations where a seller may consider providing seller financing, especially if the property has some issues that make conventional financing difficult to obtain.

A court case decided in the Court of Appeals 8th District dealt with a taxpayer well outside of the Bay Area (DeBough).  The 8th District covers Nebraska, Iowa, and states in the central part of the United States.  The Bay Area is in the 9th District.   The taxpayers sold their home in 2006 on a seller carryback financing on the sale of their home.  The taxpayer was qualified to exclude $500,000 of the gain and they used the installment sale treatment to report the taxable portion of the gain on sale.  The total gain was $657,796.  The taxpayer collected $505,000 on the installment note over the years 2006 to 2008.  Taxpayer reported $56,920 as taxable gain and $448,080 was excluded as part of the $500,000 exclusion from gain on sale of principal residence. 

Everything was fine up to this point.  The buyer ran into some financial difficulty in 2008 / 2009 and stopped making payments.  The court case does not comment on the economy and drop in real estate values across the nation in 2009 but I think it is safe to assume this played a factor in this case.  The seller reacquired the property near the end of July, 2009.  There is a provision in the Internal Revenue Code that provides tax relief for a seller that finds themselves with reacquisition of property.  If the seller is able to sell the reacquired property within one year, the subsequent sale will be considered part of the original transaction and the exclusion on gain from sale of principal residence will be preserved. 

Unfortunately for this taxpayer, they did not resell the property within a year.  The tax consequence was loss of the exclusion of gain on the sale of principal residence of $500,000.  As a result, the taxpayer was taxed on the entire $505,000 of receipts they had received on the installment note.

A homeowner can combine the exclusion from gain on the sale of their residence with the tax benefits of an installment sale to stretch out the recognition of taxable gain.  If there is a default on seller carryback financing, seek tax advice on the implications to avoid a tax trap for the unaware.

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