Understanding the Land Contract
A land contract, or contract for deed, is a type of installment sale in which a seller agrees to sell the property to a buyer over a period of time. During that time, the buyer makes installment payments which consist of both principal and interest. It is very similar to how a mortgage works, except that instead of engaging a bank to lend money, the seller serves as the lender, taking in payments and gradually releasing ownership of the property over time. Contracts may be structured similarly to residential conforming mortgages, where they pay down to zero, or may also be set up with balloons, requiring the buyer to make a large lump sum payment at some point in time.
Income from the Land Contract
Although buyers typically write one check when making their land contract payments, the seller actually receives two different types of income. The first type is the interest that they receive on the balance of the contract. The second type is the paydown of principal which, in most cases, is a realized capital gain or recapture income.
Federal Tax Treatment of the Land Contract
For federal tax purposes, the multiple income streams from a land contract are all treated differently. The income from the interest payments is regular income, taxed at whether the taxpayers highest marginal tax rate happens to be. Assuming that the property was sold at a profit, the principal payments are taxed as capital gains at 15 percent or the rate that is in effect at the time of the payment, until the balance is paid down to the property's basis. At that point, the principal payments are untaxed. In the event that the property was depreciated, the principal payments on the depreciated amount are considered recapture and taxed at 25 percent, or whatever rate is in effect.
Tax Pitfalls of the Land Contract
Most people enter into land contracts to eliminate making a large capital gains tax payment at the time of sale. However, by doing a contract they still end up paying all of the capital gains tax--they just take longer to do it. Furthermore, if capital gains taxes increase, the amount of tax to be paid will go up in the future. Also, if the buyer makes a balloon payment, all of the taxes due on that balloon will be due in one lump sum payment, negating the contract's key tax benefit.