A Necessary Disclaimer
Tax law is complex, changes frequently, and varies by your individual situation. This guide is general education, not tax advice. Always work with a licensed CPA or tax attorney before signing a real estate sale with material tax implications.
The Section 121 Primary-Residence Exclusion
If you’ve owned and lived in the property as your primary residence for at least 2 of the last 5 years, the IRS lets you exclude up to:
- $250,000 of capital gain if filing single
- $500,000 of capital gain if filing jointly
For most primary-residence sellers, this means you owe $0 in capital gains tax — even on significant appreciation. The exclusion applies to any type of sale (cash, seller-finance, Subject-To).
Installment-Sale Treatment (IRC § 453)
When you seller-finance a property, IRS installment-sale rules generally let you recognize capital gains as you receive payments, rather than all in the year of sale. This can:
- Keep you in a lower capital-gains bracket each year.
- Spread Net Investment Income Tax (NIIT) exposure over multiple years.
- Prevent you from being pushed into higher ordinary-income brackets by a large one-time gain.
Installment-sale treatment generally doesn’t apply to: inventory, depreciation recapture, or assets sold at a loss.
Depreciation Recapture (Investment Properties)
If you’ve taken depreciation deductions on a rental property, the IRS “recaptures” that depreciation when you sell — taxed at up to 25%. Key points:
- Applies even if you didn’t actually deduct the depreciation (the IRS assumes you did).
- Due in the year of sale, not spread out under installment-sale rules.
- Can be deferred by a 1031 exchange into another investment property.
1031 Exchanges (For Investment Properties Only)
A 1031 exchange defers all capital gains and depreciation recapture if you reinvest proceeds into another investment property within 180 days (with 45-day identification deadline). Key requirements:
- Only for investment or business properties — not primary residences.
- Must use a Qualified Intermediary — you cannot touch the proceeds.
- New property must be equal or greater value.
Note: 1031 exchanges and seller-financing don’t mix easily because you can’t directly reinvest the note proceeds.
Subject-To Sales & Taxes
From the IRS perspective, Subject-To is treated as a sale in the year the deed transfers. Your gain or loss is calculated at that point. Even though the existing mortgage stays in place, the tax event occurs at closing. Primary-residence exclusion still applies if you’ve met the ownership/use tests.
Short-Sale Tax Implications
When a lender forgives part of your mortgage in a short sale, the forgiven amount is generally taxable as ordinary income. However, exceptions may apply:
- Qualified Principal Residence Indebtedness exclusion: for primary-residence mortgages up to $750K (re-extended through 2025; confirm current law).
- Insolvency exclusion: if you were insolvent (liabilities exceeded assets) immediately before the discharge.
- Bankruptcy exclusion: if the debt was discharged in bankruptcy.
State Tax Considerations
Most states mirror federal treatment, but some (e.g., California, New York) have higher capital-gains rates and different exclusion rules. Some states also have transfer taxes or recording fees that apply at closing. Your CPA or real estate attorney can explain what’s specific to your state.
The Bottom Line
Before signing any real estate sale — especially one structured creatively — run the numbers past a CPA. The tax savings from doing this right often exceed everything else combined.