A possible trap on repossession of a principal residence
A person selling his or her primary residence can, if certain conditions are met, avoid paying tax on some or all of the gain realized. This is allowed per code section 121 of the Internal Revenue Code. A maximum gain of $250,000 ($500,000 for married filers) can be excluded from the sale of a home owned and used by the sellers as their principal residence for at least two out of five years before the sale.
A buyer may pay cash, finance the purchase with a mortgage or at times negotiate a deal with the seller to pay for the home with a land-contract owed to the seller (also commonly known as a “seller-financed mortgage”). What if, in the case of a seller financed mortgage, the buyer later defaults and the seller repossesses the home?
The Internal Revenue Code attempts to encompass all financial events. As such, there are some hidden tax traps for the unwary that in some situations will lead to unexpected results and can create a surprising tax liability. Seller-financed mortgages is one of these areas.
If a buyer defaults on a seller-financed mortgage and the seller later reacquires the home, there is no gain or loss reportable by the seller at the time of repossession. The seller will quite often want to re-sell this home to a new buyer. If this resale occurs soon after the repossession, any gain resulting from this second, resale is also excludable up to the maximum overall limitations including both the initial sale and the later resale. Both sales are essentially collapsed into one transaction for tax purposes.
The trap: If the seller does not re-sell the home to a new buyer within one year of repossession then BOTH the original sale and the later re-sale will be taxable to the extent of gain realized.
In some housing markets the values of home can change dramatically in just a few years. A home repossessed may have a different value then when it was originally sold. This can lead to lead to some very unpredictable tax consequences. If you are contemplating a sale of your principal residence and financing it with your own land-contract, beware of this tax code.