A “wraparound” mortgage, often called a “wrap,” is a form of owner financing where the seller sells their property to a buyer while retaining the original mortgage. The buyer makes monthly mortgage payments to the seller, and the seller is profiting on the spread between the monthly cost of their original mortgage, and the higher interest rate they are charging the buyer. The mortgage company typically isn’t informed anything has changed with the property, they’re still just getting paid each month as normal, except that the payments are now coming from the new buyer. The benefit to the buyer is typically that they are able to get more favorable mortgage terms than they could with a typical mortgage (especially if they have a less than stellar credit history).
This does situation create a complex tax scenario when determining the calculation of capital gains for the seller. Typically, owner financing is treated as an installment sale, which means the capital gains taxes for the seller are spread out over the period of time payments are made. But it was unclear whether a wrap qualifies for the installment sale treatment.
What’s an installment sale?
An installment sale is when you sell an asset such as real estate, and instead of receiving all the sale proceeds at once, you arrange with the seller to pay you at least part of the sale price in a future tax year. The tax advantage of this to the seller is that you don’t get hit with a large capital gains tax bill all at once. The installment sale treatment means that you only get taxed on the capital gains based on the proportion of the sale price that the buyer pays you during each tax year. Installment sale income is reported using form 6252.
In the 1980s, the IRS took the position that a sale with a wrap mortgage should be treated like a subject-to sale, which means that the seller would have to pay capital gains tax on the portion of the value of the property equivalent to the value of the original mortgage in the year it is sold. And the IRS also created Treasure Reg. 15A.453-1(b) to outline that treatment method. But in 1987, the tax court case Professional Equities, Inc. v. Commissioner rejected the IRS position and ruled that a wrap mortgage sale should be eligible for installment sale treatment. The IRS eventually acquiesced.
So as it stands now, a properly executed wrap-around mortgage can be treated as an installment sale. So that means the seller of a wrap only gets taxed on the capital gains based on the proportion of the sale price that the buyer pays the seller during each tax year.
The Buyer’s Mortgage Interest Tax Reporting
Depending on specifics of how the debt is recorded, the buyer may or may not be able to report the mortgage interest they are paying as a potential itemized deduction on their tax return. Per IRS publication 936, the home mortgage interest deduction is applicable to interest paid on a wrap mortgage only if the debt is secured by the property and “recorded or otherwise perfected under state law.” So it depends on whether the seller records the debt using a lien and whatever requirements are necessary to fulfill local and state laws to establish debt that is truly secured by the property. If it is proper secured debt, the seller should send the buyer a 1098 form reporting the interest.
The Seller’s Mortgage Interest Tax Reporting
The seller will report the interest income they receive from the buyer on their Schedule B as interest income. As mentioned above, if the seller records the note as a proper legal mortgage on the property, then the seller should send the buyer a 1098 each year reporting the interest payment information to the buyer and to the IRS.
The interest that the seller is paying on the original mortgage can be deducted as an investment interest expense using form 4952. Currently, investment interest expenses only end up being a tax benefit if you itemize your deductions. So if they are just taking the standard deduction, they may not actually get a tax benefit from the mortgage interest they are paying. This isn’t a great situation for their taxes because they’re being taxed on the full amount of the interest income, not just the difference between the two interest rates.
Alternatively, if the seller has multiple wrap mortgages, and they can make a reasonable argument that they are in the business of providing wrap mortgages rather than just using it as a passive investment, they may be able to instead report it on Schedule C as a business. In that case, they could report the cost of underlying mortgages as a business expenses, and only pay taxes on the net profit. But they would also have to pay self-employment tax on the income, which they otherwise wouldn’t if it was just considered investment income.
