I’ll pay someone for an answer pretty soon, I reckon, but I would really appreciate some background before I go in.
My father died about 4 years ago and left some assets. Most of those assets were liquidated and disbursed to the heirs; the amounts were not large enough to generate death duties (or whatever one calls them) at the time.
One asset has not been liquidated - the mortgage on a small house. The buyers have been paying pretty regularly, and are slowly building up a little equity. Their payments are mostly interest (which is income) and a small amount goes towards the principal.
It seems to me that the principal, as they pay it off, becomes just like any other liquidated asset, that is, it is something that can be disbursed to the heirs without anyone paying income tax on it. I am the executor of the estate as well as one of the heirs.
Can I just disburse this money occasionally, as it builds up, with a letter confirming that the money is principal rather than interest and therefore not subject to income tax?
Roddy
disclaimer - I am not your CPA. Any advice given should be verified by you with a tax and/or legal professional in person.
I am trying to understand the exact situation based off what you have written. Correct me if any of the following assumptions are wrong:
Your father owned a piece of property and sold this property to another party. Instead of the buyers paying for the property up front or taking out a mortgage from a 3rd party bank, financed the purchase through your father. This is what is called a seller-financed mortgage. Your father held the note on the property, the buyers made monthly payments to him (consisting of interest and principal), with the property as collateral on the mortgage.
Your father then died and the mortgage he held was passed to 4 heirs.
This is what normally should happen in these situations: Your father, on his individual income tax returns before he died, should have been accounting for the sale of the property and the mortgage note he held as follows: he should have been picking up interest income from the mortgage and he should have been reporting the principal payments received on Form 6252, Installment Sales. The 6252 in the initial year he sold the property and took over the seller-financed mortgage, would have reported the total sales price of the property to be paid back over the life of the note, and your father’s adjusted cost basis in the property in order to calculate the % of each principal payment received that was capital gain (If he sold the property at a loss, the entire loss would have been recognized up front, subject to capital loss limitations, and only interest income would be recorded in future years).
For the estate of your father, you should be filing form 1041 each year that the estate has been open to report income generated by the estate after his death. The interest income and principal payments/long term capital gain (still on form 6252) from the seller-financed mortgage would still need to be reported and the portion of the principal payments received that should be recognized as long term capital gain would be the same percentage as your father was picking up prior to death (there is no “step up” in basis in this case, as your father sold the property before his death and only held the note and the property was collateral) . If the money received was distributed to the heirs, then K-1’s from the 1041 should have been generated and given to each of the heirs for them to report their share of the income items generated by the estate on their personal 1040 returns.
Since you indicated he died 4 years ago, if this has not been done correctly for previous years, I would immediately contact a tax professional (and not somebody like H&R Block or Jackson Hewitt) and an attorney to discuss options/correct any mistakes.
Thank you, your recap is essentially correct except that there are fewer than 4 heirs.
We have been filing K-1’s and 1041’s (at the moment I don’t remember which form does what) every year for the income from the note. But we haven’t done anything with the long term capital gain (why is it capital gain? Why isn’t it just recovery of the original investment amount? Is there a “for dummies” book that might explain this to me?*). This money is just sitting in the bank account.
If it makes any difference, my father had a living trust and the house was in the trust. So now the estate has been completely disbursed to the heirs, and the only asset (this note) is held by the trust, of which I am the trustee.
*Here is my naive thinking on this: if you invest $1000 and receive $100 per year income for 10 years and then you receive the original $1000 principal back, the $100 (times 10) interest is clearly income, but the $1000 principal did not grow during this time so it would not represent a capital gain. Wrong?
Roddy
It is possible that there is no capital gain on the note. It all depends on what your father originally paid for the property (plus any capital improvements made to the property after he bought it before the sale). The difference between what he sold the property for and the cost basis is the gain on the property. For example, let’s say that he sold the property for $300,000, to be paid over to him (plus interest) over the life of the seller-financed mortgage note. His original cost and improvements for the property were $200,000. If this was a normal sale, he would recognize capital gain of $100,000 in the year of sale. Since this is an installment sale, the $100,000 of capital gain is spread out over the length of the seller-financed mortgage note.
So in the example above, the gain is 1/3 the amount of the total sales price. Therefore 1/3 of the principal payments received on the mortgage note (assuming the entire sale was part of the financing and no cash was paid up front) would be capital gain.
Per your example with the investing metaphor - if your father sold the property for the exact amount for that which he had invested in the property prior to the sale, there indeed would not be any gain, and only the interest on the note would be income. It is a little unusual for that to happen though, as most people that sell investment property want to sell it for more than they have paid for and put into the property.
Nothar has given excellent responses. I just thought I’d add an example to illustrate.
Let’s say that the annual mortgage payments are 12,000 to have a nice round number, and let’s say that 9,000 of this is considered to be interest. The remaining 3,000 is then divided one more time, between the cost basis of the property and the capital gain. Form 6252 establishes a percentage of capital gain in the first year you file it, then you use the same percentage in each future year. Let’s say that the capital gain percentage is 33%. Then you’d have $2,000 allocated to the cost basis (not taxable) and $1,000 allocated to the capital gain.
The result on the 1041 would be a total of $10,000 of taxable income, reported as $9,000 of interest income and $1,000 of capital gains.
Then there’s some further accounting magic done on the 1041 to determine how much of this income is taxed to the estate itself and how much of the income is passed through on forms K-1 to be taxed to the heirs. (As a general rule, if the income is being distributed, then it’s taxed to the heirs.)
I think I’m screwed then because I don’t know the cost basis. He bought the house a number of years ago, fixed it up, and then rented it out for a while until he offered the renters the mortgage option. I don’t think he required a down payment.
I might be able to find out what he paid for the house, but I’m sure I won’t be able to find out how much he spent to fix it up before letting the renters in, and then the value of the house would have changed again during the time it was being rented. However, you’re right, I’m sure the purchase price of the house was more than the expense (original price plus renovation).
I definitely see an accountant in my future.
Roddy
I would definitely recommend seeing an accountant. You likely do not need to track down the original documents for when your dad bought the property, though. All the information needed for the cost basis and percentage of principal payments that needs to be reported should have been on his individual tax returns. The returns I would want to see would be the return for the year of the sale (the year he started receiving payments on the note) which should have reported his total cost basis in the property and the percentage of gain, and the last 1040 tax return filed for his year of death, which should have a schedule of all past principal payments received since he sold it. That will give you the info needed to pick up on the 1041 returns.
I see you noted that this property used to be a rental property as well. That would have made things a little more complicated for your Dad to report on his taxes for the initial year of the sale, because he would have needed to report any depreciation recapture from the rental when it was sold, but that is supposed to be reported and picked up completely in the year of sale and should not affect the estate returns.
If any prior year 1041 returns did not report the installment sale correctly, it is likely they will need to be amended to pick up any additional capital gain to be reported that may have been omitted, as well as amending the individual returns of any beneficiaries that received K-1’s from the estate in those years, but I would make an appointment immediately with a CPA to discuss, preferably before tax season when they will be crazy busy.
Thank you, I thought of checking his returns after I wrote my last post. I do remember him complaining about how difficult his returns were and I think it had to do with this house, which gives me hope that he at least tackled it. I don’t know if he ever used an accountant, I think he tried to muddle through on his own. Anyway, it does give me hope (now I have to go dig through the storage and find his old returns; at least I know where they are).
Roddy