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The Danger of Renting with Owner Finance: Possible Tax Consequences

A few years ago, I had a client in my office and we were working on his tax return. Let’s pretend his name is Larry. He had a couple rental properties and as we were discussing one of them, he said something that didn’t sound quite right. So after talking for a few minutes, Larry told me that the property in question was being rented with owner finance. I have spent most of my career working with clients involved in real estate, so I’m sure many of them already see the irony of that statement. You see, renting with owner finance isn’t a thing. In the real estate world, you can buy or sell a property with owner finance (that’s where you don’t get a loan from the bank, but instead you make payments to the previous owner). Or you can also simply rent out a house. You can’t combine the two. Renting with owner finance doesn’t exist.

There is an old saying in the accounting world that goes “Garbage in, garbage out.” I’d be willing to bet that saying or something very similar exists in most professions. If you were baking a cake, it would mean that if the original ingredients were spoiled, the cake would be bad. The same applies in the accounting world, where if the original information isn’t correct or complete, then the results will be wrong as well.

In Larry’s case, he actually sold the property several years before he walked into my office. Unfortunately, whoever prepared the return that year had reported the property as a rental instead of using installment sale treatment. This resulted in completely different tax consequences than what should have been reported. Thankfully, the statute of limitations was not up, so several years of amended returns later we were able to rectify his situation before the IRS noticed.

Be careful to make sure you tell your CPA everything that might be pertinent to your financial situation. When in doubt, mention it and your CPA can tell you if it’s important or not. A rule that I encourage my clients to follow is that if there is a contract or similar document involved in a transaction, be sure you bring them in. Simply looking at Larry’s closing statement would have been enough to know that the property wasn’t a rental. You can’t rent something you don’t own! Your CPA will get you the most favorable treatment possible, but they can’t work with information they don’t have. Be sure you tell them everything.