Question: We want to sell our home on a private contract using a deed of trust because we can earn more interest on our money than we could in a bank savings account.

What is the limit that you can receive as a down payment before you have to pay the income tax on it, or is there such a limit? Are there circumstances where you have to pay the income tax up front?

J.C., Everett

Answer: Tax law allows you to sell your home for cash and keep up to $250,000 in profit tax-free ($500,000 for a married couple filing a joint tax return).

To qualify for this wonderful tax break, you must have lived in your home for at least two of the last five years. The two-year requirement is an aggregate number, meaning that you do not have to live in the home for two years continuously. You just have to spend a total of 24 months in the home during the last 60 months prior to the sale. If you meet that requirement, you can keep your home sales profit, up to the $250,000/$500,000 limit totally tax-free.

If you decide to carry a private contract for some or all of the purchase price, you will not have to pay capital gains tax on your home sale profits, but you will have to pay income tax on the interest income you receive from the private contract.

For example, let’s say you paid $150,000 for your home many years ago and sold it this year for $400,000. After selling expenses of approximately $35,000, you would have a net profit of approximately $215,000. If you accepted a cash offer for the house, you could keep that entire $215,000 tax-free. Of course, you would still have to pay for a place to live unless you owned a second home.

Now, here’s what happens if you choose to carry a contract instead of selling for cash: Let’s say you accepted a $40,000 cash down payment and carried the $360,000 balance of the $400,000 sales price on a private contract. The down payment would be tax-free because it is part of your profit covered by the $250,000/$500,000 capital gains exclusion. The principal portion of the monthly payments you would receive on your private contract would also be tax-free, because that is just the payment of the cash portion of the sales price.

But the interest that you charge on the private contract is interest income. That is a separate source of income, just like earning interest on a savings account in a bank. And in fact, that is just what you are doing. You would be earning interest on the financed portion of the sales price of your home.

That is why some retired people like to sell their home on a private contract, because it provides them with a steady income stream for years to come. However, the problem with that plan is that the buyers can always refinance and cash you out early, which would cut off the monthly income.

Now let’s look at the tax implications of the contract itself. If you agreed to carry the $360,000 contract at 5.5 percent interest with the payments based on a 30-year amortization schedule, the loan payments would be $2,044.04 per month. Of the first payment, $1,650 would be interest, with the remaining $394.04 allocated to principal.

Remember, the principal portion of the payment would be tax-free, so your total taxable income from the first loan payment would be $1,650. Over the first 12 months, you would earn a total of $19,678.96 in interest income on this contract. That would be reported on your annual tax return as interest income, just as if you had earned it from a savings account at a bank.

In fact, you could earn 5.5 percent today from a bank certificate of deposit, so there’s really no reason to take on the risk of selling your home on a private contract unless you can get an above-market interest rate. And if you are getting an above-market interest rate, that’s usually because you are selling to somebody who can’t qualify for a conventional mortgage – probably because they have poor credit. So be aware that you are taking on extra risk in exchange for extra interest income.

Another factor to consider when selling a home on a private contract is refinancing. The average American refinances every three to five years, so if you’re counting on the private contract payments for your retirement income, you should add a pre-payment penalty to your contract to discourage the buyers from refinancing and cutting off your interest income sooner than you expect. A typical pre-payment penalty would be six months worth of interest.

Mail your real estate questions to Steve Tytler, The Herald, P.O. Box, Everett, WA 98206. Fax questions to Tytler at 425-339-3435 or e-mail him at economy@heraldnet.com.