Seller Financing With an Existing Mortgage: Payoff, Assume, Wrap
Yes, you can seller-finance a property that still has a mortgage on it, but the way the old loan is handled decides how much gain you report in year one. A loan paid off at closing out of the buyer's money counts as a payment to you in the year of sale. A loan the buyer assumes is not a payment up to your basis, which shrinks the contract price. A wraparound note, where you keep paying the old loan, is the least settled of the three.
Total gain is the same in every version. What changes is how much of it lands in year one, and whether you have the cash to pay that tax.
Three ways the old loan is handled
| Method | What happens at closing | Year-one tax effect |
|---|---|---|
| Paid off | Escrow uses the buyer's money to retire your loan | The payoff is a year-one payment |
| Assumed or taken subject to | The buyer takes over your loan (usually with lender approval) | Not a payment, up to your basis; excess over basis is a payment |
| Wraparound | The buyer's note to you includes the loan balance; you keep paying your lender | Unsettled: the regulation treats it like an assumption; the Tax Court has disagreed |
The rules live in Temp. Reg. §15a.453-1(b)(2) and (b)(3), explained in plain English in IRS Publication 537 under "Buyer Assumes Mortgage."
Paid off at closing: that cash is a payment in year one
This is the version most sellers do without thinking, and the one that surprises them at tax time.
The regulation excludes from payments only "qualifying indebtedness ... assumed or taken subject to by the person acquiring the property," and only up to your basis (Temp. Reg. §15a.453-1(b)(3)(i); contract price, (b)(2)(iii)). A payoff at closing is different: the buyer's cash is applied, at your direction, to your own debt. Treat it as a payment to you in the year of sale. You never see the money, but it is taxed as if you did.
One wording trap: Pub. 537's lead-in sentence says "If the buyer assumes or pays off your mortgage," but the operative rules that follow speak of a mortgage the buyer assumes. A publication is not authority, and the regulation's text covers only debt assumed or taken subject to. Plan on the payoff being a payment.
The book's cases model it the same way. In Case 2 (illustrative), a $150,000 loan paid off at closing is part of the $776,000 of gain the retired sellers recognize in year one (The Waterfall Strategy).
Assumed: debt relief counts only above basis
When the buyer assumes your loan, or takes the property subject to it, three things happen (Temp. Reg. §15a.453-1(b)(2)(iii), (b)(3)(i)):
- The assumed loan is not a payment, as long as it does not exceed your installment sale basis.
- The contract price drops by the assumed loan. Since gross profit does not change, the gross profit percentage rises.
- Any excess of the loan over your basis is treated as a payment in the year of sale and is added back to the contract price.
Mortgage over basis. If the assumed mortgage is more than your basis, you recover all your basis at once, the excess is a year-one payment, and the gross profit percentage becomes 100%. Pub. 537's example: a $9,000 sale, a $6,000 mortgage assumed, a $5,000 installment sale basis. The $1,000 excess is a year-one payment, the contract price is $4,000, gross profit is $4,000, and every dollar of principal the seller receives is 100% gain.
The cash-out refinance trap. Debt you placed on the property "in contemplation of disposition" is not qualifying indebtedness if the arrangement accelerates recovery of your basis (Temp. Reg. §15a.453-1(b)(2)(iv)). Refinance right before the sale, pocket the cash, then have the buyer assume the bigger loan, and the IRS can treat that loan as a payment.
The practical side. Most commercial and residential loans need the lender's consent to an assumption, often with fees and a credit review of the buyer. With today's rates, a buyer may want your cheaper loan, so it is worth asking the lender early.
Wraparound notes: Professional Equities and the regulation
In a wraparound (an "all-inclusive" note), the buyer does not assume your loan. Instead, the buyer gives you a note for most of the price, including the old loan balance, and you keep paying your lender out of what the buyer pays you.
What the regulation says. Temp. Reg. §15a.453-1(b)(3)(ii) deems the wrapped loan "to have been taken subject to even though title to the property has not passed in the year of sale and even though the seller remains liable for payments on the wrapped indebtedness." Under that rule, a wrap is taxed like an assumption: the contract price is reduced by the wrapped debt (up to basis), and wrapped debt above basis is a year-one payment. The regulation's Examples (5) and (6) walk through the math. That text is still in the Code of Federal Regulations.
What the Tax Court did. In Professional Equities, Inc. v. Commissioner, 89 T.C. 165 (1987), a land seller took wraparound notes, the taxpayer argued the regulation was invalid, and the court entered decision for the taxpayer, following an older line of wraparound cases that began with Stonecrest Corp. v. Commissioner, 24 T.C. 659 (1955). Under that approach the wrapped loan is not treated as assumed, so it does not reduce the contract price and does not create a year-one payment.
Where that leaves you. Courts and the regulation point in different directions, and the documents matter (who holds title, who is liable, whether the buyer ever pays the lender directly). The wraparound treatment is unsettled. Do not build a plan on it without your CPA's written sign-off.
Due-on-sale clauses (practical risk)
Most mortgages let the lender call the whole loan due if the property is sold or transferred without consent. A wraparound or an informal "subject to" deal does not make that clause go away; it only means the lender has not acted yet. If the lender calls the loan, you must pay it off, often by forcing the buyer to refinance, which can end your installment note early and pull the rest of the gain into one year. Read your loan documents and talk to your lender and attorney before you rely on a wrap or an unapproved subject-to sale.
Worked example with all three
Simple example. You sell a building for $1,000,000. Your installment sale basis is $500,000, so the gain is $500,000. There is a $300,000 loan on the property. The buyer pays enough cash at closing that you net $100,000 in your pocket, and you carry the rest on a note. No depreciation recapture, to keep it clean.
| A. Loan paid off at closing | B. Buyer assumes loan | C. Wraparound (court approach) | C. Wraparound (regulation) | |
|---|---|---|---|---|
| Buyer cash at closing | $400,000 | $100,000 | $100,000 | $100,000 |
| Used to pay off your loan | $300,000 | $0 | $0 | $0 |
| Your note | $600,000 | $600,000 | $900,000 | $900,000 |
| Contract price | $1,000,000 | $700,000 | $1,000,000 | $700,000 |
| Gross profit | $500,000 | $500,000 | $500,000 | $500,000 |
| Gross profit percentage | 50% | 71.43% | 50% | 71.43% (year of sale) |
| Year-one payments | $400,000 | $100,000 | $100,000 | $100,000 |
| Year-one gain | $200,000 | $71,429 | $50,000 | $71,429 |
| Cash you actually kept | $100,000 | $100,000 | $100,000 | $100,000 |
| Total gain over the life of the deal | $500,000 | $500,000 | $500,000 | $500,000 |
Read column A slowly: you kept $100,000 of cash and reported $200,000 of gain. If that gain is taxed at 20% plus the 3.8% net investment income tax, federal tax alone is $47,600, nearly half the cash you walked away with. Add depreciation recapture or a state tax and the year-one bill can exceed the cash.
In the regulation's version of the wrap, the seller's basis in the wrap note becomes $471,429 ($500,000 basis + $71,429 gain recognized - $100,000 cash), so later principal on the $900,000 note carries about 47.6% gain. Total gain still comes to $500,000.
Run your own numbers in the installment sale calculator, with the loan payoff entered, before you set the down payment.
Bottom line
An existing mortgage does not stop a seller-financed sale, but it moves gain into year one. A payoff at closing is a year-one payment even though the money went straight to your lender. An assumption keeps the loan out of year one up to your basis. A wraparound can look best on paper, but the regulation and the Tax Court disagree, and the due-on-sale clause is a real business risk. Size the cash you take at closing to cover the year-one tax the loan creates.
For more, see the complete installment sale guide, how to set up a seller carry-back, and the note terms that protect a seller.
Questions to ask your CPA
- Is my loan going to be paid off, assumed, or wrapped, and how much year-one gain does each create?
- Is the loan balance above my installment sale basis, so part of it is a year-one payment anyway?
- Did I refinance in a way that the IRS could treat as debt placed on the property in contemplation of the sale?
- If we use a wraparound, which treatment will you take on the return, and will you sign off in writing?
- How much cash do I need at closing to pay the year-one federal and state tax?
- What does my loan's due-on-sale clause say, and what happens to my note if the lender calls it?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.