Contract for Deed: How It Works, Who Pays Taxes, Seller Risks
A contract for deed is a seller-financed real estate sale where the buyer moves in and pays the seller in installments, but the seller keeps legal title and hands over the deed only when the price is paid in full. The buyer holds "equitable title" in the meantime. Contract for deed means the same thing as a land contract in most places; what really differs is your state's law, which decides recording duties, notice periods, and whether you can cancel the contract or must foreclose.
This article focuses on those rules, who pays property tax, and the seller's risks. For federal tax purposes it is usually an installment sale; the math is at the end.
Contract for deed meaning and definition
A contract for deed is an executory contract: the sale is agreed today but completed (the deed delivered) in the future. Until then:
| Buyer (vendee) | Seller (vendor) | |
|---|---|---|
| Title | Equitable title | Legal title |
| Possession | Yes, from signing | No |
| Pays | Down payment, installments, usually taxes, insurance, repairs | Any existing mortgage on the property |
| Gets at the end | The deed | The full price plus interest |
"Equitable title" is the buyer's right to get legal title once the contract is performed. Courts and legislatures increasingly treat that right as real ownership, which is why the old seller advantage (quick forfeiture) has been cut back in many states.
How does a contract for deed work?
- The parties sign one contract covering price, down payment, interest, schedule, balloon date, taxes, insurance, maintenance and default.
- The buyer takes possession. Many contracts require the buyer to carry insurance naming the seller.
- The contract (or a memorandum) is recorded where required.
- The buyer pays monthly, often through an escrow or servicing company that also collects taxes and insurance.
- At payoff, usually by refinancing at the balloon date, the seller delivers a warranty deed.
- On default, the seller follows the state's cancellation, forfeiture or foreclosure procedure.
State rules: three examples
Rules vary widely. These three show the range; your state may be stricter or looser, so have a local real estate attorney draft the contract.
Texas (Property Code chapter 5, subchapter D, "executory contracts for conveyance"). The subchapter covers contracts for residential property the buyer (or a close relative) will live in. It also treats "an option to purchase real property that includes or is combined or executed concurrently with a residential lease agreement, together with the lease" as an executory contract (§5.062), so rent-to-own deals are caught too. The seller must record the contract within 30 days after it is executed (§5.076). Once the buyer has paid 40 percent or more of the amount due or the equivalent of 48 monthly payments, the seller cannot simply forfeit the contract; the seller must sell the buyer's interest through a trustee after a notice giving at least 60 days to cure (§5.066). Texas also imposes disclosure and annual accounting duties, so a Texas seller who ignores subchapter D can face real liability.
Minnesota (Minn. Stat. §559.21 and §507.235). Minnesota uses a statutory cancellation process. For contracts signed after August 1, 1985, the notice generally gives the buyer 60 days after service to cure, with a different period in some cases. Minnesota puts the recording duty on the buyer: contracts for deed must be recorded within four months, and a buyer who fails to record can owe a civil penalty of 2 percent of the contract debt (§507.235).
Ohio (Ohio Rev. Code §5313.07). Once the buyer has paid under the contract for five years or has paid 20 percent or more of the price, "the vendor may recover possession of his property only by use of a proceeding for foreclosure and judicial sale." Before that point, forfeiture is available under the chapter's notice rules.
The pattern: forfeiture is realistic only early in the contract, when the buyer has little equity. After that, most sellers should expect a foreclosure-like process, with its time and cost.
Does a contract for deed need to be recorded?
Often yes, and even where it is optional, recording protects both sides. For the buyer it gives public notice of their interest. For the seller, an unrecorded contract can cause trouble later: a buyer who walks away leaves a cloud that must be cleared, and in states like Texas the seller is the one who must record. Also record any termination or release when the contract ends, so the title is clean for your next sale.
Contract for deed: who pays property tax?
The contract decides. Standard practice is:
- Buyer pays property taxes, insurance, HOA dues and repairs, because the buyer has possession and the benefits of ownership.
- Tax bills may still be mailed to the seller as owner of record, and unpaid taxes become a lien on the property you still hold title to.
- Best practice for sellers: collect one-twelfth of the annual taxes and insurance with each payment into an escrow account and pay the bills yourself, or use a servicer that does. Require proof of insurance every year with you as additional insured.
For federal income tax, the person who bears the economic burden and has ownership benefits is generally the one who deducts the real estate taxes, which is usually the buyer. Ask your CPA how to handle the year of sale and any taxes you paid on the buyer's behalf.
Contract for deed pros and cons (seller's view)
| Pros | Cons |
|---|---|
| Sell to buyers banks turn down | Buyers are often thin on credit and cash |
| Interest income and often a higher price | Default and repair risk stay with you |
| Legal title retained until paid | Title retention does not avoid state foreclosure rules |
| Installment method spreads gain | Recording, disclosure and annual-statement duties in some states |
| Faster closing than a bank loan | An existing mortgage can be called under its due-on-sale clause |
About that last point: federal rules that bar lenders from calling loans on certain transfers specifically exclude a subordinate lien "created pursuant to a contract for deed" (12 CFR §191.5(b)(1)(i)). If you still have a mortgage, read due-on-sale clause before you sign.
For homes, federal consumer-lending rules can also apply to a seller who finances more than an occasional sale; see seller financing a home.
How a contract for deed is taxed
For federal income tax, the contract for deed is usually an installment sale, the same as any other seller financing:
- Sale date: when the benefits and burdens of ownership pass to the buyer (normally at signing), not when you deliver the deed years later.
- Gain: reported as you collect principal, times your gross profit percentage, on Form 6252 (§453). See seller financing tax implications.
- Interest: ordinary income, and it must be at least the applicable federal rate or some principal is recharacterized as interest.
- Depreciation: stop depreciating a rental on the sale date.
Simple example. A rental house with an adjusted basis of $150,000 is sold on a contract for deed for $250,000: $25,000 down and $225,000 at 7% over 20 years. Gross profit is $100,000 and the gross profit percentage is 40% ($100,000 / $250,000). Each dollar of principal the buyer pays carries 40 cents of taxable gain (with any unrecaptured §1250 gain recognized first under Reg. §1.453-12), and all the interest is ordinary income. If you had instead waited to report until you delivered the deed, you would be using the wrong sale date.
Run your own scenario with the calculator.
When the buyer defaults: taxes
If you cancel, forfeit or foreclose and take the property back, §1038 generally applies to repossessions of real property sold on a secured installment obligation. It limits the gain you recognize to cash and property received before the repossession, less gain already reported, capped by the gain on the original sale, less repossession costs. Full walk-through: installment note default and repossession. For how the land contract and note-and-deed-of-trust forms compare on remedies, see land contract vs seller financing.
Related
See what happens if the buyer defaults (forfeiture vs foreclosure), seller financing rules, the owner financing calculator (it works as a contract for deed calculator with a balloon payment) and the seller financing guide.
Bottom line
A contract for deed is seller financing with the deed held back until you are paid. The tax treatment is the ordinary installment method starting at signing. The legal treatment is where sellers get hurt: states like Texas, Minnesota and Ohio impose recording duties, cure periods and foreclosure requirements once the buyer has paid in. Escrow the property taxes and insurance, record correctly, charge at least the AFR, and use a local attorney's contract, not a generic form.
Questions to ask your CPA
- Is the sale date the signing date, and do I stop depreciation then?
- What is my gross profit percentage, and how much unrecaptured §1250 gain comes out first?
- How do I report the interest, and do I need the buyer's SSN on Schedule B?
- Who deducts the property taxes in the year of sale if I paid them from escrow?
- If I cancel the contract and keep the payments, how does §1038 apply?
- Does my state's contract-for-deed law change anything about timing of the sale?
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.