Real Estate Tax Calc
What is a wrap mortgage and how it differs from subject-to
A wrap mortgage (also called an all-inclusive trust deed or AITD) is a seller-financing arrangement where the seller creates a new, larger mortgage that 'wraps around' the existing underlying mortgage. The seller continues to make payments on the original mortgage while the buyer makes payments on the new, larger wrap note to the seller. The buyer never knows the details of the underlying loan — they deal only with the seller.
A subject-to purchase (or 'sub-to') is different: the buyer takes title to the property subject to the existing mortgage remaining in the seller's name. The buyer agrees to make the mortgage payments, but the loan remains legally the seller's obligation. If the buyer stops paying, the seller's credit is damaged and the seller faces foreclosure. In both structures, the existing mortgage's due-on-sale clause is technically triggered by the transfer of title — the lender can demand full payment. In practice, lenders rarely call the note unless rates have moved significantly or they discover the transfer, but the risk is real.
Both structures are used primarily when the existing financing has a favorable rate that the buyer wants to assume without formal assumption (which requires lender approval). The tax consequences differ slightly but both are governed by the installment sale rules for the seller.
Seller tax treatment: installment gain on the wrap
For a wrap mortgage seller, the tax treatment combines elements of an installment sale and ongoing interest income. The gain portion of each payment received from the buyer is taxable as installment sale income, using the gross profit percentage (gross profit divided by the contract price), reported on Form 6252. The seller computes the contract price as the selling price minus the existing mortgage taken over by the buyer (since the buyer assumes the seller's responsibility on the underlying debt).
Where the wrap differs from a simple seller-carryback: the seller is simultaneously receiving cash from the buyer and making payments on the underlying mortgage. The interest spread — the difference between the interest the buyer pays the seller on the wrap note and the interest the seller pays on the underlying mortgage — is ordinary income to the seller. If the seller's wrap note charges 8% and the underlying mortgage was originated at 4%, the 4% spread on the outstanding balance of the underlying loan is ordinary income in addition to the installment gain. This spread income is sometimes called 'override interest' and is a unique feature of wrap financing.
How the buyer deducts interest on a wrap loan
The buyer's deductible interest is the interest paid on the wrap note — the new note between buyer and seller. If the property is the buyer's primary residence, the interest qualifies as home mortgage interest (Schedule A, subject to the $750,000 acquisition debt limit). If the property is a rental, the interest is deductible on Schedule E against rental income. The buyer does not deduct payments the seller is making on the underlying mortgage — those are the seller's payments on the seller's debt.
The seller should provide the buyer with a Form 1098 (if the seller received $600 or more in interest on the wrap note and is in the business of making loans) or a written statement of interest paid for the year. Many individual wrap mortgage sellers are not in the business of lending and are not required to issue Form 1098, but failure to provide documentation creates a practical problem: the buyer needs a record of interest paid to support their deduction. Best practice is for the buyer and seller to agree in the purchase contract that the seller will provide an annual interest statement.
Subject-to buyer: who deducts the mortgage interest?
In a subject-to purchase, the existing loan stays in the seller's name but the buyer makes the payments. The question of who deducts the mortgage interest is surprisingly clear: under IRS rules, a taxpayer can only deduct interest they are legally obligated to pay. Because the seller (not the buyer) is legally obligated on the original mortgage, the seller technically has the legal right to deduct the interest — even though the buyer is making the payments.
In practice, many subject-to buyers treat the mortgage interest as their own deduction on the theory that they are the economic owner of the property and they are making the payments. This position has support in some Tax Court decisions under the concept of 'equitable ownership,' but it is not universally accepted and creates audit risk. A more defensible approach: the seller and buyer agree in writing that the buyer is making the mortgage payments as part of the purchase price allocation, and the seller waives any claim to the deduction. Still, the cleanest outcome is to eventually record a deed of trust or mortgage in the buyer's name with a formal assumption or refinance, resolving the legal ambiguity.
Due-on-sale clause: IRS versus lender considerations
Both wrap mortgages and subject-to purchases technically trigger the due-on-sale clause in most conventional mortgages and virtually all government-backed loans (FHA, VA, Fannie/Freddie). The lender has the contractual right to accelerate the loan — demand immediate repayment — if they discover the transfer without their approval. From the IRS's perspective, however, the lender's legal rights do not change the tax treatment. The sale has occurred, gain is reportable, and the installment method applies based on the actual payment stream — not on whether the lender eventually calls the note.
This creates a practical risk: a seller who uses a wrap or subject-to arrangement retains a contingent liability. If the buyer defaults, the seller's credit is exposed (subject-to) or the seller must step in and make the underlying mortgage payments while pursuing remedies against the buyer (wrap). Additionally, if the lender calls the note due to the due-on-sale violation, the entire loan balance becomes immediately due — potentially forcing the buyer to refinance on short notice or lose the property. Sellers should obtain legal counsel before entering a wrap or subject-to transaction, understand their ongoing liability exposure, and ensure the purchase agreement has clear provisions for default and property preservation.
Depreciation recapture on wrap and subject-to sales
Like all installment sales, depreciation recapture must be recognized in the year of sale on a wrap or subject-to transaction. If the seller owned a rental property and claimed depreciation, the unrecaptured Section 1250 gain is taxable in the year the transfer occurs, even though the seller will receive payments over many years. The seller should set aside funds at closing — or ensure the down payment covers at least the tax on the recapture — rather than assuming the installment payments will cover the tax as they arrive.
For a rental property sold on a wrap note, the total taxable amount in year one includes: (1) the recapture portion of the gain (recognized in full), and (2) the installment gain allocable to the down payment and any principal included in the first year's payments. In subsequent years, only the ongoing installment gain on principal received and the interest spread are taxable. Sellers often underestimate the year-one tax burden by focusing only on the installment method's deferral without accounting for the recapture acceleration.
Wrap notes and Form 6252: year-by-year reporting
The seller files Form 6252 for the year of sale and for every subsequent year in which installment payments are received. For a wrap mortgage, the 'contract price' is the selling price minus the outstanding underlying mortgage balance (since the buyer is not actually paying off that mortgage — the seller retains the underlying debt and continues making payments). The installment obligation is therefore only the equity spread, not the full purchase price.
Example: property sold for $400,000. Underlying mortgage balance is $200,000. Net contract price is $200,000 (the equity portion). Seller's adjusted basis is $150,000. Gross profit is $50,000. Gross profit percentage is 25% ($50,000 ÷ $200,000). Each principal payment from the buyer on the wrap note (not the underlying mortgage) triggers 25% gain recognition. The $200,000 of underlying mortgage is not an installment payment — it will eventually be paid off by the seller from the buyer's wrap payments.
Planning considerations for wrap and subject-to sellers and buyers
Sellers using wrap financing should plan for the combined tax hit in year one: recapture tax (full), plus installment gain on the down payment, plus state transfer taxes, plus title insurance (if obtained). Net down payment proceeds are often less than sellers expect after accounting for these costs. Structure the down payment to be at least large enough to cover the estimated year-one tax liability.
Buyers should obtain a full title search and legal review before taking subject-to or assuming a wrap note. The legal exposure (due-on-sale risk, seller's potential inability to pay underlying mortgage, title complications if seller is in financial distress) should be priced into the acquisition. From a tax planning standpoint, the buyer benefits from starting depreciation immediately on the full purchase price, and the interest component of each wrap payment (which may be slightly higher than a market-rate loan to compensate the seller for the spread) is deductible. Over time, the subject-to buyer should work toward refinancing into a loan in their own name to eliminate lender risk and simplify the tax deduction picture.
Frequently asked questions
How does a wrap mortgage seller report the gain?
On Form 6252 using the installment method. The contract price is the equity spread (selling price minus the outstanding underlying mortgage). The gross profit percentage is applied to each principal payment received from the buyer.
Can the buyer of a wrap mortgage deduct mortgage interest?
Yes, the buyer deducts the interest paid on the wrap note (not the underlying mortgage). For a rental property, this goes on Schedule E. The seller should provide an annual statement of interest paid.
Who deducts the mortgage interest in a subject-to purchase?
Legally, the seller (who remains obligated on the loan) is entitled to the deduction. Buyers often claim it based on equitable ownership, but this creates audit risk. The cleanest solution is a written agreement and eventual refinancing into the buyer's name.
Is depreciation recapture deferred in a wrap mortgage sale?
No. Depreciation recapture must be recognized in full in the year of sale, even though the principal payments are received over many years. Only the remaining capital gain qualifies for installment deferral.
What is the 'interest spread' on a wrap mortgage?
The spread is the difference between the interest rate on the wrap note and the interest rate on the underlying mortgage. This spread is ordinary income to the seller each year, reported on Schedule B.
Educational information and estimates only. Not tax advice. Tax rules change and vary by situation; consult a qualified tax professional before acting.