Subject To Real Estate: The Tax Side Nobody Explains

In a normal sale, the seller's mortgage gets paid off at closing and the buyer brings new financing. In a subject-to sale (you will also see it written "subject 2" or "sub-to"), the deed transfers to the buyer and the seller's existing mortgage simply stays where it is. Nobody pays it off. Nobody asks the lender. The buyer starts making the monthly payments on a loan that legally belongs to someone else.

That single move splits two things that normally travel together: ownership of the property and liability on the debt. Every tax question on this page traces back to that split. The tax law has an old and fairly settled answer for most of it, going back to a 1947 Supreme Court case involving debt on inherited real estate, but the answers are not obvious, and the reporting forms actively point in the wrong direction.

The mechanics are short. The parties sign a purchase agreement. At closing, the seller deeds the property to the buyer. The existing loan is not paid off, not assumed, and not modified; it stays in the seller's name with the seller liable on it. The buyer takes over the monthly payments, often through a neutral third-party loan servicing company so both sides can prove who paid what. Any price above the loan balance gets covered with cash, a seller carryback note, or both.

Why would anyone structure it this way? Interest rate arbitrage, mostly. A seller with a 3% mortgage from 2021 is sitting on financing that no buyer can replicate today, and a subject-to deal lets the buyer effectively keep that rate. It also closes fast, with no loan underwriting. For sellers, it can move a house with little equity without bringing cash to closing.

That is the neutral description. The strategy has a promotional culture around it that we are not going to feed. What we will do is show you the tax consequences, because they are real on both sides, they arrive in the first year, and they are routinely mishandled.

Before any tax analysis matters, three non-tax risks sit on top of every subject-to deal.

• The due-on-sale clause. Most mortgages let the lender demand full repayment when the property transfers without its consent. Federal law (the Garn-St Germain Act) limits when lenders can enforce these clauses, but the protected transfers are mostly death, divorce, and certain family and living-trust situations. A typical investor purchase is not on the protected list, so the lender generally keeps the option to call the loan. Whether it will, and what happens if it does, is a legal question.
• Insurance. The seller's homeowner policy insures an owner who no longer owns the house. Getting the property properly insured after closing without tipping into a claim-denial problem is an insurance and legal structuring question.
• The seller's credit and ongoing exposure. The loan stays on the seller's credit report and counts against their borrowing capacity. If the buyer stops paying, the missed payments land on the seller. Contract terms that protect the seller are drafting work for an attorney.

Your basis includes the debt you took subject to.

The buyer's cost basis is the full purchase price: cash paid, plus any seller note, plus the entire mortgage balance taken subject to. This is the Crane doctrine, from the Supreme Court's 1947 decision: debt on property counts in basis even when the owner never personally assumed it. Taking a property subject to a $210,000 loan builds $210,000 into your basis just as surely as paying $210,000 cash would.

Depreciation runs on the full basis.

If the property becomes a rental, you depreciate the building portion of that full basis (land is never depreciable) over 27.5 years straight line for residential rental property, prorated in the first year under the mid-month convention. The loan staying in someone else's name does not shrink your depreciation deduction at all.

Mortgage interest is the hard one.

You are paying interest on a loan you are not liable on, and in January the lender will send the Form 1098 to the seller, because 1098s go to the borrower of record. The deduction is still available, but it rests on an ownership analysis, not on the loan documents. Treasury regulations allow the deduction for interest paid on a mortgage on real estate "of which the taxpayer is the legal or equitable owner, even though the taxpayer is not directly liable" on the note.

A subject-to buyer who recorded the deed is normally the legal owner, which is a stronger starting position than the equitable-ownership cases where taxpayers were not even on title, like the Tax Court's Uslu decision allowing the deduction for a couple who held none of the paper but carried every benefit and burden of the home. But this is genuinely fact-dependent: courts weigh who possesses the property, who pays the carrying costs, who bears the risk of loss, and whether the arrangement is documented. A buyer whose deal papers are thin, whose payments run through an unrelated entity, or who cannot show the benefits and burdens of ownership can lose the deduction. Treat this as a position to build with documentation, not a box to check.

Property taxes are the easy one.

Real estate taxes are deductible by the person the tax is imposed on, which after closing is the owner: you. Pay them yourself (directly or through the loan's escrow) and keep proof of payment.

Sellers sometimes assume that because the mortgage is still theirs, the sale is somehow not final for tax purposes. It is. The year the deed transfers, the seller has a completed sale, and the amount realized includes the cash received, any seller carryback note, and the full balance of the mortgage the buyer took subject to. Debt relief counts as sale proceeds even though no money moved.

Gain is the usual math: amount realized minus adjusted basis. How that gain is taxed depends on what the property was. Our guide to capital gains tax on real estate covers the rate brackets; two subject-to specific layers sit on top.

Primary residence: the Section 121 exclusion still works.

If the home was the seller's principal residence and the seller owned and used it for at least 2 of the 5 years before the sale, up to $250,000 of gain is excluded, or $500,000 on a joint return, subject to the once-every-two-years rule. Selling subject to does not affect eligibility; the tests care about ownership and use, not how the buyer financed the purchase. If you are weighing a subject-to offer against keeping the property, the math in our sell or rent your house guide is the place to start.

Seller carryback: the installment-sale wrinkle.

If part of the price is a seller note collected over time, the sale can qualify for installment reporting on Form 6252, spreading gain across the years payments arrive. But there is a trap built into subject-to deals: to the extent the mortgage taken subject to exceeds the seller's basis, that excess is treated as a payment received in the year of sale, and it also pushes the gross profit percentage up. A low-basis seller can owe tax on gain in year one that far exceeds the cash that actually arrived. The worked example below puts numbers on this.

The interest mismatch runs both directions.

The lender will keep sending the seller a Form 1098 showing mortgage interest "paid" under the seller's Social Security number, because the seller is still the borrower of record. The seller did not pay that interest and should not deduct it; the deduction requires that you actually paid the interest, and after closing it is not the seller's home anyway. Meanwhile, interest the seller collects on any carryback note is ordinary interest income the seller must report.

Take a hypothetical deal with clean round numbers. A seller owns a house worth $280,000 with a $210,000 mortgage at 3.1%. The buyer pays $15,000 cash at closing, takes the property subject to the $210,000 loan, and gives the seller a $55,000 carryback note for the rest. All figures are illustrative and ignore selling costs; your facts will differ.

The buyer's filings

• Rental property: interest and property taxes go on Schedule E with the other rental numbers, and depreciation starts on Form 4562. No 1098 in your name means your payment records and deal documents carry the substantiation load.
• Personal residence: interest goes on Schedule A as home mortgage interest not reported to you on a Form 1098, and the instructions have you identify the person who received the 1098; for seller-financed interest paid to the seller, the seller's name, identifying number, and address go next to that line, and skipping the required information can draw a $50 penalty.

The seller's filings

• Report the sale in the year the deed transfers: Form 8949 and Schedule D, or Form 6252 if installment treatment applies to a carryback note.
• Report interest collected on the carryback note as interest income.
• Do not deduct the mortgage interest on the 1098 that still arrives in your name. You did not pay it, and deducting it invites a problem that is entirely avoidable.

Both sides should keep the deed, the closing statement, the servicing agreement, and a full payment history. Subject-to returns are not exotic, but they are unusual enough that preparers who have never seen one tend to force the 1098 onto the wrong return or miss the mortgage-over-basis payment entirely. This is squarely the kind of return our real estate investor CPA practice handles, on both the buyer and seller side.

Subject-to is neither a tax loophole nor a tax disaster. But there are recurring fact patterns where the tax treatment actively hurts one side, and they are worth naming before you sign.

• The low-basis seller who wanted installment deferral. As the worked example shows, debt over basis is deemed payment in year one. A seller who depreciated a rental for years can face gain recognition well ahead of the cash, and the depreciation layer is taxed as unrecaptured Section 1250 gain at a rate of up to 25% rather than the regular capital gains rates. An investor-seller comparing exit routes should also price a 1031 exchange, which generally does not pair with leaving your loan in place for a subject-to buyer.
• The buyer counting on interest deductions without the facts. If your payments run through an entity that does not hold the deed, or the deal documents do not put the benefits and burdens of ownership on you, the equitable and legal ownership analysis that supports the interest deduction gets shaky. The deduction follows ownership facts, and thin files lose.
• Wrap notes. When the seller carries a wraparound note on top of the underlying loan, there are now two layers of interest flowing in different directions, two sets of interest reporting, and a 1098 that matches neither. Wraps are where do-it-yourself returns on these deals most reliably fall apart, on both sides.
• The seller whose Section 121 clock is running. The exclusion requires use as your main home for 2 of the last 5 years. A seller who moved out long before the deed finally transfers can watch the exclusion lapse while the deal drifts.