Selling real estate with rent credited as down payment (USA)

Question

My wife and I do not live in a community property state, but we treat everything as jointly owned/spent/taxed. (In case it matters for the question)

She inherited a house appraised as (Value)

We are renting it to a relative for monthly (Rent) which we keep in a credit union account separate from other accounts. That account earns monthly (Interest).

From that account, we pay property tax (Tax) & (Insurance).  They pay any repairs/maintenance.

If that were the whole story, we would each year report the appropriate things on 1040 schedule E (not sch. 1 as I originally misinterpreted).

But there is anticipation that some year in the near future, they will buy the house for the original (Value) with (Rent) minus (Tax) & (Insurance) credited as down payment.  (A loss due to inflation & appreciation, but we don't mind because their future inheritance is reduced by exactly that loss.)

So how do we resolve the conflict between the year of sale (which might not happen—they could change their minds or not get a loan approved or something) and all the years up to that time? Do we have to hire a professional for this? I'm 69 and I've always done all our tax forms myself.  Our total income is such that a preparer's fee would exceed the tax amount!

Do we treat it as a rental, and then turn in amended returns if/when the rent payments change to down-payment on purchase? Don't want them to be double-income (first as rent, and then as sale receipt).

Answer 1

If that were the whole story, we would each year report the appropriate things on 1040 schedule 1.

I'd say Schedule E, not schedule 1. Schedule 1 is for primary/secondary residence, which this is not.

But there is anticipation that some year in the near future, they will buy the house for the original (Value) with (Tax) & (insurance) minus (Tax) & (Insurance) credited as down payment.

Seems complicated for whatever reason. Do you have an actual written contract? When you say "anticipation" - are you anticipating they'll make you an offer?

So how do we resolve the conflict between the year of sale (which might not happen—they could change their minds or not get a loan approved or something) and all the years up to that time?

There's no conflict. You inherited the house for $Value, and you sold it for $Sale_Price in some future year. You'll have a gain of $Sale_Price - $Value. You'll pay taxes on the difference. There's additional consideration of the depreciation recapture (the fact that you're currently choosing not to deduct depreciation is irrelevant to the recapture) which is taxed at a flat tax rate of 25% IIRC.

How you reach the $Sale_Price when you sell doesn't really matter, it's between you and the buyer. Unless you have an explicit signed contract now for a transfer of ownership at some future date, there's nothing you should concern yourself about with regards to the "anticipated" future transaction.