Owner Financing Primer
At one level taxes on seller financed transaction are fairly simple. The payments are split into the interest portion and the principal portion; presumably someone did an amortization table as part of the closing so everyone knows what amounts to report. If this is a sale of a personal residence the seller should have no taxes to pay on the capital portion of the payment. The interest portion will be taxable as income on Schedule B, which already has a place for seller financed mortgages. The buyers will be able to deduct the interest paid from their taxes.
However, the above assumes the contract is paying as scheduled and payments are credited as arriving at the same time each month. Sometimes sellers try to maximize their income by requiring the exact interest to be calculated for the day on which the payment was received. They don't want the buyer to "beat" them out of some income by paying late, but before the late payment penalty date. They stop this by calculating the exact daily interest amount do.
There is a reason conventional mortgages are always due on the first; it makes the calculations easy and predictable. If interest is calculated for exact days there is no way to know what the amount of interest paid is until after the payment is received. If a payment check bounces the interest will be recalculated. I suspect the extra hassle and confusion ends up costing a lot more than any extra income.
Taxes get exceptionally complex if the contract is sold at a discount to a third party. When that happens the original seller is out of the loop. He reports whatever he was paid for the contract as a capital gain (probably tax free since it was his home) and that's the end of it. The buyer keeps making payments as normal and deducting the interest.
The third party buyer will have to split the payments received into three segments. One segment is the return of capital; no taxes due on this. A second segment is the interest. This is clearly interest income to the contract buyer and is reported as such. The third segment is the profit from the discount. If the contract buyer bought the mortgage for seventy-five cents per dollar then twenty-five cents of every dollar of capital paid by the buyer is profit. Depending on holding period this would be long or short term capital gain to the contract buyer.
Taxing authorities tend to have a somewhat naive/simplistic view of mortgages and think the amounts and terms written in the contract mean something. As you might imagine, contract buyers have developed techniques and strategies to minimize and/or postpone the taxes due. If you lust for more detail about how corporations, LLC's, Trusts and other techniques are used to accomplish this visit Invest in Debt and affiliated sites to learn more. It can be a fascinating and profitable game.