Are you planning to sell real estate before the end of the year? Naturally, you hope to entice a qualified buyer who has plenty of cash on hand. But being open to the idea of an installment sale may help you seal the deal. Fortunately, installment sales also offer tax savings for sellers. Here's how these deals work.
Should You Elect Out of Installment Sale Treatment? When you sell real estate on the installment basis, you can elect out of installment sale reporting by paying tax on the entire gain in the year of the sale. Why would you ever do that? There are several possible reasons.
For example, you might expect to pay lower tax rates in 2017 than in 2018 or 2019. In that case, you may prefer to pay the full amount of tax due on your 2017 tax return.
Or you might have capital losses or suspended passive losses that will offset the tax on an installment sale gain. Therefore, you may benefit by reporting all your gain in the year of the sale, instead of spreading it out over time.
Not sure how to report your sale? Your tax advisor can calculate your cumulative tax liability with and without installment sale reporting. Then you'll have the information needed to make an informed choice on your 2017 tax return.
Qualifying as an Installment Sale
With installment sales, the buyer makes payments to the seller over time, rather than handing over a lump sum at closing. The buyer's obligation to make future payments to the seller may be spelled out in a deed of trust, note, land contract, mortgage or other evidence of debt.
Under the tax code, an installment sale allows the seller to defer tax on a gain from the sale and possibly reduce the overall tax liability by spreading out the tax liability over several years. So, it's a popular tax planning technique for real estate owners.
To qualify as an installment sale under the tax law, you must receive at least one payment after the year of the sale. For example, if you sell real estate in October and receive a total of three monthly payments in October, November and December, you aren't eligible for installment sale reporting. Conversely, if you arrange to receive only two payments — say, one in December 2017 and the other in January 2018 — you qualify.
Moreover, if it suits your needs, you can "elect out of" installment sale treatment when you file your 2017 tax return. (See "Should You Elect Out of Installment Sale Treatment?" at right.) Also note that the installment sale rules apply only to gains, not losses.
Understanding the Exclusions
The following types of transactions are not eligible for installment sale reporting:
- Sale of inventory of personal property,
- Sales of personal property by a dealer (a person who regularly sells or otherwise disposes of this type of personal property on the installment basis), unless the property is used or produced in farming,
- Sales of timeshares and residential lots by dealers, unless the buyer elects to pay a special interest charge, and
- Sales of stock or securities traded on an established securities market.
For these types of transactions, you must report the entire gain on the sale in the year in which it occurs.
Reaping the Tax Benefits
Although installment sales require you to wait several years to receive the property's full fair market value, they offer three key tax advantages:
1. Long-term capital gains treatment. With an installment sale of real estate, any gain is taxed as tax-favored long-term gain if you've owned the property for longer than one year. Under current tax law, the maximum long-term capital gains rate is 15%, or 20% if you are in the top ordinary income tax bracket of 39.6%. Even if you're also liable for the 3.8% net investment income tax (NIIT), the maximum combined federal tax rate is limited to 23.8%.
2. Tax deferral. Instead of paying tax on the entire gain in one year, only a portion of your gain is taxable in the year of the sale. The remainder is taxable in the years payments are received.
The taxable portion of each payment is based on the "gross profit ratio." To calculate this ratio, divide the gross profit from the sale by the price.
For example, in November 2017, you sell a small apartment building that you acquired in 2005 with an adjusted tax basis of $600,000. The buyer agrees to pay $1.5 million in three annual installments of $500,000 each. Because your gross profit is $900,000 ($1.5 million - $600,000), the taxable percentage of each installment received is 60% ($900,000 / $1.5 million). When you report the sale on your 2017 tax return, you have to pay tax on only $300,000 of the gain (60% x $500,000). You'll also be taxed on $300,000 of gain in 2018 and 2019.
3. Lower tax liability. Because your gain from an installment sale is spread out over several years, you may benefit from the tax rate differential in each of those years. For simplicity, let's assume that you arrange a five-year installment sale where $50,000 of the gain is taxed at the 15% rate each year instead of the 20% rate (if the entire gain had been taxed in the year of sale). As a result, you save $2,500 ($50,000 x 5% tax rate differential) each year for a total savings of $12,500 ($2,500 x 5 years). These rates may change in the future if tax reforms are enacted, however.
Navigating Other Tax Hurdles
Beware: The tax law contains some hidden "tax traps" for the unwary when property is sold on the installment sale basis. First, any depreciation claimed on the property must be recaptured as ordinary income to the extent it exceeds the amount allowed under the straight-line method. The adjusted basis of the property is increased by the amount of recaptured income, thereby decreasing the gain realized in future years.
In addition, if the sales price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid on the deferred tax to the extent that your outstanding installment obligations exceed $5 million.
Finally, sales of depreciable property to related parties are prohibited unless you can demonstrate that tax avoidance wasn't a principal purpose of the sale. Furthermore, if the related party disposes of the property within two years, either by resale or some other method, the remaining tax is due immediately.
Important note: The definition of a "related party" isn't limited to immediate family members, such as your spouse, children, grandchildren, siblings and parents. It also includes a partnership or corporation in which you have a controlling interest or an estate or trust that you're connected to. To avoid any negative tax results when deals involve related parties, consider adding a clause that stipulates that the property can't be disposed of within two years.
Installment sales aren't right for every real estate transaction, but for patient sellers who aren't strapped for cash, installment sales can help finalize an agreement. Your tax advisor can help you cement a profitable deal with favorable tax consequences.