When selling real estate, the thought of paying a hefty capital gains tax can weigh heavily on any investor’s mind. However, there’s a useful tax tool available to taxpayers under IRC § 453 in the form of installment sales. This method not only defers tax payments but can also potentially lower the total tax liability. Here’s what you need to know about installment sales and how they can benefit you.
What Is An Installment Sale?
An installment sale occurs when you sell a property and receive at least one payment after the year of the sale. This doesn’t require spreading payments over several years; even one payment crossing into the next tax year qualifies as an installment sale.
Key Benefits of Installment Sales:
- Tax Deferral: Spread tax payments over multiple years, aligning them with cash received.
- Potential Tax Savings: By receiving smaller gains yearly, you might qualify for a lower tax bracket in some years.
- Improved Cash Flow: Pay taxes as you receive payments, not upfront.
Who Can Benefit from Installment Sales?
Taxpayers selling property held for investment or business purposes are prime candidates for installment sales. However, it’s important to know what qualifies:
- Eligible Properties: Real estate, personal property, and business assets.
- Ineligible Transactions: Inventory, publicly traded securities, and depreciable property sold to related parties.
How An Installment Sale Works
Here’s an example:
- Original Purchase: A taxpayer buys a property for $200,000.
- Sale Price: The property is sold for $300,000 with payments spread over five years.
- Taxable Gain: Only the profit portion of each payment ($100,000 divided over five years) is taxed annually.
How an Installment Sale Can Potentially Lower Your Tax Liability
One of the key advantages of an installment sale is the ability to defer recognizing the entire gain in the year of sale. This deferral not only spreads out the tax burden but may also reduce the total tax liability by leveraging lower tax rates in future years.
Here’s a simplified example to illustrate this concept:
Example: Bailey, LLC sells residential real property in 20X7 that it acquired in 20X0 with an adjusted tax basis of $600,000. The purchaser (an unrelated party) agrees to pay Bailey $1,500,000 in three annual installments of $500,000 each.
Because Bailey’s gross profit is $900,000 ($1,500,000 minus $600,000), the taxable percentage of each installment received is 60 percent ($900,000/$1,500,000). When Bailey reports the sale on his 20X7 return, he will have to pay tax on only $300,000 of the gain (60% X $500,000). Note: he will also be taxed on $300,000 of gain in 20X8 and 20X9.
Since the gain from the installment sale is spread out over several years, the taxpayer can benefit from the tax rate differential in each of those three years. For example, let’s assume that since the payment has been split up into three installments, each year the $300,000 taxable gain is taxed at the 15 percent rate instead of the 20 percent tax rate (if the entire gain had been taxed in the year of sale). The taxpayer would save $15,000 ($300,000 x 5% tax rate differential) each year for a total savings of $45,000 ($15,000 x 3 years).
Can I Sell My Main Residence with an Installment Sale?
Yes, you can sell your main residence using an installment sale, but there are some specific rules and considerations to keep in mind.
Primary Residence Exclusion:
When selling your main residence, you may qualify for a significant tax break under the primary residence exclusion. This exclusion allows single taxpayers to exclude up to $250,000 of capital gains from the sale of their main home, and married couples filing jointly can exclude up to $500,000.
If your gain exceeds this exclusion, an installment sale can be used to defer taxes on the remaining gain. For example:
- If you sell your home and realize a $600,000 gain, a married couple can exclude $500,000.
- The remaining $100,000 of gain can then be spread out and taxed over the years in which installment payments are received.
Interest Income Considerations:
In addition to recognizing a portion of the gain each year, you may also receive interest on the unpaid balance of the sale price. This interest is taxable as ordinary income and must be reported annually.
Key Restrictions:
It’s important to note that the installment sale method cannot be used to defer gains if the property is sold at a loss or if you do not qualify for the primary residence exclusion (e.g., if you didn’t meet the ownership and use test). Additionally, selling a home to a related party under certain circumstances may limit your ability to use the installment method.
Is It Right for You?
An installment sale of your primary residence can be a valuable strategy to manage your tax liability, especially if the gain exceeds the exclusion amount. However, the rules can be complex, and it’s crucial to work with a tax advisor to ensure you fully comply with IRS requirements and maximize your financial benefits.
Are There Drawbacks to Installment Sales?
While installment sales offer numerous advantages, there are some downsides:
- If tax rates rise, future payments might face higher taxes.
- Calculations and reporting require careful management, including filing IRS Form 6252 annually.
- If the buyer defaults, recovering property or missed payments are not guaranteed.
Talk To a Licensed Tax Advisor
For real estate investors or anyone selling property, an installment sale could be a powerful strategy. But as with any tax strategy, there are nuances. Consulting with an experienced tax advisor ensures you maximize the benefits while staying compliant.
At Boxelder Consulting, we’re here to help you navigate installment sales and other tax strategies to grow and protect your wealth. Contact us today to get started!
