Selling your home for a huge profit is nearly every homeowner's dream come true. Who wouldn't want to make a pretty penny off his or her home? But in order to really profit on your home's sale, you may want to defer taking your profit in lump sum. Read on to find out why, and to learn about another option: an installment sale.

Big Payout = Big Tax Bill
Let's take a look at a common homeowner situation:

Example - When a Gain on a Property Increases Tax Liability
Hal Bookman looked at the buyer\'s offer for his rental home and couldn\'t believe the number that was printed there. His property had doubled in value in only five years, and he hadn\'t considered it cheap even when he bought it. However, when Hal gleefully told his tax advisor about the sale, his advisor was less excited; taking the income in one lump sum would not be in Hal\'s best interest from a tax perspective.
If Hal declares the entire proceeds of the sale in the same year he sells the property, he will be ineligible for virtually all of the tax credits to which he would normally be entitled. His itemized deductions would also be reduced as a result of the additional income from the sale. Hal asks his tax advisor if there is anything he can do to reduce his taxable income for the year. The advisor knows just the tool to use: an installment sale agreement.

The Purpose of Installment Sales
According to Publication 537, the IRS allows taxpayers to defer gains on major sales of property or other investments with an installment sale agreement. This arrangement permits sellers to declare a prorated portion of their capital gains over several years, as long as the proper paperwork is completed during the year of the sale.

How the Installment Sale Method Works
Declaring gains under an installment sale is theoretically simple. The taxation of installment sales mirrors that of annuities, where a prorated portion of each payment is considered a return of principal. The only stipulations are that the property being sold cannot be a publicly traded security of any kind, and the taxpayer cannot be a dealer of the sold property in any sense.

Let's take a look at an example of this method, and see how Hal could structure his installment sale if he wanted to defer his income taxes to a future year.

Example - Deferring Taxes With an Installment Sale
Hal receives $400,000 for his rental home. He bought the property for $188,000 and paid $12,000 in selling expenses, which are added to the home\'s basis, making it $200,000. Therefore, Hal has $200,000 ($400,000 - $200,000) of reportable gain to declare. Hal\'s advisor recommends he break down his sale proceeds into eight annual installments of $50,000 each, instead of declaring $400,000 in one year. As long as the installments are constructively received each year, this method will allow Hal to remain eligible for tax credits and deductions that the lump-sum payment would prevent him from receiving.

Reporting Installment Sale Income
Installment sale income can be broken down into three separate categories: gain, principal and interest. Each of these categories is treated differently on Form 1040.

Capital Gain
In the above example, Hal must declare the gain each year as being either long or short term depending upon whether the gain was long or short term in the year of the sale. Long-term gains are taxed at a lower rate, while short-term gains are taxed as ordinary income. Because Hal held the house for five years, the gain in this case will be long-term. If the gain had been short-term, Hal still would be taxed on the installment income at a lower rate than he would if he had to declare the lump sum gain. This is because short-term gains are taxed as ordinary income at the taxpayer's top marginal tax rate. The gain from an installment sale is reported on IRS Form 6252 and then carried to the Schedule D on Form 1040.

Taxpayers with installment sale income must also charge interest to the buyer at a rate that is the lower of the applicable federal rate (or 9% compounded semiannually). The buyer will pay interest on the unpaid installments until the balance has been remanded. Therefore, if Hal charges the 9% rate on his sale to the buyer, he will also receive and report approximately an additional $4,500 of interest income for each $50,000 installment that has yet to be paid. The interest is reported separately as ordinary interest income on Schedule B. (Note: If the interest is not reported separately, then the IRS will consider part of the sale proceeds to be interest.)

Part of each installment sale is considered by the IRS to be a tax-free return of principal. This amount can be determined by calculating the exclusion ratio. Divide the amount of actual gain by the sale price, which in this case is $200,000/$400,000, providing an exclusion ratio of 50%. Simply multiply this ratio by the amount of the installment: This is the amount that is to be excluded from tax because it is designated as principal. Therefore, $25,000 ($50,000 x 50%) of principal is returned each year.

Mortgages and Contract Price
If the buyer of the property assumes a mortgage or some other promissory note with the purchase, the cost basis of the property must be reduced by the amount of the mortgage/note. For example, if the rental property that Hal sold for $400,000 has a mortgage of $100,000, then the contract price is reduced to $300,000 ($400,000-$100,000). This means that Hal will only have $100,000 of total gain to report in installments.

If the amount of the mortgage exceeds the total adjusted basis of the property, then the difference must be reported as a payment in the first year, and the contract price is increased by that amount. For example, if Hal's property has a mortgage of $250,000, the basis of the house will be $200,000 ($188,000 + $12,000). In this case, Hal will have to report an excess payment of $50,000 during the first year in addition to the installment payment. The contract price will also then be $250,000, leaving $150,000 for a taxable gain.

There are many rules and regulations pertaining to installment sales that must be followed carefully. However, those who understand the rules can retain their eligibility for many deductions and credits that must otherwise be forfeited. For more information on subtopics like changes in selling price, the different forms that payments received can take, and when it might be better to forgo an installment agreement and take a lump-sum payment instead visit the IRS website or consult your tax advisor.

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