Selling a rental property for a huge profit can be a dream come true. After all, who wouldn't want to make a pretty penny off their investment real estate? Still, to maximize the profit from such a sale, you may want to defer taking your earnings as a lump sum. Read on to find out why, and to learn about another option: an installment sale.
- The IRS allows taxpayers to defer a portion of the gain on the sale of an investment property with an installment sale agreement, thereby avoiding a big tax bill.
- Installment sale income can be broken down into gain, principal (or, your adjusted basis in the property), and interest. Each of these categories is treated differently on Form 1040.
- The gross profit percentage is then used to figure installment sale income for a given tax year.
- If the buyer assumes a mortgage or other promissory note on the property, the cost basis of the property must be reduced by the amount of the mortgage/note.
Big Payout = Big Tax Bill
Let's take a look at a common situation:
Hal Bookman looked at the buyer's offer for his rental home, and he couldn't believe the number he saw. His property value had increased substantially in only five years. However, when Hal gleefully told his tax advisor about the sale, the advisor was less excited; taking the income as 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 pay 25% on the portion of the gain that corresponds to any depreciation deductions he has previously taken on the rental property. Additionally, any gain beyond the depreciation recapture is taxed at 15% (for taxpayers with taxable income between $78,750 and $434,550 if single, or $488,850 if married filing jointly) or 25% (for taxpayers above those thresholds). 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
Installment sales are defined as a sale of property in which at least one payment is not made until after the tax year of the sale. As detailed in "Publication 537," the Internal Revenue Service (IRS) allows taxpayers to defer a portion of the gain on the sale of an investment property with an installment sale agreement. This arrangement permits sellers to declare a prorated portion of their capital gains over several years. However, a seller is not allowed to use the installment sale method when reporting a loss. Additionally, the seller is also able to opt out of the installment sale method when reporting a gain.
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 or a part of a firm's regular inventory, and the taxpayer cannot be a dealer of the sold property (with the exception of certain time share dealers who elect for a special interest charge under the installment sale method).
Let's see how Hal, from the story above, could structure his installment sale if he wanted to defer his capital gain taxes to a future year. Hal receives an offer of $400,000 for his rental home. He bought the property for $300,000. Over the years, he has taken $100,000 in depreciation deductions, making his adjusted basis $200,000. Therefore, Hal has $200,000 ($400,000 – $200,000) of taxable 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 record the profits, and therefore a prorated portion of the gains, over the eight years.
Reporting Installment Sale Income
Installment sale income can be broken down into three separate categories: gain, principal (or, your adjusted basis in the property), and interest. Each of these categories is treated differently on Form 1040. The gross profit percentage is then used to figure installment sale income for a given tax year.
In the above example, Hal must declare the gain each year as being either long term or short term, depending on whether the gain was long- or short-term as of 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, would be long-term.
If the gain had been short-term, Hal still may be taxed on the installment income at a lower rate than he would have 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. If the prorated gain does not push him into the next tax bracket, this rate has the potential to be lower. The gain from an installment sale is reported on IRS Form 6252 and then carried to Schedule D on Form 1040.
Taxpayers with installment-sale income must also report interest charged to the buyer, which is taxed at ordinary income rates. Interest provided in the sales contract is referred to as stated interest. If stated interest is insufficient (or zero), part of the principal portion of the sale must be recharacterized as "unstated 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 filling out Worksheet A on Publication 537. The principal (adjusted basis) for installment sale purposes is the total of your actual adjusted basis in the property plus any selling expenses and depreciation recapture.
In this example, Hal has $200,000 as an adjusted basis in his home. He must add back $100,000 for his depreciation recapture and $10,000 for selling expenses in order to calculate his adjusted basis for installment sale purposes. This figure is $310,000.
Gross profit percentage
To calculate the gross profit percentage, you must subtract the adjusted basis for installment sale purposes—$310,000, in this example—from the sale price in order to calculate the total gain. Here the total gain is $90,000 ($400,000 – $310,000). Next divide the total gain by the sale price, which in this case is 22.5% ($90,000 / $400,000), and you have the gross profit percentage. Finally, to calculate the taxable gain each year, multiply this percentage by the amount of the installment. Thus, Hal's taxable gain each year is considered to be $11,250 ($50,000 x 22.5%).
There are many rules and regulations pertaining to installment sales, and they must be followed carefully.
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. If, for example, the rental property that Hal sold for $400,000 has a mortgage of $100,000, the contract price is reduced to $300,000 ($400,000 – $100,000).
If the amount of the mortgage exceeds the total adjusted basis of the property, the difference must be reported as a payment in the first year and the contract price is increased by that amount. Let's assume, for instance, that Hal's property has a mortgage of $250,000. In this case, in addition to the installment payment, Hal will have to report an excess payment of $50,000 during the first year.
The Bottom Line
There are many rules and regulations pertaining to installment sales, and they must be followed carefully. 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. As always, be sure to consult your tax advisor to discuss your specific tax situation.