Despite the real estate meltdown, you may own a piece of prime investment property that is still worth considerably more than when you acquired it, and if you sell it now, you may realize a sizeable profit. You could use the money to purchase other real estate, or you might reinvest the proceeds in stock market bargains. But your profit will be reduced by capital gains taxes.
One good way to ease that tax burden is to arrange an “installment sale” of the property. That way, rather than getting a lump-sum payment from the buyer, you agree to receive a series of installment payments, typically spanning a period of several years.
One benefit of an installment sale is that it may help you find a buyer. Being willing to strike this sort of deal when credit is tight helps potential buyers avoid taking a loan through conventional channels. But the larger advantage to you is in tax savings. Because you aren’t taxed on payments until they are received, you can spread out the resulting tax liability over the length of the agreement. Delaying some of the taxable gains could also help you avoid being bumped into a higher tax bracket.
To qualify for tax deferral on an installment sale, you must receive payments over a period of two or more years. The taxable portion of each payment is determined by calculating the “gross profit ratio”—the gross profit divided by the contract price. Multiplying your gain for the year by the gross profit ratio gives you the amount that will be treated as a taxable capital gain for that year. Currently, most taxpayers pay a maximum tax rate on long-term capital gains (for property held more than a year) of 15%, although some upper-income investors are taxed at a maximum 20% rate.
Suppose you bought a small apartment building several years ago for $500,000, and your adjusted cost basis for the building is $300,000. After finding a qualified buyer, you agree to sell the building for $750,000 in three annual installments of $250,000 each.
Your gross profit on the sale is $450,000—the $750,000 sale price minus your $300,000 basis. That gives you a gross profit ratio for each installment payment of 60%—$450,000 divided by $750,000. When you report the sale on your tax return for the year of the sale, you’re required to pay tax on only $150,000 of your gain. That’s 60% of the $250,000 payment. In each of the following two years, you’ll also report a long-term gain of $150,000.
There are some technical wrinkles here that you and your tax advisor will need to consider. Any depreciation you have claimed on the property must be recaptured as ordinary income in the year of the sale to the extent it exceeds the amount allowed under the straight-line method of depreciation. Also, the adjusted basis of the property is increased by the amount of recaptured income. That could decrease the gain you realize in future years.
There’s also a potential tax pitfall for certain installment-sale sellers. If the sales price of your real estate (other than farm property) exceeds $150,000, interest must be paid on the deferred tax to the extent that the outstanding installment obligations exceed $5 million. If you can stay below that $5 million threshold you’ll avoid this complication.
You don’t have to make a special election on your tax return to benefit from installment-sale treatment. The tax deferral is automatic. However, being entitled to this tax break doesn’t mean you have to take it. If it suits your purposes, you could still elect to pay tax on the entire gain in the year of the sale—even though you’ll be receiving payments over several years.
Why would you do that? There are several possibilities. Maybe you expect to have little or no other capital gain income this year but are expecting a windfall next year. Paying all of your tax on the sale this year could be preferable to deferring part of it until next year, when you’ll already face a steep tax bill. Similarly, you may have capital losses or other losses this year that are large enough to offset most or all of your gain on the property sale. In that situation, delaying some of your gain until later years could actually end up costing you more at tax time.
Of course, taxes aren’t the only consideration. With an installment sale, you’re assuming the risk that the buyer may fail to make future payments, and during this recession, that’s not a risk to take lightly. We can work with you, your tax advisor, and your attorney to help you decide whether an installment sale makes sense in your situation.
© 2020. All Rights Reserved.