An installment sale can be a prudent tax strategy for someone who is selling property or an asset. In an installment sale, the seller receives at least one payment after the tax year in which the sale happened. Rather than receiving the total contract price for the asset at one time, like in a traditional sale, the seller spreads the payment for the property over time using a specific installment sale contract like a note, mortgage, or some other form of contract that specifies the terms of repayment.
Under the federal tax rules, the seller then would recognize gain from the installment sale over the tax years when he or she receives the payments, instead of recognizing all of the gain in the year of sale. Some of the benefits of this strategy could be qualifying for a lower capital gains tax rate, paying tax at a lower ordinary tax rate and lowering your adjusted gross income. All of these benefits can produce significant tax savings over time. Conversely, if you were to recognize the entire gain and pay all the tax on the gain in the year of the sale, you could be thrown into a higher tax bracket, paying tax at a higher capital gains tax rate and have a higher adjusted gross income. Adjusted gross income is important because the higher it goes, important tax deductions and credits begin to partially phase-out or phase out completely. Specific tax rules apply to different types of installment sales. The seller does have the option to elect not to use the installment sales method.
The installment sales method cannot be used for some types of sales transactions. Transactions that do not qualify for an installment sale include sales by dealers who operate a trade or business in real estate, like those who ‘flip’ houses. Another example of a sale that would not qualify would be a sale of securities, stocks or bonds.
When a seller receives a payment under the installment sale, he or she receives funds that must be divided into three parts. The first part is allocated to the interest due under the note or interest that must be imputed; the second part is allocated to the return of the basis of the property and the third part is allocated to the gain on the sale. A taxpayer must report interest income under an installment sale as ordinary income. If the installment agreement does not have a stated interest rate, then the seller must impute an interest rate[1]. After a seller has determined what interest is due or imputed, he or she is able to determine the selling price. The gain reported in any given year under the installment method is equal to the total payments received during the year (other than interest) multiplied by the ‘gross profit percentage’[2] as calculated for the installment sale. It does not matter how the future payments are structured, whether done under a note, mortgage, or some other form of contract.
As with anything, there are risks involved. One risk is the reliance on the buyer performing according to the terms of the contract. You also have to weigh the possibility of capital gains and ordinary tax rates increasing in future years. As you would imagine, this has been a hot topic of late because of the change in the office of the President. However, all of those risks need to be weighed along with the many potential benefits. We are here to help you with that important decision.
[1] The IRS has criteria that must be followed in this regard that are beyond the scope of this article. Please contact us for any assistance you might need with this calculation.
[2] (The sale price less the property’s adjusted basis) /the contract price.
Article Submitted by Michael J. Reynolds, CPA, CEPA
