Real estate installment sales are a great way to purchase property, especially if you don’t have the cash available upfront. In an installment sale, you agree to buy a property over time, usually by making monthly payments. This can be a great option if you are not able to get a mortgage or if you want to take advantage of current market conditions.
If you own an investment property or a small business, sooner or later, you will probably want to sell it.
One of the downsides of selling a business or investment property is the huge tax bill at the end. Profits are likely subject to the capital gains tax—perhaps at a much higher rate than you expect.
When you sell your property using a seller-financed installment sale, you can delay paying taxes on the sale until a later year. This is usually a good idea because it gives you more time to pay the taxes.
And the installment sale could cut your tax bill if spreading out your profits over multiple years puts you in a lower tax bracket.
But as with most programs that can lower your taxes, your lawmakers and the IRS impose a number of limitations.
What Is an Installment Sale?
An installment sale is a sale of eligible property where you receive at least one payment after the close of the taxable year in which the sale occurs. If you make a profit on an installment sale, you report part of your profit when you receive each payment.
You document the buyer’s obligation to make future payments to you, with a deed of trust, note, land contract, mortgage, or other evidence of the buyer’s debt to you. You should also secure the debt.
Although you can’t use the installment method to report a loss, you can choose to report all of your gain in the year of sale.
Installment Sale Advantages
Installment sales have a number of benefits for both you as a seller and your buyer:
- You can finalize the sale without the buyer having to pay the entire amount of the transaction in one lump sum.
- You may finalize the sale agreement without waiting for the buyer to get approval from a third party.
- The buyer and seller can negotiate the terms of the transaction to suit their needs without having to obtain approval from a third-party lender.
- You can postpone paying taxes on your profit, and you might be able to pay a lower tax rate in the future.
- The buyer obtains full ownership of the property.
How Is an Installment Sale Reported?
Payments that you receive from an installment sale consist of three parts:
- Taxable part (gain or profit)
- Non-taxable part (return of basis)
Each year you receive a payment, you pay taxes on the interest and taxable part. The part of the payment allocated to your basis is not taxable. The basis is the amount of money you put down on a property for an installment sale.
Once you have decided how much of each payment to include as interest, the taxable portion of the remaining payment is calculated.
No Installment Sale in These Instances
There are certain types of property and transactions for which the installment method cannot be used, such as:
- Inventory that is composed of personal belongings. However, this regulation does not apply to farming property utilized or produced.
- The sale of real property held for sale in the ordinary course of a trade or business to consumers is known as “commercial resale.” However, if dealers of timeshares and residential lots choose to pay a special interest charge, they can treat certain sales as installment sales and report using the installment method.
- The trading of stock or securities that have been listed on a regular market. The sale of depreciable property to a related buyer, unless you can show to the satisfaction of the IRS that the sale was not made for tax avoidance.
Frequently Asked Questions about Installment Sales:
What is an example of an installment sale?
You sell the property at a contract price of $600,000, and your gross profit is $150,000. Your gross profit percentage is 25 percent ($150,000 ÷ $600,000). After subtracting interest, you report 25 percent of each payment, including the down payment, as installment sale income from the sale for the tax year in which you receive the payment. The remainder (balance) of each payment is the tax-free return of your adjusted basis.
Say your buyer makes a payment of $12,250, of which $2,250 is interest. Of the remaining $10,000, $2,500 (25 percent) is taxable profit and $7,500 is non-taxable return of basis.
What qualifies for installment sales?
For tax purposes, a purchase is required in installments and a minimum payment is required after the year the sale occurs. Generally, when you sell property in October but receive three payments per month during October, Nov – December, the amount will be excluded for installment sales reporting.
How does installment sale work?
Payment of installment payments happens if either party sells a business to the other party or makes at least one installment payment in a different tax year. In a payment sale, a business can be sold or bought and receive fewer payments each tax year.
Who would benefit from an installment sale?
A sale in installments allows a shopper to partly avoid taxes but improve cash flow. This is because you are restoring income to a desired tax rate by extending it over an extended period thus reducing capital gains from higher tax rates.
How to Know if the Installment Method is Right for Your Business?
If you are considering using the installment method to sell property, first make sure that your transaction is not one of the types listed above that are ineligible for this treatment. You should also speak with a tax strategist like Jose Ramirez who you can contact for any additional questions to ensure that using the installment method is right for your particular situation.