If you use an installment sale to help sell a property, you can benefit from a tax deferral and potentially lower your overall tax bill. But you have to watch out for some tax traps if you do.
Installment sale definition
Typically, you create an installment sale when you receive payments for a property sold in the tax year of the sale and at least one other tax year. For example, if you sell real estate at a profit in 2021 and receive payments from 2021 to 2026, your real estate transaction is an installment sale.
An installment sale creates a tax event each year you receive payments. In the example above, part of your gain is taxable in 2021 and each year until 2026.
Note that property held for more than one year is eligible for favorable capital gains tax treatment. The current tax rate on long-term capital gains is 0-20%, compared to 37% for the top bracket of ordinary income tax.
You also have the option of paying any tax due on the sale up front, to avoid paying tax on installments in future years. In some cases, this will lower your overall tax bill, although it may require tax planning assistance.
Benefits of an installment sale
With an installment sale, you may be able to reduce your total tax on the sale of the property by spreading that income over several years. In addition, the buyer will often pay you a higher interest rate than a standard bank loan for the remainder of the amount owed.
The tax traps of installment sales
Warning of related parties. If you sell a property to a related party and the property is then transferred within two years, in most cases all remaining taxes are due immediately. The definition of tax law related parties is bigger than you might think. He understands:
- Small children
- A partnership or a company in which you have a controlling interest
- An estate or trust to which you are related
To avoid this major tax surprise, consider stipulating in the contract that the property cannot be transferred within two years.
Depreciation recovery potential. Also be careful if you have taken any depreciation on the property in previous years. In certain circumstances, you will have to pay additional tax related to this depreciation when you sell the property.
Gains not losses. Be aware that the installment sale processing is only available for gains, not losses. Other special rules may apply, so contact us if you need advice specific to your situation.
Of course, the tax discussions currently in Congress could have an impact on how installment sales and long-term capital gains will be taxed in the future. If you are planning an installment sale, consider requesting a consultation to discuss the tax implications.
– By Nancy J. Ekrem, CPA
PC of the DME CPA group
Certified Accountants and Business Consultants