If you use an installment sale to help sell real estate, you can benefit from tax deferral and possibly lower your overall tax bill. But you need to watch out for certain tax traps if you do.
Generally, you create an installment sale when you receive payments for sold property in the tax year of the sale and at least one other tax year. For instance, if you sell real estate for a profit in 2017 and receive payments in 2017 through 2021, your real estate transaction is an installment sale.
An installment sale creates a tax event in each year you receive payments. In the above example, part of your gain is taxable in 2017 and each year through 2021.
Note that real estate held longer than one year qualifies for favorable capital gains tax treatment. The tax rate on long-term capital gains is from 0 to 20 percent, compared with the top ordinary income tax bracket of 39.6 percent.
You also have the ability to pay all the tax due on the sale upfront, to avoid paying tax on the installments in future years. In some cases you'll reduce your overall tax bill this way, though it may require some help with tax planning.
With an installment sale, you may be able to lower your total tax on the sale of the property by spreading this income out over several years. In addition, the buyer will typically pay a rate of interest to you higher than a typical bank loan for the remainder of the amount due.
Related parties caution. If you sell property to a related party and the property is then disposed of within two years, in most cases all the remaining tax comes due immediately. The tax law definition of “related parties” is more expansive than you might think. It includes:
To avoid this major tax surprise, consider stipulating in the contract that the property can’t be disposed of within two years.
Depreciation recapture potential. Also be cautious if you took any depreciation on the property in prior years. In some circumstances you will owe extra tax related to that depreciation when you sell the property.
Gains not losses. Be aware that installment sale treatment is only available for gains, not losses. Other special rules may apply, so reach out if you need advice specific to your situation.
Of course, tax reform discussions now in Congress might impact how installment sales and long-term capital gains are treated. If you're planning an installment sale, consider reaching out for a consultation to discuss the tax implications.
As always, feel free to pass this Tip along to friends, and reach out if you need help with your personal tax and finance situation.
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