Selling a rental property for a big profit can be a dream come true. After all, who wouldn’t want to earn a pretty penny from their investment property? However, to maximize profit from such a sale, you may want to defer your earnings as a lump sum. Read on to find out why, and to learn about another option: an installment sale.
The central theses
- The IRS allows taxpayers to defer a portion of the gain from the sale of an investment property with an installment sale arrangement, thereby avoiding a large tax bill.
- Income from installment sales can be broken down into profit, capital (or your adjusted basis in the property) and interest. Each of these categories is treated differently on Form 1040.
- The gross profit percentage is then used to calculate the installment sales income for a given tax year.
- If the buyer assumes a mortgage or other promissory note on the property, the cost basis of the property must be reduced by the amount of the mortgage/promissory note.
Big payout = Big tax bill
Let’s look at a common situation:
Hal Bookman looked at the buyer’s listing for his rental home and couldn’t believe the number he was seeing. His property value had increased significantly in just five years. However, when Hal happily told his tax advisor about the sale, the advisor was less excited; It would not be in Hals’ best interest from a tax perspective to flatten the income.
If Hal declares all proceeds of the sale in the same year that he sells the property, he will pay 25% on the Profit equal to any depreciation deductions he has previously taken over the rental property. Additionally, any gain in excess of depreciation recovery is taxed at 15% (for taxpayers with taxable income between $80,000 and $441,450 if single or $496,600 if married together) or 25% (for taxpayers above these thresholds).,Hal asks his accountant if there’s anything he can do to reduce his taxable income for the year.
The consultant knows exactly the right tool: an installment purchase contract.
The purpose of the installment sale
Installment sales are defined as sales of real estate where at least one payment is made after the tax year of the sale. As detailed in “Publication 537”, that Internal Revenue Service (IRS) allows taxpayers to defer a portion of the gain from the sale of an investment property with an installment sale agreement. This arrangement allows Seller to explain a proportionate part of theirs capital gain over several years. However, a seller is not allowed to use the installment selling method when reporting a loss. In addition, the seller can disable the installment selling method when reporting a profit.
This is how the installment selling method works
Declaring profits from an installment sale is theoretically easy. The taxation of installment sales corresponds to that of pensions, with a prorated portion of each payment being considered a return of principal. The only condition is that the property for sale must not be publicly traded safety or part of a company’s regular inventory, and the taxpayer can not be dealer of the property sold (with the exception of certain timeshare dealers who elect to charge special interest under the installment sales method).,,
From the story above, let’s see how Hal might structure his installment sale if he wanted to defer his capital gains taxes to a future year. Hal receives an offer of $400,000 for his rental home. He bought the property for $300,000. He’s made $100,000 over the years depreciation deductions, make his customized base $200,000. Therefore, Hal must declare $200,000 ($400,000 – $200,000) in taxable profit.
Hal’s advisor recommends splitting his sale proceeds into eight annual installments of $50,000 each rather than declaring $400,000 in one year. As long as the rates are constructively maintained each year, this method allows Hal to book the gains, and therefore a pro rata portion of the gains, over the eight years.
Installment Sales Revenue Reporting
Income from installment sales can be broken down into three distinct categories: to win, rector (or your customized base in property) and interest. Each of these categories is treated differently Form 1040. The gross profit percentage is then used to calculate the installment sales income for a given tax year.
In the example above, Hal must declare profit each year as either long-term or long-term in the short term, depending on whether the gain in the year of disposal was long-term or short-term. Long-term gains, on the other hand, are taxed at a lower rate short-term gains are taxed as ordinary income.,Since Hal kept the house for five years, the gain in this case would be long-term.
If the gain had been short-term, Hal could still be taxed on the installment income at a lower rate than he would have had to declare the capital gain. This is because short-term gains are taxed as ordinary income at the top of the taxpayer marginal tax rate.,If the proportionate profit does not push him into the next tax bracket, this rate can be lower. Profit from an installment sale is reported to the IRS Form 6252 and then carried to Planned on Form 1040.
Taxpayers with income from installment sales must also report the interest charged to the purchaser, which is taxed at normal income rates. The interest granted in the contract of sale is referred to as reported interest. If the reported interest is insufficient (or zero), a portion of the principal amount of the sale must be recharacterized as “unreported interest.” ,,
A portion of each installment sale is considered a tax-free return of principal by the IRS. This amount can be found by completing Worksheet A in Publication 537. The principal amount (adjusted basis) for installment sale purposes is the sum of your actual adjusted basis in the property plus any selling expenses and amortization refunded.
In this example, Hal has $200,000 in his house as an adjusted base. He needs to add $100,000 for his depreciation chargeback and $10,000 for selling expenses to calculate his adjusted base for installment sales purposes. That number is $310,000.
Percentage of Gross Profit
To calculate the gross profit percentage, you must subtract the adjusted base for installment sales purposes—$310,000 in this example—from the sales price to calculate the total profit. Here the total win is $90,000 ($400,000 – $310,000). Next, divide the total profit by the selling price, which in this case is 22.5% ($90,000 / $400,000) and you have the gross profit percentage. Finally, to calculate the taxable profit each year, multiply that percentage by the amount of the rate. Thus, Hal’s taxable income is assumed to be $11,250 ($50,000 x 22.5%) each year.
There are many rules and regulations regarding installment sales that need to be followed carefully.
Mortgages and contract price
If the buyer of the property assumes that a mortgage or something else promissory note Upon purchase, the cost basis of the property must be reduced by the amount of the mortgage/debenture. For example, if the rental property that Hal sold for $400,000 has a $100,000 mortgage, the contract price is reduced to $300,000 ($400,000 – $100,000).
If the amount of the mortgage exceeds the total adjusted floor area of the property, the difference must be reported as a payment in the first year and the contract price will be increased by that amount. For example, suppose Hal’s property is mortgaged for $250,000. In this case, Hal must report an overpayment of $50,000 in addition to the first-year installment.
The final result
There are many rules and regulations regarding installment sales that need to be followed carefully. For more information on sub-topics such as changing the selling price, the different forms of payment collection, and when it might be better to forego an installment arrangement and instead take a lump sum payment, see the IRS website. As always, consult your tax advisor to discuss your specific tax situation.