When you sell an asset on installment, you may be able to avoid paying tax in the year of sale and instead pay tax on your gain as you receive payments over future years. Under the tax law, an installment sale is any sale of property where at least one payment is received after the tax year in which the sale occurs.
Each payment is allocated between a tax-free return-of-cost, taxable gain, and interest. The allocation between return-of-cost and gain is based on a gross profit percentage calculated as the gain divided by the contract price multiplied by the principal payments. Interest accrues normally on the unpaid balance.
Example 1: John owns investment real estate worth $300,000. He purchased the land for $120,000. John has no debt on the property. In December 2012, he enters into a land contract to sell the property for $30,000 down and $270,000 paid over three years beginning January 2013.
To determine how much of each payment is taxable, John must first calculate his gross profit percentage by dividing his gain on the property by the contract price. John therefore divides his gain of $180,000 by the sales price of $300,000 for a gross profit percentage of 60%.
60% of each payment represents gain. In 2012, John recognizes $18,000 ($30,000 down payment multiplied by 60% gross profit). From 2013 to 2015, John will report the remaining 162,000 of gain as principal payments are received. John will also report any interest income as additional income.
Example 2: Same facts as above except John has a $100,000 mortgage on the property. The buyer assumes the mortgage and pays John $200,000. John will receive $30,000 in 2012 and the remaining $170,000 over the next three years. The tax law does not require John to recognize on the $100,000 mortgage assumption immediately. Instead, the mortgage assumption is taxed as payments are received. This is accomplished by a downward adjustment to the contract price.
Here, the contract price of $300,000 is reduced by the $100,000 assumption to $200,000. The gross profit percentage is calculated as the gain of $180,000 divided by the contract price of $200,000. Notice how the gross profit percentage is increased to 90%. John will recognize $27,000 of gain in 2012 ($30,000 down payment multiplied by 90%) and $153,000 gain over the next three years for a total gain of $180,000.
Traps to Watch Out For
Depreciation recapture: When property is sold at a gain, the gain will usually be taxed at capital gain rates. However, when depreciable property is sold at a gain, part of that gain will be recharacterized as ordinary income (and taxed at higher rates) to the extent of prior depreciation. Any depreciation recapture income must be included in income in the year of sale (i.e., it cannot be deferred into future years as payments are received).
Section 1250 gain: Section 1250 gain applies to certain depreciation recapture on real estate. It is taxed at a 25% capital gain rate. If the installment sale gain includes both 25% and 15% capital gain, all 25% capital gain is recognized before any 15% capital gain is recognized.
Sales of property between a taxpayer and a business she controls do NOT qualify for installment sale treatment if the property is depreciable by the purchaser: The IRS is concerned that the seller recognizes capital gain over a number of years, but the business he controls takes an immediate depreciation deduction for the cost of the property.
Deferred gain on installment sales between related parties must be recognized immediately if the property is resold within 2 years of the sale between related parties:
Example: John sells property to his son on installment for $100,000 payable $10,000 per year for ten years. John’s son immediately sells the property for his $100,000 cost. John’s son recognizes no gain because he sold the property for its cost. If this disallowance rule did not apply, John would still defer the gain over ten years even though his family as a whole received $100,000 for the property immediately.
Gain will not be accelerated under the 2 year rule if:
- The second disposition is the result of an involuntary conversion (e.g., condemnation of the property) and the sale to the related party occurred prior to the threat of conversion
- The second disposition occurs after the earlier of the death of (1) the related buyer or (2) related seller
- There was no tax avoidance motive in the second disposition. An example is where the terms of the second sale are equal to or longer than the term of the first sale. Here, there is no immediate cash receipt as there was in the above example
When the total balance of certain installment receivables exceed $5 million, the IRS requires interest to be paid on deferred gains.
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230