Randy J. Elder, CPA, P.C.

Installment Sale – a Useful Tool to Minimize Taxes

With the tax season behind us, now is a perfect time to explore tax saving strategies for 2015. One strategy used effectively by many small business owners is the installment sale. If you are considering the sale of property this year but worried about the hit to your tax bill, you might want to take a closer look at using an installment sale.

Installment sale of real property

First some background on capital gains and taxes
Selling a property that you have owned for a period of time can result in a large capital gain. Reporting all of the capital gain in one year will generally result in a higher capital gains rate and potentially subject the gain to an additional 3.8% surtax. (You may remember that the 3.8% surtax on net investment income came about with the passage of the Affordable Care Act).

Capital Gains Rates. Long-term capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer’s regular tax bracket for the year. Here’s how the rates vary.

Regular Tax Bracket Capital Gains Rate
15% or less 0%
25% to 35% 15%
39.6% 20%

Surtax. Tax law treats capital gains (other than those derived from a trade or business) as investment income. Higher-income taxpayers are subject to the 3.8% surtax on net investment income. This means that a large gain, if taken all in the same year, can push a taxpayer’s income over the threshold for this tax. For individuals, the surtax is 3.8% of the lesser of (1) the taxpayer’s net investment income or (2) the excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount for his or her filing status. The threshold amounts are:
* $125,000 for married taxpayers filing separately.
* $200,000 for taxpayers filing as single or head of household.
* $250,000 for married taxpayers filing jointly or as a surviving spouse

This is where an installment sale can help to minimize taxes. If the gain is spread over several years taxpayers can potentially avoid getting bumped up into a higher tax bracket and reduce or eliminate the amount of gain subjected to the 3.8% surtax.

Here is how the installment sale works. If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what a bank charges. For a sale to qualify as an installment sale, at least one payment must be received after the year in which the sale occurs. Installment sales are most frequently used when the property that is sold is real estate, and cannot be used to report the sale of publicly traded stock or securities. It can get a bit complicated so I’ve provided an example below to further illustrate how this works.

Example: You own a lot for which you originally paid $20,000. You paid it off some time ago, leaving you with no outstanding mortgage on the lot. You sell the property for $320,000 with 20% down and carry a $260,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $12,000.

Computation of Gain

Sale price      $320,000
Cost               <$20,000>
Sales cost     <$12,000>
Net Profit     $288,000
Profit % = $288,000/$320,000 =90%

Of your $64,000 down payment, $12,000 went to pay the selling costs, leaving you with $52,000 cash. The 20% down payment is 90% taxable, making $57,600 ($64,000 x .90) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. In addition, the interest payments on the note are taxable and also subject to the investment surtax.

In this example by using the installment method the income for the year was reduced by $230,400 ($288,000 – $57,600). You can see how this reduction could help to reduce the taxpayer’s tax liability. Of course the actual tax savings will depend on the individual taxpayer’s other income and circumstances.

If the installment sale looks like a promising strategy for you, there are a few additional things to consider.

Existing mortgages – If the property you are considering selling is currently mortgaged, that mortgage would need to be paid off during the sale. You can pay the mortgage off in full or even investigate alternatives such as taking a secondary lending position or wrapping the existing loan into the new loan.

Tying up your funds – If the installment sale looks promising but tying up your funds into a mortgage doesn’t fit your long-term financial plans you can look at options with shorter terms. For example, you might establish a note due date that is amortized over 30 years but becomes due and payable in 5 years. Just be aware that a large lump sum payment at the end of the 5 years could cause the higher tax rate and surtax to apply in that year. Make sure you pay close attention to both the current and future tax consequences when structuring the installment agreement.

Early payoff of the note – There is always the chance that the buyer of your property pays off the installment note early or sells the property. In this case the tax related benefits of your installment plan would be negated. The balance of the taxable portion would be taxable in the year the note is paid off or the property is sold, unless the new buyer assumes the note.

Tax law changes – Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws change during the course of your installment agreement, the tax on the installment income could increase or decrease, but mostly likely increase.
The installment sale can be an effective tool but it may not be right for all taxpayers or circumstances. If you have questions about the use of the installment sale in your particular tax situation, please contact me.