Sell Now, Pay Later: Capital Gains Tax Deferral via Installment Sale Agreements

Real Estate, Tax

With the current real estate market heavily favored towards sellers, property owners are looking to cash in on the appreciated value of their real estate holdings. However, that lucrative sale may come with a hefty tax bill from Uncle Sam. 

Fortunately, it is possible to defer a portion of the gain if the transaction is structured as an installment sale. Though it may seem like a no-brainer, it is important to understand all the key factors involved before agreeing to an installment sale transaction.

Background

Generally, when real property is sold through traditional financing, the seller will pay tax on the entire gain. However, if a seller finances the sale (i.e. the buy makes mortgage payments to the seller instead of a bank), some of the capital gain can be deferred to the future.

When a real estate sale transaction is structured as an installment sale, a portion of the cash to be received by the seller is deferred. Likewise, most if not all of the pending gain from the sale is also deferred under Internal Revenue Code (IRC) Section 453. 

Conceptually, income would be recognized on the portion of cash received that is attributable to the gain from the sale of the property. This percentage is calculated at the time of sale by dividing the gross profit (total sales price minus the cost basis) by the total sales price. This percentage is applied each year to the cash received to determine the portion of the deferred gain to be recognized.

For example, if a property is sold during 2022 for a total sales price of $500,000 that has a cost basis of $100,000, a $400,000 gain would be recognized. However, if the sale is structured as an installment sale, with $50,000 in principal to be paid over the next 10 years, $40,000 would be recognized in income each year for 10 years ($400,000 / $500,000 x $50,000).

As with most decisions surrounding tax strategies, an installment sale agreement is not a “one size fits all” solution, even with the prospect of deferring taxes to a future year. Below are a few factors to consider before agreeing to an installment sale on the sale of real property.

Depreciation Recapture

If depreciation expense was taken on property that is sold, then the amount of the gain on sale may be split between ordinary and capital. Any portion of the total gain that is attributable to depreciation recapture must be recognized in the year of sale. 

Certain improvement property that benefits from accelerated depreciation deductions can trigger recaptured ordinary income up to the amounts previously deducted as depreciation. Therefore, sellers should plan to pay tax in the year of sale on any depreciation recapture even if most of the capital gains will be deferred to future years.

Capital Gains Tax Rates

The capital gains tax rate may vary based on the seller’s overall taxable income. Currently, there are three capital gains tax rates – 0%, 15%, and 20%. Certain investors may also be subject to the 3.8% net investment income tax unless the taxpayer is classified as a real estate professional. 

Recognizing the entire gain in the year of sale may push the seller into a higher capital gains tax bracket when compared to spreading out the impact to taxable income over several years.

Uncertainty with Future Tax Legislation

Uncertainty in the tax law when it comes to future increases to the capital gains rates may be a reason to recognize the entire gain in the year of sale. Also, if a taxpayer anticipates being in a higher tax bracket in future years, recognizing gains in the year of sale while at a lower rate could be more advantageous.

Tax on Interest Income

When the installment sale agreement is drawn up, an amortization table is also created, which lays out the payment terms for the buyer, including interest. The seller would recognize interest income annually, which is taxed at ordinary rates, serving as an additional factor that wouldn’t be present if the gain is recognized in full during the year of sale.

Additional Tax on Large Installment Sales

On the topic of interest income, for larger real estate sale transactions, the concepts found under IRC Section 453A may come into play. In general, Section 453A requires the calculation of interest income on transactions that exceed $150,000 in sales price and have a remaining installment balance of $5 million. This is in addition to the interest calculated on the agreement itself (mentioned above), as it is recalculated each year on the remaining deferred tax liability.

Creditor Risk

In an installment sale agreement, the seller essentially becomes a de facto creditor of the buyer. As such, it is possible for the buyer to default on the repayment terms of the agreement. While the seller would be able to take back the real property, there may be a gain to recognize upon repossession. Furthermore, the calculation of the gain itself differs for real vs. personal property as personal property receives a step-up in basis to its fair market value at the time it is repossessed.

Election to Opt Out of Installment Sale Treatment

Given the factors listed above, it is important to note that a seller can elect out of installment sale tax treatment even if the terms of the transaction call for cash payments over time. Therefore, should the seller anticipate an unfavorable tax position by delaying the recognition of gain, the taxpayer is well within his or her right to pay the tax up front while receiving cash per the terms of the agreement.

Tax Reporting Requirements of an Installment Sale

Should a real estate transaction result in installment sale treatment, the resulting gain will be reported on Form 6252. This form also calculates the gross profit percentage in the initial year of sale. That percentage is then multiplied by the principal portion of cash received in future years to determine the amount of deferred gain to be recognized annually. Any interest income is separately reported, either on Schedule B of Form 1040 or via Schedule K-1 if the transaction took place via a passthrough entity.

Author: Andrew Murray, CPA, Real Estate Services Group Team Member | [email protected]

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The installment sale rules found in Section 453 can be difficult to wade through. Reach out to a member of Withum’s Real Estate Team to help determine if an installment sale agreement is right for a particular situation.