Maximizing Tax Benefits of Installment Sales

Special tax rules apply to real estate gains

If you are trying to sell appreciated commercial real estate in today’s market, you may have to compromise. For instance, if you refuse to budge on price, you might have to make other reasonable concessions, such as agreeing to an installment sale for a buyer with limited liquidity. As the name implies, the buyer pays you in a series of installments instead of providing all the cash up front.

This could actually be beneficial from a tax perspective if payments are made over two years or more. In that case, not only do you defer some of the tax due on the appreciation in value, but you may reduce your tax liability.

Background: With an installment sale of real estate, you generally are in line for preferential tax treatment. First, the gain is generally taxed as a long-term gain (i.e., you have owned the property for longer than one year), resulting in a maximum capital gain rate of 15%, or 20% if you are in the top ordinary income tax bracket. Even if you are also liable for the 3.8% Medicare surtax on net investment income, the maximum combined tax rate at the federal level is limited to 23.8%.

Second, only a portion of your gain is taxable in the year of the sale. The remainder is taxable in the years in which payments are received. By spreading out the tax over several years, you might pay less tax overall because more of the capital gain may be taxed at the 15% rate.

The taxable portion of each payment is based on the “gross profit ratio.” Gross profit ratio is determined by dividing the gross profit from the real estate sale by the price.

Example: Suppose you acquired commercial real estate 10 years ago that has an adjusted basis of $600,000. You agree to sell the property in 2015 for $1.5 million in three annual installments of $500,000 each. Because your gross profit is $900,000 ($1.5 million – $600,000), the taxable percentage of each installment received is 60% ($900,000 ÷ $1.5 million). When you report the sale on your 2015 tax return, you have to pay tax on only $300,000 of gain (60% of $500,000).

Any depreciation claimed on the property must be recaptured as ordinary income to the extent that it exceeds the amount allowed under the straight-line method. The adjusted basis of the property is increased by the amount of recaptured income, thus decreasing the gain realized in future years.

But watch out for a little-known tax trap. If the sale price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid on the deferred tax to the extent that your outstanding installment obligations exceed the $5 million mark.

Finally, if it suits your purposes, you can elect to forgo installment sale treatment when you file your 2015 tax return. This could be advantageous if 2015 is an unusually low-income year for you. Consult your tax advisers before arranging an installment sale of real estate or making any tax return decisions.

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