Do you own real estate that will produce a big capital gain when you sell it? Fortunately, you may be able to realize significant tax benefits by negotiating an installment sale of the property. However, there are several potential tax traps to avoid.
How do you qualify for installment sale reporting? It's relatively easy. All you have to do is arrange to receive payments over at least two tax years. For example, say you contract to sell real estate in December of this year and receive the first payment that month. Then the buyer makes a second payment in January of the next year. Result: You meet the two-year requirement, so you're eligible for installment sale treatment.
Generally, installment sale treatment is automatic for real estate transactions (assuming payment is received in two or more years), so you don't have to make any special tax return choices (see below). But you don't qualify for this tax break if you're classified — for tax purposes — as a "real estate dealer." A real estate dealer is someone who regularly buys and sells real estate in the ordinary course of business.
Although you'll still owe tax under the installment sale method, you're in line for three key tax breaks.
1. Capital gain tax rates. With an installment sale of real estate, any gain is treated as favorably-taxed long-term gain if you've owned the property for longer than one year. Currently, the federal income tax rate for long-term capital gains is 15% for most individuals. The maximum 20% rate on long-term gains applies to high-income individuals. In contrast, the top tax rate on ordinary income is 37%. Note that the maximum federal rate on real estate gains attributable to depreciation is 25% instead of the standard 20% maximum rate.
2. Tax deferral. Instead of paying tax on the entire gain in the year of the sale, only a portion of your gain is subject to tax. The remainder is taxed in the years in which payments are actually received. How do you figure it out? The taxable portion of each payment is based on the "gross profit ratio" determined by dividing the gross profit from the real estate sale by the net sale price.
Suppose you acquired a warehouse several years ago for $1 million. You arrange to sell the warehouse in 2019 for $2 million and have the buyer pay four annual installments of $500,000 each, beginning this year. Because your gross profit is $1 million ($2 million minus $1 million), the taxable percentage of each installment received is 50% ($1 million divided by $2 million).
When you report the sale on your tax return for this year, you're taxed on only $250,000 of the gain (50% of $500,000). Then you pay tax on $250,000 of gain in each of the next three years.
3. Potentially lower tax bill. Since the taxable gain from an installment sale is spread out over several years, you may benefit from tax rate differentials in those years. For simplicity, let's assume that you arrange a three-year installment sale where $100,000 of the gain is taxed at the 15% rate each year instead of the 20% maximum rate. Accordingly, you save $5,000 ($100,000 times 5% tax rate differential) each year, for a total tax savings of $15,000 ($5,000 times 3).
But you're not out of the woods just yet. The tax law contains several tax traps for the unwary when real estate is sold on the installment basis.
The definition of a "related party" may be more far-reaching than you think. It's not just your children, grandchildren, parents, etc. It also includes a corporation or partnership in which you have a controlling interest. Practical advice: Make sure the contract for any sale to a related party stipulates that the property can't be disposed of within two years.
Finally, we've said that installment sale reporting is usually automatic for property sales when sales proceeds are received in at least two different tax years, but you can "elect out" of installment sale treatment if it suits your purposes. For instance, you might prefer to pay the entire tax in the year of the sale if it's otherwise a low tax year for you, or you can offset the tax with suspended passive losses, or if you think tax rates might be higher in future years. Keep this option in your back pocket to be used only as needed at tax return time.
In summary, consider an installment sale of real estate as a way to nail down favorable tax results. You can rely on your tax advisor for guidance.
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