Article Highlights:
- Automatic Application of the Installment Method
- Electing Out of the Installment Method
- Depreciation Recapture
- Determining the Contract Price and Profit Percentage
- Pros and Cons of an Installment Sale
- Buyer Assumes Existing Mortgage
- Disposition of an Installment Note Before It's Paid Off
- Transfer Because of Death
- Business Installment Sales
When selling a rental property at a profit, taxpayers can stretch out their tax payment over the term of the sale profits by using the installment sales technique, which is a valuable tool. Although this approach has numerous advantages, it has complications and things to take into account, particularly when renting out houses. The installment sales technique has several subtleties that must be understood in order to fully appreciate and maximize its applicability to rental property transactions. These include its automatic application, the opting out option, depreciation recapture, and other important topics.
- Automatic Application of the Installment Method - When a rental property is sold at a profit and at least one payment is received after the year of sale, the installment sales technique is automatically applicable. Instead of realizing the whole gain in the year of sale, this strategy enables the seller to spread out the recognition of profits across the period that payments are received. In order to balance the tax obligation with the cash flow from the sale, the gain on the sale is reported proportionately as payments are received. In the event that the sale is a loss, the payment method is not applicable.
- Electing Out of the Installment Method - Although sellers have the option to opt out, the installment method takes effect automatically in the event that all selling revenues are not collected within the sale year. Without IRS approval, this option is irreversible and must be made before the tax return deadline for the year of the sale. Regardless of when the funds are received, choosing out entails realizing the whole gain in the year of sale. If the seller anticipates future increases in tax rates or has a lower income in a given year, this might be favorable.
- Depreciation Recapture - The recovery of depreciation is a crucial factor to be taken into account when selling a rental property. Regardless of the installment method, the part of the gain due to depreciation deductions taken during the rental term must be returned as ordinary income in the year of sale. Since this recapture cannot be deferred under the installment approach, it might have a substantial effect on the tax burden in the year of sale.
- Determining the Contract Price and Profit Percentage - In an installment sale, the buyer's anticipated mortgage is deducted from the seller's total consideration, which is the contract price. The gross profit (selling price minus adjusted basis) is then divided by the contract price to determine the gross profit percentage. This percentage is important because it establishes the amount of every payment that is deemed taxable gain.
Pros of an Installment Sale:
- Tax Deferral - The primary advantage is the deferral of taxes, allowing the seller to spread the tax liability over several years.
- Possibility of a Lower Tax Rate - Capital gains rates are based on a taxpayer's adjusted gross income, so the tax rate could be less for some years during the installment collection period than in the sale year.
- Cash Flow Management - It provides a steady stream of income over time, which can be particularly beneficial for retirement planning or other long-term financial strategies.
- Potential Interest Income - Sellers can potentially earn interest on the deferred payments, increasing the overall return on the sale.
Cons of an Installment Sale:
- Interest Rate Risk - If the seller finances the sale at a fixed interest rate, there's a risk that interest rates will rise, and the seller will be locked into a lower rate.
- Possibility of a Higher Tax Rate - Capital gains rates vary based on a taxpayer's adjusted gross income, so the tax rate could be more during the installment collection period than in the sale year. In addition, Congress could increase the rates and/or lower the income point at which the capital gains rate applies.
- Buyer Default Risk - There's always a risk that the buyer may default on the installment payments, leaving the seller to deal with foreclosure or renegotiation.
- Depreciation Recapture - The requirement to recapture depreciation in the year of sale can result in a significant upfront tax liability.
- Taxation of the Down Payment - The down payment received in the year of sale is part of the total payments and is subject to the same gross profit percentage calculation as other payments. This means a portion of the down payment will be recognized as gain in the year of sale.
- Buyer Assumes Existing Mortgage - If the buyer assumes the existing mortgage on the rental property, the amount of the mortgage assumed is subtracted from the selling price to determine the contract price. This can reduce the seller's immediate tax liability but also decreases the overall contract price, affecting the gross profit percentage.
- Disposition of an Installment Note Before It's Paid Off - Selling or otherwise disposing of the installment note before it's fully paid off triggers immediate recognition of all remaining gain, potentially resulting in a significant tax liability in the year of disposition. This requires careful planning to manage the tax impact.
- Transfer Because of Death - Whoever receives the installment obligation as a result of the seller's death is taxed on the installment payments the same as the seller would have been had the seller lived to receive the payments. An installment note does not receive a step up in value based upon the seller's death.
On the other hand, an installment obligation is deemed to be disposed of if it is canceled, loses its enforceability, or is passed to the buyer as a result of the obligation's holder's passing. The estate in this case has to calculate its gain or loss on the disposition. The fair market value of the installment obligation is regarded as being no less than its full face value in the event that the holder and the buyer are related.
- Business Installment Sales- Installment sales can also be used when a business is sold. Essentially, the same rules apply, but complexity arises when the sales price is composed of different assets, for example business equipment, real property, and goodwill.
The installment sales method offers a flexible and tax-efficient strategy for selling rental properties, allowing sellers to spread their tax liability over the period payments are received. However, it requires careful consideration of various factors, including depreciation recapture, the calculation of the contract price and gross profit percentage, and the potential risks and benefits. Proper planning can help maximize the advantages of the installment sales method while minimizing its drawbacks.
