Avoiding a Big Tax Bill on Real Estate Gains

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Avoiding a Big Tax Bill on Real Estate Gains

Selling a rental property for a large profit might be a pipe dream. To maximize the profit from such a deal, however, taxes must be minimized.

One method is an installment sale. Don’t worry, the Internal Revenue Service (IRS) has cleared this.

Key Takeaways

  • The IRS permits taxpayers to delay a part of the gain on the sale of an investment property via an installment sale agreement, which may lower the seller’s profit taxes.
  • Gain, principle (or your adjusted basis in the property), and interest are all components of installment sale revenue. On Form 1040, each of these categories is addressed differently.
  • The gross profit percentage is then utilized to calculate installment sale income for the tax year in question.
  • If the buyer acquires a mortgage or other promissory note on the property, the cost basis must be decreased by the mortgage amount.

Big Payout Equals Big Tax Bill

Let’s take a look at a common situation:

Hal Bookman couldn’t believe the amount he saw on the buyer’s bid for his rental house. In barely five years, his home worth had climbed significantly. When Hal excitedly notified his tax adviser about the sale, the advice was cautious: Taking the revenue in one lump amount would not be in Hal’s best interest from a tax standpoint.

If Hal reports the whole selling proceeds in the same year that he sells the property, he will pay a 25% tax on the amount of the gain that corresponds to any depreciation deductions he previously took on the rental property.

For taxpayers with taxable income between $41,676 and $459,750 if single, or $83,351 and $517,200 if married filing jointly in 2022, any gain beyond the depreciation recapture is taxed at 15%. Taxpayers having income exceeding certain criteria in 2022 will be taxed at a rate of 20%.

Hal consults with his tax expert to see if there is anything he can do to lower his taxable income for the year.

The counselor is well-versed in the appropriate tool: an installment selling agreement.

What Is an Installment Sale?

In this context, an installment sale is defined as a property transaction in which at least one payment is not paid until after the tax year of the sale.

  After-Tax Real Rate of Return Definition

With an installment sale agreement, the Internal Revenue Service (IRS) permits taxpayers to postpone a part of the gain on the sale of an investment property. Sellers may declare a prorated share of their capital gains over a number of years under this arrangement.

When declaring a loss, a seller may not employ the installment sale technique.

How the Installment Sale Method Works

Theoretically, declaring profits on an installment sale is straightforward. Installment sales are taxed similarly to annuities, with a prorated amount of each payment deemed a return of principle.

The sole requirements are that the item being sold is neither a publicly traded securities or part of a firm’s normal inventory, and that the taxpayer is not a dealer of the sold property (with the exception of certain timeshare dealers who elect for a special interest charge under the installment sale method).

Example of an Installment Sale

Let’s look at how Hal may organize his installment sale in the previous scenario if he wished to delay his capital gains taxes to a later year.

Hal gets a $400,000 offer on his rental property. He paid $300,000 for the property. He has deducted $100,000 in depreciation over the years, bringing his adjusted basis to $200,000.

As a result, Hal must disclose $200,000 in taxable profits ($400,000 – $200,000).

Instead of reporting $400,000 in one year, Hal’s counsel advises him to divide the income into eight yearly payments of $50,000 each. As long as the payments are received constructively each year, Hal will be able to register the earnings, and hence a prorated share of the gains, over the eight years.

Reporting Installment Sale Income

Income from installment sales is divided into three categories: capital gain, interest, and principal. Form 1040 treats each of them independently.

The gross profit percentage is then utilized to calculate installment sale income for the tax year in question.

Capital Gain

In the above example, Hal must disclose the gain as long-term or short-term each year, depending on the year of sale. Short-term profits are taxed like regular income, but long-term gains are taxed at a reduced rate.

  Tax Lien Certificate Definition

Because Hal kept the residence for five years, the gain would be long-term in this situation.

If the gain had been short-term, Hal may have been taxed at a lower rate on the installment income than he would have been if he had had to disclose the lump-sum gain. This is due to the fact that short-term profits are taxed as regular income at the taxpayer’s highest marginal tax rate.

This rate may be lower if the prorated gain does not put him into the next tax bracket. Gains from installment sales are recorded on IRS Form 6252 and then carried to Schedule D on Form 1040.

Interest

Taxpayers who receive installment-sale revenue must additionally declare the buyer’s interest, which is taxed at regular income rates.

The interest given in the sales contract is known as stated interest. If stated interest is inadequate (or zero), a portion of the sale’s principle must be recharacterized as “unstated interest.”

Principal

The IRS considers a portion of each installment sale to be a tax-free return of principle. Worksheet A on Publication 537 may be used to calculate this amount.

For installment sale purposes, the principle (adjusted basis) is the sum of your actual adjusted basis in the property plus any selling charges and depreciation recapture.

In this scenario, Hal’s adjusted basis in his house is $200,000. In order to compute his adjusted basis for installment sale purposes, he must subtract $100,000 for depreciation recapture and $10,000 for selling expenditures. This sum is $310,000.

Gross Profit Percentage

In order to compute the gross profit %, deduct the adjusted basis for installment sale purposes—$310,000 in this example—from the selling price. The overall benefit in this scenario is $90,000 ($400,000 – $310,000).

The gross profit percentage is calculated by dividing the entire gain by the selling price, which in this example is 22.5% ($90,000 / $400,000).

Finally, multiply this percentage by the amount of the payment to compute the taxable gain each year. As a result, Hal’s taxable gain per year is $11,250 ($50,000 x 22.5%).

There are several laws and regulations governing installment sales, all of which must be strictly adhered to. When in doubt, consult a tax expert.

  Sales Tax Definition

Mortgages and Contract Price

If the buyer acquires a mortgage or other promissory note as part of the transaction, the cost basis of the property must be decreased by the amount of the mortgage or note. Returning to our example, suppose Hal had a $100,000 mortgage on the property he sold.

If Hal’s $400,000 rental property has a $100,000 mortgage, the contract price is decreased to $300,000 ($400,000 – $100,000).

If the mortgage amount exceeds the property’s entire adjusted basis, the difference must be recorded as a payment in the first year, and the contract price is raised by that amount.

For example, suppose Hal’s home had a mortgage of $250,000. In addition to the monthly payment, Hal must disclose a $50,000 excess payment ($250,000 – $200,000) during the first year.

What Constitutes an Installment Sale?

In a real estate investment property installment sale, the buyer pays payments to the seller over time rather than in one large amount.

More precisely, at least one payment must be paid after the tax year in which the transaction occurs, according to the IRS definition.

What Are the 3 Parts of an Installment Sale Payment?

The three parts of an installment sale include:

  • Interest Income: Declared or Unstated
  • Principal: the return of your adjusted basis in the property for the purposes of installment sales.
  • Gain on sale: the short- or long-term capital gain dependent on the period of ownership prior to the selling year.

What Tax Form Should I Use to Report Interest Income From an Installment Sale?

To report installment sale interest income, utilize Form 6252, Installment Sale Income.

Form 6252 information passes through to Schedule D, Capital Gains and Losses, which flows through to Form 1040.

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