Understanding Tax Terms: Installment Sales

July 23, 2021

If you  use an installment sale to help sell property, you can benefit from tax  deferral and possibly lower your overall tax bill. But you need to watch out  for certain tax traps if you do.

Installment Sale Defined

Generally,  you create an installment sale when you receive payments for sold property in  the tax year of the sale and at least one other tax year. For instance, if  you sell real estate for a profit in 2021 and receive payments in 2021  through 2026, your real estate transaction is an installment sale.

Tax Implications

An  installment sale creates a tax event in each year you receive payments. In  the above example, part of your gain is taxable in 2021 and each year through  2026.

Note  that property held longer than one year qualifies for favorable capital gains  tax treatment. The current tax rate on long-term capital gains is from 0 to  20 percent, compared with the top ordinary income tax bracket of 37 percent.

You  also have the ability to pay all the tax due on the sale up-front, to avoid  paying tax on the installments in future years. In some cases you'll reduce  your overall tax bill this way, though it may require some help with tax  planning.

Benefits of an Installment Sale

With an  installment sale, you may be able to lower your total tax on the sale of the  property by spreading this income out over several years. In addition, the  buyer will often pay a rate of interest to you higher than a typical bank  loan for the remainder of the amount due.

Installment Sale Tax Traps

Related parties caution. If you sell property to a related party and the property is  then disposed of within two years, in most cases all the remaining tax comes  due immediately. The tax law definition of related parties is more  expansive than you might think. It includes:

  • Spouses
  • Children
  • Grandchildren
  • Siblings
  • Parents
  • A partnership or corporation in which you have a controlling interest
  • An estate or trust you’re connected to

To  avoid this major tax surprise, consider stipulating in the contract that the  property can’t be disposed of within two years.

Depreciation recapture potential. Also be cautious if you took any  depreciation on the property in prior years. In some circumstances you will  owe extra tax related to that depreciation when you sell the property.

Gains not losses. Be aware that installment sale treatment is only available for  gains, not losses. Other special rules may apply, so reach out if you need  advice specific to your situation.

Of  course, tax discussions now in Congress might impact how installment sales  and long-term capital gains are taxed in the future. If you're planning an  installment sale, consider reaching out for a consultation to discuss the tax  implications.

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