Most property sellers think about selling real estate like this:
List Property -> Sell Property -> Receive Cash
There are times when receiving a lump sum of cash is beneficial. For instance – when the Seller will be purchasing another personal residence, paying off debts, or… taking a trip around the world.
However, in some instances, receiving a lump sum isn’t beneficial:
- The Seller could be responsible for significant capital gains taxes.
- Cash sitting idle in today’s low-interest-rate environment earns next to nothing.
- There’s always the temptation to spend money as it burns a hole in one’s bank account.
As note professionals and real estate investors, it’s essential to understand the above issues and understand how installment sales can be a solution.
What Is a Real Estate Installment Sale?
IRS Publication 537 defines an installment sale as:
“…a sale of property where you receive at least one payment after the tax year of the sale.”
When a Seller agrees with a Buyer to accept payments over time, AND the term extends into the next tax year, that’s an installment sale. Most of us also recognize this as a form of seller financing.
Real Estate Installment Sale Example
Steve is going to be selling a house he had been renting out for $500,000.
He purchased the house many years earlier for $250,000. While owning the home, he invested another $50,000 in upgrading the kitchen and bathrooms. His “adjusted basis” (total capital invested) is $300,000 ($250K + $50K). His capital gain on appreciation is $200,000*
Guess who wants to tax Steve on his juicy $200K capital gain? That’s right… the IRS. Depending on which state he lives in, his state tax authority may want a piece too. Making matters worse, adding an extra $200,000 to his existing income in a single year may push him into a higher tax bracket.
But Steve is smart. He realizes a few things:
- He doesn’t have an immediate need for the sales proceeds.
- He’s gotten used to the monthly income from his rental property.
- He could sell the house on an installment sale. By doing so:
- He will DEFER receiving the capital gains portion of the sale over many years.
- He will receive interest on the unpaid principal balance.
- He will receive monthly payments.
NOTE: Because Steve is REALLY smart, he speaks with his tax professional when first considering and before implementing this. (You should too.) He also familiarizes himself with creating notes and relies on other experienced team members to fill in the gaps.
* The IRS reporting formula factors selling expenses and existing debt into selling costs, as well as deprecation recapture into adjusted basis. While many sales will include these items, this article chooses a streamlined scenario.
How Does Deferring Capital Gains Work?
Receiving payments and interest over time are simple concepts, but deferring capital gains deserves an additional explanation.
When Steve sells his property, 40% of the selling price will be a capital gain. The IRS calls this gross profit percentage ($200,000 (capital gains) / $500,000 (selling price) = 40%)
If he sells the house and receives a $50,000 down payment at the time of sale, 40% of the downpayment is reported as capital gains, and the remaining portion is reported as a return of capital (basis.)
$20,000 – capital gains (taxable)
$30,000 – return of capital (non-taxable)
$50,000 – total down payment
The PRINCIPAL portion of each subsequent payment will be allocated the same as the down payment: 40% capital gains and 60% return of capital.
Therefore, if Steve receives five loan payments of $1,000 each in year one, the TAXABLE portion of those payments will not be $5,000; it will be $2,000 ($1,000 x 5 x 40%).
The total amount of taxable capital gains he will receive in tax year one will be $25,000. He has deferred the remaining $175,000 in capital gains until subsequent tax years. Thus, Steve will only pay capital gains taxes in the FOLLOWING years on the amount of capital gain he receives in EACH tax year.
Can Interest Be Deferred?
Unfortunately, the short and long answers are both no. Interest is taxable as ordinary income in the year it’s received. Even if your agreement with the borrower is at 0% interest or calls for a no-interest period, IRS rules of unstated interest or original issue discount (OID) apply.
What are Unstated Interest and OID?
If the installment sale agreement doesn’t provide for stated interest above a published threshold, part of each payment must be characterized as interest. Current Applicable Federal Rates (AFR) are published monthly and can be referenced here.
Selling A Primary Residence
If you are selling your primary residence, and your capital gains (if single) are $250,000 or less (up to $500,000 if married), you are exempt from capital gains taxes.
In this instance, you may still choose to sell with seller financing, but using the installment method will provide no advantage because there are no capital gains to defer. You must also have lived in the property for at least two of the last five years.
Does a Real Estate Installment Sale Have Disadvantages or Limitations?
No scenario is perfect, and again, your unique scenario is something that you should discuss in advance with licensed and qualified professionals.
That said, for those who can benefit from installment sales, the disadvantages and limitations mostly fall under the heading of common sense. They include:
- Risk of Non-Payment: If your borrower falls behind or defaults, not only will it impact your ongoing cash flow, but it also can lead to expensive and drawn-out legal proceedings, taking back the property, etc. To minimize risk, use a third-party underwriter such as Call-The-Underwriter, who will verify your borrower’s ability to repay.
- Taxes and Insurance: Unpaid property taxes and insurance premiums carry a high risk of loss for a lender. Engage a reliable loan servicer to monitor both. Even better, allow for your servicer to impound taxes and insurance funds to an escrow account each month and make the payments when due.
- Reporting: The reporting is specific, and record-keeping is critical. IRS form 6252 is used to determine and report installment sale income. Most should and will choose to work with a tax professional when filing each year.
- Dealer Sales: The installment sale method can’t be used for real property held for sale to customers in the ordinary course of a trade or business. If you’re in this situation, you are a real estate professional. House flippers are an example. The homes they purchase to sell later are considered inventory.
- Selling at a Loss: IRS installment sales are only permitted when there is a gain on sale, not a loss. You are not precluded from using seller financing. However, you will not be able to defer a loss for tax purposes.
- Sale To A Related Person: Special rules apply. See IRS Publication 537 “Sale and Later Disposition.”
Final Thoughts on Real Estate Installment Sales
As note professionals and real estate investors, it is important to understand tax deferment strategies such as real estate installment sales or 1031 exchanges. The reason is that it’s our job to listen to people and help them with their problems.
Imagine bidding on a property, and the Seller agrees to seller finance because you discovered she was concerned about capital gains taxes. As a result, you introduced her to the concept of installment sales and won the deal on terms over other investors. You listened and then reached into your knowledge toolbox to suggest the solution.
Finally, knowledgeable investors know the value of controlling when, and sometimes if, they pay income taxes. Methods such as tax deference require planning but can reap huge rewards.
About The Author:
Marco Bario is a Real Estate and Real Estate Note Investor from Sherman Oaks, CA. He is also the President of Porch Swing Funding, specializing in the purchase of secondary market seller-financed mortgage notes.
Contact him at (833) 457-7776, on LinkedIn (@marcobario), or at porchswingfunding.com.
This article is designed for informational purposes only. It is provided with the understanding that the author and this website are not engaged in rendering legal, accounting, or investing advice. If legal, tax and investment advice or other expert assistance are required, the services of a competent professional should be sought.
IRS Publication 537 (Installment Sales) – https://www.irs.gov/forms-pubs/about-publication-537
IRS Form 6252 (Installment Sale Income) – https://www.irs.gov/forms-pubs/about-form-6252
IRS Publication 551 (Basis of Assets) – https://www.irs.gov/forms-pubs/about-publication-551