In today’s stymied real estate market, lenders are more cautious about making loans and sellers are more inclined to agree to carry financing to sell their properties more quickly. Here’s a look at how installment sales could work for your clients.
Installment sales are structured so that the seller receives payments for parts of the purchase price over a period of time following the closing.
If a buyer makes a substantial down payment and is sufficiently creditworthy, and if the seller either owns a property outright or has the resources to pay off any remaining mortgage, installment sales can be beneficial to both parties.
An installment sale also enables a seller to defer income taxes when at least one installment payment is received after the tax year in which the transaction closed. The seller recognizes the gain over the taxable years in which the payments are actually received.
Deferring taxes can be a real benefit to home owners whose capital gain exceeds the $250,000 individual exemption on the sale of a principal residence or who haven’t held the home for the two-year period required. Installment sales also benefit investment sellers who don’t want to use a Section 1031 exchange to defer taxes.
Each installment payment consists of three elements:
- A partial return of the seller’s adjusted basis in the property sold, which isn’t taxable to the seller.
- A portion of the taxpayer’s realized gain on the sale, which is taxable as a capital gain.
- Accrued interest, which is taxable as ordinary interest income. An installment note must include an adequate stated rate of interest to be paid by the buyer. An adequate rate of interest is equal to or greater than the rate published by the IRS.
Each year, a seller receiving payments from an installment sale must determine how much of the year’s payments are taxable as capital gains and how much are a nontaxable recovery of the seller’s cost basis.
The taxpayer’s adjusted basis starts with the original purchase price, including initial closing costs. It then increases by any capital improvements and the selling expenses incurred in the sale. It’s reduced by any depreciation taken during the time of the seller’s ownership. The taxpayer multiplies the non-interest portion of the total payments received in that year by the gross profit ratio for the sale.\
The gross profit ratio is the taxpayer’s total anticipated gross profit divided by the total contract price. The anticipated gross profit is the contract price less the taxpayer’s adjusted basis. The contract price is equal to the selling price, reduced by the amount of any qualifying indebtedness that is assumed by the buyer.
Qualifying indebtedness is limited to the seller’s adjusted basis in the property. If the seller has refinanced the property and taken cash in an amount that creates indebtedness greater than the seller’s adjusted basis, the qualified indebtedness for purposes of calculating the contract price is limited to the adjusted basis.
Consider the example of a sale of raw land (below). In Year 1, Seller sold Black Acres to Buyer for $1.2 million. Buyer paid $200,000 in cash at closing and agreed to assume the current $200,000 mortgage. Seller agreed to finance $800,000 of the purchase price over a five-year installment note, with the first installment being due in Year 2.
The gross profit of $400,000 is divided by the seller-financing contract price of $1 million to determine a gross profit ratio of 40 percent. In applying this gross profit percentage to the $200,000 received in Year 1, the seller will recognize $80,000 of gain in the year of the sale. If the principal portion of the payments received by seller in Year 2 is equal to $160,000, the seller will recognize gain equal to 40 percent of $160,000, or $64,000 in Year 2. (Note that gain on real property that depreciates, such as an office building, would be calculated differently because gain from depreciation is taxed at 25 percent.)
Installment sellers should consult an attorney to better understand the risks of default by the buyer and inquire about ways to reduce the risk.
Selling price: $1,200,000
Less assumed mortgage: ($200,000)
Contract price: $1,000,000
Adjusted basis: ($720,000)
Selling expenses: ($80,000)
Gross profit (selling price minus adjusted basis minus selling expenses): $400,000