If you’re selling a prime piece of real estate, you can probably get top dollar in today’s market. But it may be worthwhile to structure the deal so you receive payments over several years.
Strategy: Sell the property on the “installment sale” basis. As long as you receive payments from the buyer in two or more tax years, you don’t owe current tax on all of your gain in the year of sale.
Not only does this defer the tax, it may also reduce your overall tax bill on the gain.
Recent tax-law changes further encourage real estate sellers to use the installment-sale method.
Here’s the whole story: Under the installment sale rules, only a portion of the gain is taxable in the year in which you receive a payment. Also, the taxable portion on the sale qualifies for favorable capital gain treatment.
The current maximum federal income tax rate on long-term capital gains is 20% for taxpayers in the highest ordinary income tax bracket. However, most taxpayers will owe no more than 15% to the feds on long-term capital gains. For sales of depreciable real estate, a maximum federal rate of 25% applies to the portion of gain attributable to your depreciation deductions. In addition, a 3.8% Medicare surtax now applies to the lesser of “net investment income,”(NII) which includes most sales of rental real estate properties, or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold of $250,000 for joint filers (or a MAGI of $200,000 for single filers). These figures are not indexed for inflation.
Thus, you could pay an effective tax rate of 23.8% (20% + 3.8%) or 28.8% (25% + 3.8%) on the sale of highly appreciated long-term capital gain property in 2015.
What is the taxable portion of the payment? It’s based on the “gross profit ratio.” Gross profit ratio is determined by dividing the gross profit from the real estate sale by the contract price.
Example: You acquired a parcel of commercially zoned land several years ago. It has an adjusted tax basis of $600,000. In 2015, you agree to sell the property for $1.5 million in five annual installments of $300,000 each with the first installment received in 2015. Because your gross profit is $900,000 ($1.5 million – $600,000), the taxable percentage of each installment payment is 60% ($900,000 divided by $1.5 million).
When you report the sale on your 2015 tax return, you’re only taxed on $180,000 of gain (60% of $300,000), reducing your exposure to the 20% capital gains rate and the 3.8% net investment income tax.
For simplicity, let’s say you save the 5% capital gains differential on $100,000 of income each year. That’s a tax savings of $25,000 (5% of $500,000)—well worth the wait.
Finally, watch out for a little-known tax trap. If the sales price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid to the government on the deferred tax to the extent that your outstanding installment receivables exceed $5 million.