If you sell real property, you can avoid or reduce your capital gains tax by structuring the deal as an installment sale. Here’s how it works.
What is a real estate installment sale?
In a traditional property sale, the seller receives all of its gains in one lump sum at closing. Any amount of gain that exceeds the IRS’s capital gain exemption amount is subject to capital gains tax.
With an installment sale, the buyer doesn’t pay the full sales price at closing. Instead, the parties draw up an installment plan in writing under which the buyer pays the seller over some agreed-upon number of months or years. The Internal Revenue Service defines an installment sale as any sale of real property where at least one payment is received by the seller after the year in which the sale closed. The most common example would be a seller-financed sale, where the buyer makes a down payment and then monthly payments over an agreed-upon number of months or years.
How installment sale taxes work
Instead of realizing all of his gains — and a potentially significant capital gains tax — at closing, the seller in an installment sale receives gain over time. This gain is considered income, not a capital gain, which lowers the seller’s tax bill.
A seller’s gain is equal to the contract sales price minus the seller’s basis in the property. The basis is the amount the seller paid for the property plus legal fees, title insurance and title search fees, abstract fees and transfer taxes. Any improvements the seller put into the property also count as part of the basis.
In an installment sale, the IRS uses the seller’s percentage of gain to determine how much of each installment payment to treat as taxable. For example, if the seller’s gain on the sale equals 30 percent, then 30 percent of each installment payment is counted as gain. Interest the buyer pays to the seller is also treated as income to the seller.
An installment sale of real estate must include an executed deed of trust and a recorded promissory note. The seller must use IRS Form 6252 to report each year.
An installment sale cannot be used when:
- The sale results in a loss to the seller.
- The seller operates a trade or business in real estate. For example, a house flipper cannot take advantage of this tax benefit.
- The property sold is a security, such as a stock or bond.
The advantage of an installment sale
The primary advantage of an installment sale to the seller is the deferral of gain on the property, spreading it over years beyond the tax year in which the sale was closed. Instead of a capital gain received in one lump, it is spread as income over one or more years. For buyers, an installment plan helps make it possible to buy property without a mortgage.
The seller faces potential risk if the buyer at some point defaults. As part of the terms of the installment sale, the seller should require the buyer to put up the property as collateral to secure the note.
Because the IRS rules on installment sales can be complicated, it’s important to hire a qualified tax attorney or other professional to help you.
Related – The Tax Benefit of Selling Your Home