The Installment Sale Method

A rental property can be sold for a large profit, which is a great opportunity. Who wouldn't love to make a good buck on their investment property? However, you might want to delay taking your earnings as an entire lump sum to maximize your profit. Continue reading to learn more about why and how to make an installment sale.

The purpose Of Installment Sales

An installment sale is a property sale in which at least one payment is not made after the tax year. Publication 537 explains that the Internal Revenue Service allows taxpayers the option to defer a portion of the gain from the sale of investment property through an installment sale agreement. This arrangement allows sellers the ability to defer a portion of their capital gain for several years. A seller cannot use the installment sales method to report a loss. The seller can also opt out of the installment sales method for reporting again.

How The Installment Sales Method Works

The theory of declaring gains under an installment sale is simple. It is easy to declare gains under an installment sale. The taxation of these sales is similar to annuities, where a portion of each payment will be considered a return on principal. There are two restrictions: the property cannot be publicly traded security or part of a firm's regular inventory. The taxpayer cannot be a dealer for the sold property (with the exception of timeshare dealers who choose to pay a special interest fee under the installment sale method).

The Purpose Of Installment Sales

An installment sale is a property sale in which at least one payment is not made after the tax year. Publication 537 explains that the Internal Revenue Service allows taxpayers the option to defer a portion of the gain from the sale of investment property through an installment sale agreement. This arrangement allows sellers the ability to defer a portion of their capital gain for several years. A seller cannot use the installment sales method to report a loss. The seller can also opt out of the installment sales method for reporting again.

How The Installment Sales Method Works

The theory of declaring gains under an installment sale is simple. It is easy to declare gains under an installment sale. The taxation of annuities mirrors the principle of prorated principal returns. Only two conditions apply the property to be sold must not be a publicly traded security or part of a firm's regular inventory. The taxpayer cannot also be a dealer for the sold property.

Let's look at John's installment sale structure if he wants to defer capital gains taxes to a future calendar year. John is offered $400,000 to rent his home. John purchased the property for $300,000. He bought the property for $300,000. John now has $200,000 (between $400,000 and $200,000) in taxable gains to declare.

John's advisor suggests dividing his sale proceeds into eight annual installments each of $50,000, rather than declaring $400,000 every year. Thus, John will be able to keep track of his profits and prorate the gains over eight years, as long as the installments are received each year constructively.

Reporting Installment Sale Income

You can break down your income from installment sales into three categories: gain and principal (or your adjusted basis in the property) and interest. Each category is dealt with differently on form 1040. This is used to calculate installment sales income for a particular tax year.

Capital Gain

John must declare each year the gain as short-term depending on whether it was long-term or short-term at the time of the sale. The tax rate on long-term gains is lower than for short-term gains. This depends on whether the gain was long-term or short-term as of the year of the sale.

John may still be subject to tax on his installment income even if the gain was short-term. This is because John would not have been subject to the same tax if he had had to declare the lump sum gain. However, the tax rate on installment income may be lower if the gain is short-term. An installment sale gain is reported on IRS form 6252 and then transferred to schedule D on Form 1040.

Interest

Installment-sale income taxpayers must also report the interest paid to the buyer. This is subject to ordinary income tax. The interest started in the sale contract is called stated interest. Insufficient or zero-stated interest must be recharacterized to "unstated" interest.

Principal

The IRS considers a portion of each installment sale to be a tax-free principal return. You can calculate this amount by filling in Worksheet A from Publication 537. For installment sale purposes, the principal (adjusted base) is the sum of your adjusted basis in the property and any selling expenses.

John's adjusted basis for his home is $200,000 in this example. To calculate his adjusted basis for installment sales purposes, he must subtract $100,000 for depreciation recapture. He also needs to add $10,000 for selling expenses. This sum is $310,000

Gross Profit Percentage

To calculate your gross profit percentage, subtract the adjusted basis (in this case, $310,000) from the sale price. The total gain here is $90,000. This is between $400,000 and $310,000. Divide the total gain by sale price (in this example, 22.5% = $90,000/$400,000) to get the gross profit percentage. To calculate the taxable profit each year, divide this percentage by the amount paid in installments. John's annual taxable gain is $11,250 ($50,000 x 22,.5%).

Mortgages And Contract Price

The property's cost base must be decreased if the buyer assumes a loan or another promissory Note. For example, if John sells a rental property for $400,000 and has a $100,000 mortgage, the contract price will be reduced to $300,000.

If the mortgage amount exceeds the total property adjusted basis, the difference must be reported in the first year as a payment, and the difference will increase the contract price. For example, let's say John has a mortgage of $250,000. John will need to report an additional $50,000 payment in the first year, along with the monthly installment.

The Summary

You must follow all regulations and rules regarding installment sales. You can find more information about subtopics, such as changes in selling prices, the various forms that payments can take, and when it may be better to take a lump-sum instead of an installment agreement at the IRS website. For more information on tax issues, consult your tax advisor.