What is an Installment Sale and When is it a Good Option?
selling a piece of real estate: the installment sale.
An installment sale is an option for someone selling property, for a gain, where at least one payment is scheduled to be received after the tax year in which the sale occurs.
If a sale does qualify as an installment sale, then the gain must be reported under the installment method. The only exception to this rule occurs when the seller chooses to “elect out” and thus report all income as gain in the year of the sale rather than spreading it out over time. Otherwise, the seller must use the installment method where the income recognized for any taxable year is proportional to the payments received in that year. The payments themselves are taxed in three components, including:
1. Return of Capital
2. Capital Gain
To determine tax liability in any given year, it is important to calculate the gross profit ratio for the transaction. To calculate the gross profit ratio, the initial cost of the property is subtracted from the contract price and then divided by the contract price.
Assume that a buyer made an initial down payment of $100,000 on a $225,000 property. The remaining $125,000 is carried back by the seller and amortized over 30 years with an interest rate of 7% and monthly payments of $830.00. In this scenario, the buyer makes the initial down payment and pays for six months in the year of the sale. To calculate the tax liability of the seller, the gross profit ratio needs to be determined:
Contract Price = $225,000 (Total selling price of property)
Cost = -$50,000 (Original cost of property plus maintenance costs)
Gross Profit = +$175,000
Gross Profit Ratio = $175,000/$225,000 or 77.8%.
For this transaction, 77.8% of every dollar is considered profit and thus subject to capital gains tax whenever received. In the year of the sale, the seller received $100,000 (the down payment) plus six payments of $830 totaling $4980. Using a simple online real estate calculator with an APR of 7%, we find that of those six payments $630 was interest. The remaining $4320 is interest income.
Thus, 77.8% of the $100,630 would be subject to capital gains tax in every single calendar year in which the seller receives payment for the property. In addition to the capital gains tax on the sale of the property, the seller would still need to declare the $4320 as taxable income. However, 22.2% of the principal received in any calendar year is considered tax free but all interest is taxable when received. Basically, the sale of the property created a capital gain anyway—the use of an installment sale simply spread capital gain tax liability over length of payment plan while adding an interest income tax liability.
An installment sale is a great way to spread a tax liability over an extended period of time, but it does carry a greater risk for the seller. Unlike a traditional sale where a bank loans the buyer the money necessary to purchase the property, the seller will not receive the total purchase price at once. While the installment sale does allow buyers to purchase real estate without bank financing, it also means the seller assumes greater risk regarding the buyer’s creditworthiness and his ability to manage the asset responsibly. If the buyer is unable to make timely payments, the seller would be responsible for the costs of foreclosure and repossession.