How to Increase Net Profits with Installment Sale Rules

The sale of an asset, especially a large asset such as real estate, can trigger a substantial tax obligation. Finding ways to reduce the tax burden is time well spent, as prudent tax planning can result in significant savings. One of the strategies used to reduce taxable gain from the sale of property is using the installment sale method. This strategy allows the taxpayer to defer their taxable gain from a sale of an asset in a subsequent year. There are, however, many factors and unique situations that should be considered before undergoing an installment sale. As tax consultants, we’ll help shed some light on the subject.

Core Concepts

• Installment sale definition: Property sold in which some or all the proceeds are collected in years after the year of sale.
• Tax benefit: The installment sale method defers the gain recognized from a sale of property. Instead of all the gain being recognized in the year of sale, the gain is proportionately recognized when sales proceeds are received.
• Property ineligible for installment sale rules:
  • Property sold at a loss. When property is sold at a loss, the entire loss is recognized during the year of sale, regardless of whether sales proceeds are received over multiple years.
  • Dealers of real or personal property. A “dealer” is defined as someone who is in the business of selling a certain kind of property, whether real property or personal property. There are, however, multiple exceptions for the dealer ineligibility rule. Exceptions include the sale of farm property, timeshares, and residentials lots.
  • Publicly traded property.
  • Depreciable property to related parties.
  • Revolving credit plans.
  • Interests representing income from services rendered.
• Depreciation recapture. Regarding personal property (Section 1245 property) that was previously depreciated on a taxpayer’s tax return, the gain to the extent of the depreciation taken cannot be deferred to subsequent years. This gain from this “depreciation recapture” must be recognized in the year of sale.
• If you receive interest from the party you sold your property to, the interest received is recorded as ordinary income, like how interest from a bank account is recorded.
• Automatic application. When selling property where proceeds will be received in subsequent years, installment sale rules automatically apply. If desired, a taxpayer may opt out of the installment sale treatment and report all the gain in the year of sale.
• State taxes. The deferred gain is subject to both federal and state income taxes. If a taxpayer moves to a different state, they may still need to pay state income taxes on the sales proceeds to the state in which the sale occurred.

Tax Planning Factors to Consider
There are several factors that need to be considered when determining if an installment sale is beneficial. See the pros and cons of installment sales below.

• Pros of the installment method

• • Tax savings. This is the main benefit of the installment sale method. If the installment sale method isn’t used, all the gain will be recognized in the year of sale, which could push the taxpayer into a higher tax bracket (as seen in the example below). Also, if the taxpayer expects he or she will be in a lower tax bracket in future years, the tax paid on the deferred gain will be lower.
  • Interest rate charged on installment note

• Cons of the installment method

• • Estimated rate of return on reinvested proceeds from sale. This is where not using the installment sale method is advantageous. If all the sale proceeds are received in the year of sale, 100% of the sale proceeds can be placed in other investments starting on day one.
  • Risk of default on installment note. This also means that the sales proceeds received related to unrecognized gain (otherwise known as a return of basis) become taxable in the year of default.

Example

Assume a taxpayer sells a piece of property for $1,000,000 and has a taxable gain of $500,000. The analyses below depict the different between using and not using the installment sale method. Note that the total sale proceeds and gain recognized are the same, but the tax paid, return on reinvested sales proceeds and interest income are all different.

Conclusion

The installment sale method may be a lucrative method of tax and wealth management. There are multiple factors that must be considered before determining which kind of sale is best. Contact tax consultant Craig Mulcahy at Mahoney CPAs and Advisors to help with making this decision.

For more information on the three stages of acquisitions and sales, read our blog on Real Estate Acquisition and Development.