Installment sales have many advantages for real estate investors. They have tax deferment, flexibility for the buyer, a stream of payments to the seller, and lower taxable gains. But what if you want to arrange an installment sale to a family member? Or a business that you own a majority stake in?
In that case, the IRS (or, better, your accountant) will waive a red flag. However, this doesn't mean the installment sale can't go through successfully. It's a matter of meeting certain requirements.
An installment sale allows investors to defer taxes on gains for up to 30 years. Rather than take a lump sum payment on the sale of a property, the investor is paid over some predetermined time frame.
For example, an investor has a $500,000 cost basis in a property and sells it for $800,000. The sale is made through an installment sale arrangement. To determine the taxable percentage of each installment, divide the gross profit by the sale price. In this case: $300,000/$800,000 = 37.5%.
The investors agree on annual payments of $100,000. To calculate the annual taxable gain, multiply the annual installment by the taxable percentage: $100,000 x 37.5% = $37,500. The seller's annual taxable gain is $37,500.
The benefit to the seller is instead of an annual taxable gain of $300,000; it is only $37,500. Of course, that is their annual gain for the next eight years when the installment sale completes.
The IRS doesn’t allow special tax treatment if an installment sale is made to a related party. The IRS looks at this sale as potential tax evasion. In this case, any payments received are considered received in the year of the sale.
However, IRS Publication 527 does have an exception for related persons:
You can use the installment method to report a sale of depreciable property to a related person if no significant tax deferral benefit will be derived from the sale. You must show to the satisfaction of the IRS that avoidance of federal income tax wasn’t one of the principal purposes of the sale.
A related party/person can be a family member or a corporate entity in which you own a majority share. However, the list of what qualifies as a related party is fairly long.
An installment sale can be made to a related party if certain conditions are met. However, before initiating the sale, it is best to work with a real estate or tax attorney to ensure IRS rules on installment sales to related parties are not violated.