In previous blogs, we’ve discussed ways to defer capital gains taxes. A couple of examples are using the 1031 exchange or tax-loss harvesting.
Installment sales can also be a tool for capital gains tax deferral. An installment sale is defined as the sale of property where at least one payment is received after the close of the tax year in which an asset is sold.
When selling an asset, the IRS needs to know the gross profit on that sale. This is true for installment sales as well. In basic terms, gross profit is the sales price of your asset less the asset’s adjusted basis. Going further, the adjusted basis is defined as what you paid to acquire the real estate asset, less capital improvements, casualty loss, or other decreases.
Gross profit is fairly straightforward if you sell an asset for a lump sum payment. But what happens if you’re selling an asset through an installment sale? You still need to report gross profit on installment payments. But the method is a little more complex.
Generally, the following should be calculated when determining gross profit from an installment sale:
Let’s say, for example, that you sell an asset for $30,000 and your adjusted basis on that asset is $24,000. You’ve come to an installment sales agreement of 15 payments, over time.
Here’s how you might calculate your realized gross profit:
So $400 is your realized gross profit every time the buyer pays you through the installment sale.
The above example is very basic. In reality, when you sell real estate, other costs will be involved, like broker fees, title expenses, and depreciation recapture. Furthermore, you’ll be taxed on profits realized as you receive each installment payment. You’ll also be required to report any interest involved with these installment payments.
Because installment sales can be complex, it’s a good idea to work with a qualified tax advisor to figure out gross profit, taxes owed, or other calculations when you’re dealing with an installment sale.