Installment sales have favorable tax treatment, making them attractive for certain sellers. Rather than receiving proceeds from the sale of an investment property at once, the seller receives payments over time. For those who value tax benefits over the immediate need for cash, an installment sale can work in their favor.
In this article, we'll explain how capital gains are taxed on an installment sale.
What Is An Installment Sale?
An installment sale allows an investor to spread gains from the sale of a property over several payments. This has the effect of spreading realized gains from the sale over time. Because gains are spread out over time, so is the tax bill. The investor’s tax bill might be spread over several years. It all depends on the installment sale arrangement.
To be eligible for an installment sale, at least one payment must be made after the tax year in which the sale occurs. The number of payments and frequency is up to the buyer and seller — 12 per year, one per year, or some other number of payments can be used.
Note that installment sales cannot be used when a property is sold for a loss.
Taxation of Gains On An Installment Sale
To see how a taxable gain on an installment sale is taxed, it’s best to work through an example. This example pertains only to investment properties. For those flipping properties, taxation is generally more disadvantageous than that of an installment sale.
Note that these numbers are purely fictional and not accurate to real life. We are simply showing how the numbers work with taxation.
$250,000 — adjusted basis of property
$350,000 — sale price
The gross profit on this sale is $100,000. The taxable percentage of each installment is:
$100,000 / $350,000 = 28.57%.
The buyer will make seven annual payments of $50,000 (i.e., $350,000 / 7). The tax amount of the payment is $50,000 x 0.2857 = $14,285. The remaining $35,175 goes to the principal.
At a 20% long-term capital gains tax rate, the investor will owe $14,285 x 0.20 = $2,857 in yearly taxes.
Additionally, the investor is charging a 6% interest rate. Each year, the investor will earn $350,000 x 0.05 = $17,500 in interest. Interest income will be taxed at the ordinary income tax rate. For this investor, that rate is 25%. $17,500 x 0.25 = $4,375 in taxes each year.
Some investments may be liable for the 3.8% net investment income tax (NIIT) and depreciation recapture as well.
Note there is a special condition for adequate stated interest per IRS Topic No. 705:
If the installment sales contract doesn't provide for adequate stated interest, part of the stated principal may be recharacterized as unstated interest or original issue discount for tax purposes, even if you have a loss. You must use the applicable federal rate (AFR) to figure the amount of stated principal recharacterized as unstated interest or original issue discount.
From this example, we can see that the investor is able to spread his taxes out over several years. Additionally, the investor will earn income from interest.
Creating an installment sale agreement and calculating its tax implications can be very complex. That’s why it is best to work with a tax specialist when considering an installment sale.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
