Using an Installment Sale with a 1031 Exchange

One tax-deferral strategy that can be useful when selling investment real estate is the 1031 Exchange. Through this, you sell your relinquished property and then put the proceeds into a replacement property (with help from a Qualified Intermediary). When successful, you can defer capital gains and depreciation recapture taxes generated from the sale of your property.

But there might be a situation where you receive part of the sale proceeds as cash rather than putting them into the replacement property. The money is called “boot” and is subject to taxes. That is unless you consider an installment sale strategy.

An installment sale doesn’t necessarily defer taxes you might owe on the boot. But it can spread out the liability over time, so you aren’t paying taxes all at once.

Defining an Installment Sale

You get paid whenever you sell a capital asset (like real estate). An installment sale means that you receive those payments over a period of time as long as you receive at least one payment following the tax year of the sale. The potential advantage of this process is that you pay taxes on each installment payment you receive rather than on a single lump sum.

How it Works with a Like-Kind Exchange

Here’s how an installment sale might pair with a 1031 exchange:

• You agree with the buyer of your relinquished property to receive part of the proceeds as cash through installment payments.
• You receive some payment upfront and at least one payment in the year following the sale. You’re taxed on both payments.
• You continue to receive payments from the buyer over time and are taxed only on what you receive.

While there might be tax benefits in using an installment sale as part of your 1031 exchange, there are also caveats to consider:

• The buyer could default, meaning payments stop
• If interest rates increase significantly, the value of your payments could erode

Understanding Form 6252

Another issue with using an installment agreement for your boot is the complexity and extra paperwork involved. One such document is the IRS Form 6252, “Installment Sale Income.” Information for this three-part form includes:

• Gross profit and contract price related to the sale
• Income expected from installments
• Related party installment sale income

Form 6252 is filled out and attached to your tax return for each year that you receive installment income.

Knowing your Tax-Advantaged Options

If you’re involved with a 1031 exchange and decide to cash out part of the proceeds from the sale of your relinquished property, an installment sale can help spread out the tax burden generated from boot. However, this method isn’t for everyone or every situation. Do keep in mind that depreciation recapture on boot is taxable in the year of the sale and cannot be deferred through an installment sale. Analyzing your investment goals and financial situation before deciding on this path is essential.

It’s also essential to work with a tax advisor or CPA familiar with installment sales and 1031 exchanges to figure out your best approach and comply with the IRS rules.

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.