Selling real estate at an appreciated value can generate a good-news, not-so-good-news scenario. The good news is that selling real estate at a higher amount than what you bought it for can mean profit. The not-so-good-news is that this profit – or capital gains – will be taxed, based on your specific tax bracket.
One strategy that can be used to help reduce capital gains taxes on real estate or other eligible items is the installment sale. According to the IRS, an installment sale occurs if you receive at least one payment from a buyer after the tax year during which a property sale occurs.
Let’s say you want to sell real estate for $50,000. You might accept a 20% upfront downpayment from the buyer ($10,000) in 2022. This leaves $40,000 remaining. For this to be a true installment sale, the buyer would need to pay you part of the amount – like $10,000 – in 2003, the year following the initial transaction.
Installment sales can offer the following benefits to a seller:
Reduced taxes on capital gains. Getting back to our above example, if you decided to take the $50,000 in one lump sum, and your income was in the 15% bracket for capital gains, you’d have to pay $7,500 in taxes for the year. But through an installment sale, you’re only taxed on the realized gain. This means that you’d owe that 15% on $10,000 (or $1,500) for the year.
Here’s another issue to consider. The capital gains you earn on an asset sale increase your adjusted gross income (AGI). This could put you in a higher tax bracket (meaning more taxes owed). You could lower that AGI by accepting installment payments rather than taking the payment in one lump sum.
Do keep in mind that depreciation recapture payment is required in the year of the sale, even an installment sale.
Appeal to potential buyers. Not everyone has $50,000 just lying around to buy property. And they might not have the means to borrow that money. In these situations, offering an installment sale agreement could increase your buyer pool. Rent-to-own is one example of an installment sale; in fact, the IRS will, in certain cases, characterize a lease or rent-to-own option as an installment sale.
While there are installment sale benefits for owners, there are also certain caveats. For example:
- The asset must qualify. Assets typically taxed as ordinary income (like securities or inventory) aren’t eligible for installment sales.
- Paperwork must be signed. While a handshake deal might be a nice thought, the buyer and seller involved with an installment transaction must sign an installment agreement, among other documentation.
- You'll still owe. Though installment sales can help reduce your AGI and capital gains, the interest you charge on payment installments is taxed as ordinary income.
Even with the above-mentioned caveats, using an installment sale to dispose of property can help reduce your tax burden. When structured correctly, this method can help reduce owed capital gains, while potentially offering your property to a larger pool of likely buyers.
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.
Hypothetical examples shown are for illustrative purposes only.
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.
