When a property is sold for a gain, the investor may end up with a sizable tax bill. There are several ways to handle a large tax bill:
- Offset gains with losses from other sources
- Defer taxes through a 1031 exchange
- Utilize Form 6252
In this article, we’ll explore how Form 6252 helps investors defer taxes.
What Is Form 6252?
Form 6252 is used for installment sales. An installment sale is one that allows the buyer to pay for a property over time. For the seller, it allows them to defer taxes on a sale until income is received. Rather than one large tax bill, an installment sale splits the bill over time.
Because an installment sale is basically giving the buyer a loan (from the seller), there is interest income during the time the installment is being used. If this interest is not included in the sale agreement (called imputed interest), “unstated interest” is then incurred as interest income when filing your taxes. Unstated interest is taxed at the ordinary income rate, making including interest in the sale a generally better outcome.
If there is interest income, what rate should be charged to the buyer? The interest rate must follow the Applicable Federal Interest rates (AFRs). It is the minimum amount that must be reported for an installment sale.
Form 6252 has three main sections:
- Gross Profit and Contract Price
- Installment Sale Income
- Related Party Installment Sale Income
For many people, part 3 won’t be used. A related party is a family member or entity that you have control over.
Part I of the Form will list income, depreciation, cost basis, and liabilities to arrive at the gross profit. The contract price is also listed in this section.
Part II reports the amount of payments received during the year and calculates the amount of gain against it. This is the amount that taxes will be owed on.
The following is an example of what an installment sale may look like:
$20k down @ 5% interest
Buyer pays $1500/mo note
For the seller, the various components of the sale are taxed at different rates:
Return of basis — $0 (not taxed)
Depreciation recapture — 25% (straight-line depreciation recapture)
Capital gain — 20% (long-term rate if held for a year or more)
Interest income — 25% tax rate (ordinary income)
There are three types of income involved with Form 6252:
- Depreciation recapture
- Capital gain
- Income from sale of business property
Some other benefits to using an installment sale include the potential to avoid the following:
- QBI (qualified business income) phase out
- NIIT (net investment income tax)
- Higher premiums on Medicare Part B for people age 65 and older
If you are selling multiple properties, a form must be used for each property.
When To Use Form 6252?
If you’re financing a buyer, you may be able to use Form 6252. If your goal is to reduce taxes paid in a single year, an installment can help. It’s also best to check with your tax account for any scenario that you’re considering to make sure it qualifies for Form 6252.
There are specific situations that don’t qualify for Form 6252:
- Sale of inventory
- sale marketable securities — reported as normal gain on income tax return (i.e., don’t need Form 6252)
- Selling depreciable property to a related person
- Electing out (i.e., you are not using an installment sale)
- Loss on the sale — you can’t use installment sale treatment
You may not need Form 6252 if selling to a grantor trust or single member LLC since there is no income tax event. These are disregarded entities and thus the sale is disregarded for income tax purposes.
Another consideration when deciding if an installment sale is right for you is to consider if your capital can earn more (with another opportunity) than the rate of return you’ll receive on the loan.
Always check with your tax accountant for any potential exceptions to Form 6252.
