Completing a 1031 exchange is a common way for real estate investors to defer capital gains tax liabilities on the sale of investment properties.
Another less-frequent method of potentially deferring capital gains taxes is through a structured installment sale. In this type of sales agreement, sellers with appreciated real property assets are able to spread realized capital gains over the course of several years rather than taking on the entire financial burden in a single tax year.
Let’s take a closer look at how installment sales work and provide some examples.
Installment Sales in Real Estate
Internal Revenue Code Section 453 defines an installment sale as the disposition of property where at least one payment is received after the close of the tax year in which the asset was sold. This method cannot be employed on assets that are sold at a loss.
Installment sales usually involve some form of seller financing that’s recognized through a deed of trust or contract. After the buyer and seller agree on sale terms and payments, the buyer makes payments in accordance with the terms of the contract, which can help the purchaser better manage cash flow during and after the acquisition. The seller, meanwhile, pays any realized capital gains taxes in the year he or she receives payment. Gain is recognized by gross profit percentage and by the schedule of funds received. Sellers report installment payments on IRS Form 6252: Installment Sale Income and submit it with their annual tax return.
The installment sales method typically works best on real property assets that are wholly owned by investors. Since the property has no mortgage, the seller is in a better financial position to fund some portion of the purchase. One reason why installment sales are less common than other forms of disposition is because they can bring significantly greater risk to investors.
Risk factors in an installment sale may include:
- Accounting can be more difficult and therefore more costly
- Buyer default could result in the seller reacquiring the asset
- Illiquidity as sellers await delivery of the full purchase price
- Potential for asset depreciation due to natural disaster or some other unexpected event that erodes real estate values.
Installment Sale Examples
Here are two theoretical examples of how installment sales work.
You own a retail building that originally cost $2 million, but after realizing significant asset appreciation, you strike a deal to sell the property for $4 million. During this year and over the next three consecutive years, the buyer of the property agrees to pay you four annual installments of $1 million each.
The capital gain you’ll pay on your gross profit of $2 million is spread out over each installment. Since the taxable percentage of each installment payment is 50 percent ($2 million/$4 million), you'll be taxed on $500,000 of gain (50 percent of $1 million) with each installment payment. The other 50 percent of the installment payment is the return of your original basis in the investment.
Here’s one more example: You divest a residential rental property for $400,000 that you bought 10 years ago for $160,000. Your buyer puts down $40,000 and agrees to pay the balance over the next nine years. Your net gain in the property is $240,000, which represents 60 percent of the sale price. That means that 60 percent of each annual payment of $40,000 is from capital gains, while the remaining 40 percent is the return of your cost basis in the property. At tax time, you’ll pay capital gains taxes on $24,000 (60 percent of $40,000).
Putting it all Together
Installment sales can be used to spread capital gains tax liabilities out over time. However, there are many moving pieces in an installment sale of an investment property, and there’s a lot that can go wrong and derail the buyer’s ability to uphold the financial terms of the sale. Investors should consider engaging the services of a tax professional, real estate attorney, and residential or commercial property broker before entering into any installment sales agreements.
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.