Selling a property you’ve owned for a long time can be a great financial decision. But it can also lead to a significant capital gain, which can increase your tax bill. This article explores how using an installment sale can help you spread out that tax burden and potentially save money.
Capital Gains and Surtaxes: Why Spreading Out Income Matters
Capital gains taxes are levied on the profit you make when you sell an asset, like real estate. The rate you pay depends on your taxable income for the year. Lower income brackets may qualify for a 0% rate, while higher earners can face a 20% rate.
On top of capital gains taxes, there’s also a 3.8% surtax on net investment income for higher-income taxpayers. This surtax applies to capital gains (except those from businesses) and can further increase your tax liability.
The problem with selling a property outright is that all the capital gains are recognized in one year. This can push you into a higher tax bracket and subject you to the surtax.
Enter the Installment Sale: Spreading Out the Tax Bite
An installment sale allows you to spread out the recognition of capital gains over multiple years. Here’s how it works:
- Seller Financing: Instead of receiving the entire sale price upfront, you agree to finance a portion of the sale for the buyer. This means you’ll receive a down payment and then collect payments on the remaining balance over time.
- Tax on Profits Only: You only pay capital gains taxes on the portion of each payment that represents your profit. Any principal payments you receive go towards reducing your tax basis in the property, which lowers your capital gain and ultimately your tax bill.
Example: Reducing Your Tax Burden with an Installment Sale
Let’s say you own a lot you originally bought for $10,000. You’ve paid it off completely, and now you’re selling it for $300,000. The buyer offers a 20% down payment ($60,000) and finances the rest at 3% interest with an installment agreement.
Here’s how the tax implications might look:
- Sale Price: $300,000
- Cost: $10,000
- Sales Costs: $9,000 (hypothetical)
- Net Profit: $281,000
- Profit Percentage: 93.67%
Of your $60,000 down payment, $9,000 goes towards covering selling costs. This leaves you with $51,000 in cash. Since the down payment represents 20% of the sale price, 93.67% of it is considered taxable income in the first year ($56,202).
The remaining principal payments you receive in subsequent years will also be taxed, but at a potentially lower rate depending on your income in those years. Additionally, the interest payments you collect on the installment note are considered taxable income and subject to the investment surtax.
In this example, using the installment sale method reduces your taxable income in the first year by $224,798 ($281,000 – $56,202). How much this benefits you depends on your overall tax situation and income in future years.
Additional Considerations for Installment Sales
While installment sales offer tax advantages, there are some things to keep in mind:
- Existing Mortgages: If your property has a mortgage, you’ll need to pay it off during the sale. You might be able to structure an installment sale by incorporating the existing loan into the new one, but this requires careful negotiation.
- Tying Up Funds: An installment sale means your money is tied up in the mortgage for a longer period. This might not align with your financial goals, even if it offers a potentially higher return on investment and tax benefits.
- Shorter Terms: You can shorten the installment period by setting a due date for the note that’s earlier than the amortization schedule. However, this could lead to a large lump sum payment in the future, potentially pushing you into a higher tax bracket in that year.
- Early Payoff: The buyer may decide to pay off the note early, triggering all the remaining capital gains to be taxed in that year. The same applies if they sell the property before the installment agreement is complete.
- Tax Law Changes: The tax treatment of installment sales can change over time. New laws could increase or decrease your tax burden on future payments.
Final thoughts
While installment sales offer a strategic approach to minimize taxes when selling property, they may not be suitable for every situation. Consulting with a tax advisor is crucial to assess whether an installment sale aligns with your financial objectives and circumstances. Factors like existing mortgages, your investment timeline, and potential tax law changes all play a role in this decision.
For personalized guidance on navigating tax-efficient property sales, reach out to our team of experts. We’re here to help you explore all your options, optimize your tax strategy, and achieve your financial goals.
