Selling a property you’ve owned for a long time can result in a significant capital gain. Reporting this gain in one year can push you into a higher tax bracket and subject you to the 3.8% surtax on net investment income. But there’s a strategy to avoid this: the installment sale.
Capital Gains Tax Rates
Long-term capital gains (LTCG) from assets held over a year are taxed at lower rates than ordinary income. The rate depends on your taxable income, which is your adjusted gross income (AGI) minus standard deduction or itemized deductions.
- 0% rate: Applies to single filers with taxable income below $47,025, head of household filers below $63,000, and married couples filing jointly below $94,050 (for 2024).
- 15% rate: Applies if your taxable income falls within specific ranges depending on your filing status.
- 20% rate: Applies to taxable income exceeding the 15% rate thresholds.
Surtax on Net Investment Income
Capital gains (except from businesses) are considered investment income. Higher-income taxpayers are subject to a 3.8% surtax on net investment income exceeding specific thresholds based on filing status.
This is where installment sales can be beneficial.
How Installment Sales Work
With an installment sale, you sell your property for a down payment and finance the remaining balance through a buyer’s note. You only pay taxes on the portion of the down payment (and subsequent principal payments) representing your taxable gain. You also collect interest on the outstanding balance, similar to a bank’s interest rates.
Here are the requirements for an installment sale:
- Reasonable down payment.
- At least one payment must be received after the sale year.
- Publicly traded stocks or securities cannot be sold using this method.
Example: Using an Installment Sale to Reduce Tax Liability
Let’s say you own a lot purchased for $10,000 (no mortgage). You sell it for $300,000 with a 20% down payment ($60,000) and finance the remaining $240,000 at 5% interest using the installment sale method. There are no additional payments in the year of sale, and selling costs are $9,000.
Of your $60,000 down payment, $9,000 goes towards selling costs, leaving $51,000 cash. Since the 20% down payment is 93.67% taxable, $56,202 ($60,000 x .9367) is taxable in the first year. The amount of principal reported each subsequent year depends on the installment agreement. Remember, interest payments on the note are also taxable and subject to the investment income surtax.
By using the installment method, the taxable income for the year is reduced by $224,798 ($281,000 – $56,202). The impact on your overall tax liability depends on your other income and circumstances.
Additional Considerations for Installment Sales
- Existing Mortgages: If your property has a mortgage, it must be paid off during the sale. You might be able to work out an installment sale by taking a secondary loan position or wrapping the existing loan into the new loan.
- Tying Up Your Funds: Tying up your funds in a mortgage might not align with your long-term financial plans. Shorter terms can be achieved with a due date on the note that’s shorter than the amortization period. However, a large lump sum payment at the end could cause higher taxes and surtax to apply in that year. Careful planning regarding the installment agreement is crucial.
- Early Payoff of the Note: The buyer may pay off the note early or sell the property, triggering the remaining taxable portion to be taxed in that year unless the new buyer assumes the note.
- Tax Law Changes: Income from an installment sale is taxed under the laws in effect when payments are received. Future tax laws could increase or decrease the tax on installment income. Additionally, the income ranges for the 0%, 15%, and 20% capital gains rates are adjusted for inflation annually. While this usually benefits taxpayers, Congress could remove these favorable LTCG rates in the future.
Conclusion
Installment sales can be a valuable strategy to spread out capital gains taxes and potentially avoid higher tax brackets and the net investment income surtax. However, it’s important to consider your individual circumstances and consult with a tax advisor to determine if an installment sale is the right option for you. They can help you navigate the complexities of tax law and structure the sale to maximize your tax benefits.
Do you have questions about installment sales and how they can help you save on capital gains taxes? Contact us today for a consultation!
