Know the Tax Consequences of an Installment Sale

In a slow real estate market where financing can be tough to obtain, some investors are finding they have a better chance of disposing of real property in an installment sale. When structured properly, this type of transaction provides some financial benefits to both buyer and seller. But you need to understand the ins and outs before you jump in.

Installment Sale Benefits

An installment sale occurs when you transfer property in exchange for a promissory note and receive at least one payment after the tax year of the sale. The beauty of such a sale is that it allows you to receive interest on the full amount of the promissory note, often at a rate that exceeds the rate you could earn from other types of investments, while simultaneously deferring your taxes and improving your cash flow.

Installment arrangements can pay off for buyers, too. Buyers avoid paying the full amount upfront without dealing with the headaches of obtaining outside financing.

There may be some disadvantages for sellers, however. For instance, you might not get paid, so you'd have to deal with foreclosure. Or you might defer gain into a year when tax rates are higher, causing you to pay more tax overall. Remember, income tax rates increased in 2013.

The Installment Method

You generally must report an installment sale on your tax return under the installment method. Each installment payment typically comprises three components:

1. Interest income
2. Return of your adjusted basis in the property
3. Gain on the sale

For every taxable year in which you receive an installment payment, you must report as income the interest and gain components.

Calculating taxable gain involves multiplying the amount of payments, excluding interest, received in the taxable year by the gross profit ratio for the sale. The gross profit ratio is equal to the gross profit (the selling price less your adjusted basis)

divided by the total contract price (the selling price less any qualifying indebtedness, mortgages, debts and other liabilities assumed or taken by the buyer, that doesn't exceed your basis).

The selling price includes the money and the fair market value of any other property you received for the sale of the property, selling expenses paid by the buyer and existing debt encumbering the property (regardless of whether the buyer assumes personal liability for it).

You may be considered to have received a taxable payment even if the buyer doesn't pay you directly. If the buyer assumes or pays any of your debts or expenses, it could be deemed a payment in the year of the sale. In many cases, though, the buyer assumption of your debt is treated as a recovery of your basis, rather than a payment.

Dealers of time-shares and residential lots can report certain sales on the installment method if they elect to pay a special interest charge.

Your financial advisor may be able to help you structure your transactions to avoid this.

Many Considerations

While an installment sale can be beneficial to you as well as the buyer, be aware that you can elect out of installment sale tax treatment and report all of the gain as income in the year of the sale. This might be preferable if you expect tax rates to increase or you have loss carryforwards or other carryforward deductions. The rules are complicated and there are many factors to consider, so discuss with your accountant or financial consultant whether an installment sale could work for you.