In addition to the sales price, the specific terms of a real estate contract play a vital role in making the transaction acceptable to all parties. Sellers of real estate may be able to remain in a lower tax bracket, as well as receive interest income, by selling a property through an installment sale.
An installment sale is a sale of property for which the seller receives some portion of the price after the year of disposition. For income tax purposes, a gain on the sale generally must be spread out over the years in which payments are received. There are several advantages to deferring the gain on an installment sale to a later year.
Lower tax rates
A large amount of gain reported in a single year may place you in a higher tax bracket. Payments received over multiple years are likely to also include interest income. A portion of the gain is included in each payment you receive, so it is necessary to determine precisely how much of each payment to report as taxable income.
Even though installment payments are received over multiple years, the total sales price of the property is compared to your cost basis to determine the amount of profit in each payment. Your basis in the sold property is your original cost plus any major improvements. The total gain on the sale is divided by the sales price to arrive at a gross profit percentage.
Gain in each payment
Based on the interest rate and the outstanding balance, a portion of each payment is interest income. The remaining portion of each payment consists of the two following components, each determined by your gross profit percentage:
- a nontaxable return of your cost basis
- the taxable profit
Capital gain tax treatment
Investment real estate is considered a capital asset, and it may be eligible for preferential capital gains tax treatment. The taxable portion of each installment payment is taxed as a capital gain, rather than at ordinary income rates. Interest income is ordinary income and is taxed at your regular income tax rate.
A seller can choose to opt out of installment sale reporting and include the entire gain in the year of sale. If you have current investment losses on other assets, you might prefer to use those losses to offset an installment sale gain in a single tax year.
Real estate used as a business asset is not eligible for capital gains tax treatment, but it can be sold through an installment sale. Contact a real estate attorney for more information about the advantages of selling your property in an installment sale. Consider Levin & Levin, LLP - Attorneys at Law, for your real estate needs.