Avoiding a Big Tax Bill on Real Estate Gains

Owning real estate is a big dream for many investors. But it’s a huge investment—one that can be fairly lucrative. Selling a rental property for a huge profit can be a dream come true. Still, to maximize the profit from such a sale, you need to minimize the taxes on it. An installment sale is one strategy. Don’t worry: This is Internal Revenue Service (IRS) approved.

Big Payout Equals Big Tax Bill

Let’s take a look at a common situation:

Hal Bookman looked at the buyer’s offer for his rental home, and he couldn’t believe the number he saw. His property value increased substantially in only five years. However, when Hal gleefully told his tax advisor about the sale, the advisor was cautious: Taking the income as a lump sum payment would not be in Hal’s best interest from a tax perspective.

If Hal declares the entire proceeds of the sale in the same year he sells the property, he pays 25% on the portion of the gain that corresponds to any depreciation deductions he has previously taken on the rental property.

Any gain beyond the depreciation recapture is taxed at 15% for taxpayers with taxable income between $41,676 and $459,750 if single, or $83,351 and $517,200 if married filing jointly in 2022. These amounts increase to $44,625 and $492,300 for single filers, as well as $89,250 and $553,850 for married couples filing jointly in 2023. Taxpayers with income above these thresholds are taxed at 20%

Hal asks his tax advisor if there is anything he can do to reduce his taxable income for the year. The advisor knows just the tool to use: an installment sale agreement.

What Is an Installment Sale?

An installment sale is defined as the sale of property in which at least one payment is not made until after the tax year of the sale.

The IRS allows taxpayers to defer a portion of the gain on the sale of an investment property with an installment sale agreement. This arrangement permits sellers to declare a prorated portion of their capital gains over several years.

A seller is not allowed to use the installment sale method when reporting a loss.

How the Installment Sale Method Works

Declaring gains under an installment sale is theoretically simple. The taxation of installment sales mirrors that of annuities, in which a prorated portion of each payment is considered a return of principal.

The only stipulations are that the property being sold cannot be a publicly traded security or a part of a firm’s regular inventory, and the taxpayer cannot be a dealer of the sold property (with the exception of certain timeshare dealers who elect for a special interest charge under the installment sale method).

Reporting Installment Sale Income

Installment sale income can be broken down into three separate categories: capital gain, interest, and principal. Each of these is treated separately on Form 1040.

The gross profit percentage is then used to figure installment sale income for a given tax year.

Capital Gain

In the above example, Hal must declare the gain each year as being either long-term or short-term, depending on which it was in the year of the sale. Long-term gains are taxed at a lower rate, while short-term gains are taxed as ordinary income.

Because Hal held the house for five years, the gain, in this case, would be long-term.

If the gain had been short-term, Hal still may be taxed on the installment income at a lower rate than he would have if he had to declare the lump sum gain. This is because short-term gains are taxed as ordinary income, at the taxpayer’s top marginal tax rate.

If the prorated gain does not push him into the next tax bracket, this rate may be lower. The gain from an installment sale is reported on IRS Form 6252 and then carried to Schedule D on Form 1040.

Interest

Taxpayers with installment sale income must also report interest charged to the buyer, which is taxed at ordinary income rates.

Interest provided in the sales contract is referred to as stated interest. If stated interest is insufficient (or zero), part of the principal portion of the sale must be recharacterized as unstated interest.

Principal

Part of each installment sale is considered by the IRS to be a tax-free return of principal. This amount can be determined by filling out Worksheet A on Publication 537.

The principal (adjusted basis) for installment sale purposes is the total of your actual adjusted basis in the property plus any selling expenses and depreciation recapture.

In this example, Hal has $200,000 as an adjusted basis in his home. He must add back $100,000 for his depreciation recapture and $10,000 for selling expenses in order to calculate his adjusted basis for installment sale purposes. This figure is $310,000.

Gross Profit Percentage

To calculate the gross profit percentage, you must subtract the adjusted basis for installment sale purposes—$310,000, in this example—from the sale price in order to calculate the total gain. In this example, the total gain is $90,000 ($400,000 – $310,000).

Next, divide the total gain by the sale price, which in this case is 22.5% ($90,000 ÷ $400,000), and you have the gross profit percentage.

Finally, to calculate the taxable gain each year, multiply this percentage by the amount of the installment. Thus, Hal’s taxable gain each year is considered to be $11,250 ($50,000 x 22.5%).

Mortgages and Contract Price

If the buyer of the property assumes a mortgage or some other promissory note with the purchase, the cost basis of the property must be reduced by the amount of the mortgage or note. To return to our example, let’s say that Hal has a $100,000 mortgage on the property he sold.

If the rental property that Hal sold for $400,000 has a mortgage of $100,000, the contract price is reduced to $300,000 ($400,000 – $100,000).

If the amount of the mortgage exceeds the total adjusted basis of the property, the difference must be reported as a payment in the first year and the contract price is increased by that amount.

For instance, say that Hal’s property has a mortgage of $250,000. In addition to the installment payment, Hal will have to report an excess payment of $50,000 ($250,000 – $200,000) during the first year.

Example of an Installment Sale

Using the example from above, let’s see how Hal could structure his installment sale if he wanted to defer his capital gain taxes to a future year.

Hal receives an offer of $400,000 for his rental home. He bought the property for $300,000. Over the years, he has taken $100,000 in depreciation deductions, making his adjusted basis $200,000.

Therefore, Hal has $200,000 ($400,000 – $200,000) of taxable gains to declare.

Hal’s advisor recommends he break down his sale proceeds into eight annual installments of $50,000 each instead of declaring $400,000 in one year. As long as the installments are constructively received each year, this method will allow Hal to record the profits, and therefore a prorated portion of the gains, over the eight years.