Using Installment Sales to Defer Taxes

July 2021

Selling a property one has owned for a long period of time will frequently result in a large capital gain. Reporting all of the gain in one year will generally expose it to higher-than-normal capital gains rates and subject the gain to the 3.8% surtax on net investment income. With higher capital gains tax rates potentially on the horizon, it’s important to know your options for deferring tax on gains. One of those deferral opportunities is what’s known as an installment sale. An installment sale could fend off taxes imposed at higher levels of income by spreading the income over multiple years.

Here is how it works. If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what banks charge. For a sale to qualify as an installment sale, at least one payment must be received after the calendar year in which the sale occurs. Installment sales are most frequently used when the property that is sold is real estate and cannot be used to report the sale of publicly traded stock or securities.

Example: You own a lot for which you originally paid $10,000. You paid it off some time ago, leaving you with no outstanding mortgage on the lot. You sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $9,000.

Of the $60,000 down payment you received, $9,000 went to pay the selling costs, leaving you with $51,000 cash. The 20% down payment is 93.67% taxable, making $56,202 ($60,000 x .9367) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. Additionally, the interest payments on the note are taxable and also subject to the investment surtax.

Thus, in the example, by using the installment method the income for the year was reduced by $224,798 ($281,000 – $56,202). The impact on the taxpayer’s overall tax liability depends on the taxpayer’s other income and circumstances.  

Here are some additional considerations when contemplating an installment sale.

Existing mortgages – If the property you are considering selling is currently mortgaged, that mortgage must be paid off during the sale. Even if you do not have the financial resources available to pay off the existing loan, there may be ways to work out an installment sale by taking a secondary lending position or wrapping the existing loan into the new loan.  

Tying up your funds – Tying up your funds into a mortgage may not fit your long-term financial plans, even though you might receive a higher return on your investment and potentially avoid a higher tax rate and the net investment income surtax. Shorter periods can be obtained by establishing a note due date that is shorter than the amortization period. For example, the note may be amortized over 30 years, which produces a lower payment for the buyer but becomes due and payable in 5 years. However, a large lump sum payment at the end of the 5 years could induce the higher tax rate and surtax to apply to the seller in that year. So pay close attention to the tax consequences when structuring the installment agreement.

Early payoff of the note – The buyer of your property may decide to pay off the installment note early or sell the property, in which case your installment plan would be defeated and the balance of the taxable portion would be taxable in the year the note is paid off early or the property is sold, unless the new buyer assumes the note.

Tax law changes – Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws are changed, the tax on the installment income could increase or decrease. Based on recent history, it would probably increase.

Installment sales do not always work in all situations. Contact Cray Kaiser to determine whether an installment sale will fit your particular needs and circumstances.