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.
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 2022.1 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 2023.2 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.
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.3 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.
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).4
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.
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Mark P. Cussen I Investopedia I April 8, 2023