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Selling a property one has owned for an extended period will frequently result in a significant capital gain, and reporting all the gain in one year will generally expose the gain to higher-than-normal capital gains rates and subject the increase to the 3.8% surtax on net investment income.
Capital gains rates: Long-term capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer's taxable income for the year. The capital gains rate is zero at the low end for 2023 (not over $89,250 for joint filers, $59,750 for head of household status, or $44,625 for other filing statuses). If your taxable income is more than $553,850 (joint), $523,050 (head of household), $492,300 (single), or $276,900 (married separate), the capital gains rate is 20%. If your taxable income is between the low and high-end amounts, the rate is 15%. As you can see, more significant gains push the taxpayer into higher capital gains rates.
Surtax on net investment income – Tax law treats capital gains (other than those derived from a trade or business) as investment income upon which higher-income taxpayers are subject to a 3.8% surtax on net investment income. A significant gain generally pushes a taxpayer's income over the threshold for this tax. For individuals, the surtax is 3.8% of the lesser of (1) the taxpayer's net investment income or (2) the excess of the taxpayer's modified adjusted gross income (MAGI) over the threshold amount for their filing status. The threshold amounts are:
$125,000 for married taxpayers filing separately.
$200,000 for taxpayers filing as single or head of household.
250,000 for married taxpayers filing jointly or as a surviving spouse.
This is where an installment sale could fend off these additional taxes by spreading the income over multiple years.
Here is how it works. Suppose you sell your property for a reasonable down payment and carry the note on the property yourself. In that case, 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 a bank's charges. For a sale to qualify as an installment sale, at least one payment must be received after the year 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 no outstanding mortgage on the lot. Using the installment sale method, you sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest. No additional payment is received in the year of sale. The sales costs are $9,000.
Of your $60,000 down payment, $9,000 went to pay the selling costs, leaving you with $51,000 cash. The 20% down payment is 93.67% taxable, making the first year $56,202 ($60,000 x .9367) taxable. The amount of principal received and reported each subsequent year will be based on the terms of the installment agreement. In addition, the interest payments on the note are taxable and subject to the investment surtax.
Thus, in the example, using the installment method, the income for the year was reduced by $224,798 ($281,000 – $56,202). How that helps 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 would need to be paid off during the sale. Even if you do not have the financial resources to pay off the existing loan, there might be ways to work out an installment sale by taking a secondary lending position or wrapping the current loan into a 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 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 five years could cause the higher tax rate and surtax to apply to the seller that year – so close attention must be paid 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. 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 when the installment payments are received under the laws in effect. 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 only work in some situations. To determine whether an installment sale will fit your needs and circumstances, please get in touch with this office for assistance.