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Selling a property you have owned for an extended period will frequently result in a significant capital gain, and reporting all of the gains in one year will generally expose the gain to higher than average capital gains rates and subject the gain to the 3.8% surtax on net investment income.
Capital gains rates: Rather than being taxed at ordinary income tax rates, which currently can be as high as 37%, long-term capital gains (LTCG) can be taxed at 0%, 15%, or 20%, depending upon your overall taxable income for the year. "Long-term" means that you've owned the property you sold for over one year. In most cases, taxable income is your adjusted gross income less the standard deduction for your filing status or itemized deductions claimed on Schedule A of Form 1040.
At the low end, if you file a joint return with your spouse and your 2024 taxable income is $0 through $94,050, the LTCG rate is zero. The zero-rate taxable income limits for other filing statuses are $63,000 for head of household and $47,025 for single and married separate.
If you file a joint return and your taxable income is $94,051 through $583,750 ($63,001 - $551,350 if the head of household, $47,026 - $518,900 if single, or $47,026 - $291,850 if married separate), then the top long-term capital gains rate is 15%. If your taxable income exceeds the 15%-rate limit, the LTCG rate is 20%. As you can see, more significant gains push you 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 their net investment income. A significant gain may push your income over the threshold for this tax. The surtax is 3.8% of the lesser of (1) your net investment income or (2) the excess of your modified adjusted gross income (MAGI) over the threshold amount based on your 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 installment sales work. 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 5% 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 also subject to the investment income surtax.
Thus, in the example, the taxable income for the year was reduced by $224,798 ($281,000 – $56,202) using the installment method. How that helps your overall tax liability depends on your 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 available to pay off the existing loan when the sale is structured as a regular installment sale, there might 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 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 you in that year – so close attention needs to 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. The pay ranges at which the 0%, 15%, or 20% capital gain rates apply are adjusted annually for inflation, which favors taxpayers. Still, Congress could decide to remove the favorable LTCG rates in future years, which is certainly not advantageous for taxpayers.
Installment sales do not always work in all situations. Contact us to determine whether an installment sale will fit your needs and circumstances.