More and more taxpayers it seems are finding themselves compelled to engage in a structured installment sale of closely held business assets or rental real estate and I couldn't help but notice that there are some common misconceptions about the associated tax implications, particularly if 'related parties' are involved in a transaction. So this is what I am telling people:
Report installment sales on IRS Form 6252
Report interest from installment sales on Schedule B
Report capital gains from installment sales on Schedule D.
Beware of some pitfalls. For example if you elect installment treatment on a sale to a relative (spouse, child, grandchild, parent, grandparent, sibling) and they resell the property within two years of the original sale date, you’ll owe tax on the entire remaining unpaid balance the year the relative sells the property.
Another pitfall to be aware of is if you like installment sale tax advantages, but you’re worried your buyer might default on payments, consider a “structured sale,” where you take part or all of your proceeds in the form of commercial annuity payments. Here’s how it works:
- You negotiate a traditional installment sale with your buyer.
- Your buyer assigns the right to make payments to an independent third-party and pays the purchase price, in cash, to that third party. (Using a third party avoids the “constructive receipt” which would make the sale immediately taxable.)
- The third party uses the buyer’s cash to buy an immediate annuity from a top-rated life insurance company.
- You pay taxes on your gain as you receive those annuity installments.
Installment sales where you receive payments in more than one tax year let you defer tax on sales until you actually receive those payments. Tax is divided among the actual installments and due as you receive them. Here’s how it works:
- Calculate your gain on the sale.
- Calculate the percentage of your total sale price consisting of basis and the percentage consisting of taxable gain.
- Multiply each installment by your profit percentage to figure taxable gain from that installment.
- You have to charge adequate interest on each installment. Otherwise the IRS can re-characterize part of each installment as interest, taxed at ordinary rates, instead of capital gain. The minimum rate is generally the “applicable federal rate” in effect at the time of the sale. Interest on unpaid installments is taxed as ordinary income.
For example, generally speaking, if you buy a building for $600,000 then sell it for $1 million. 40% of your sale price is gain, so 40% of each installment is taxed as capital gain.
Beware of these rules for special circumstances:
- If you sell depreciated property, you’ll owe tax on recaptured depreciation at ordinary rates, and on “un-recaptured Section 1250 gain,” capped at 25%, in the year of sale.
- You can’t elect installment sale treatment for depreciable property you sell to a business you control or a to trust with you or your spouse as a beneficiary.
- If you sell property with no fixed price, such as an “earnout” sale of a business or property for a fixed percentage of sales or rent, divide the property’s basis into the term of the installments, then pay tax on any gain above that amount.
- If the total of installment payments owed to you in any year tops $5 million, you’ll owe interest at the federal underpayment rate on the balance exceeding $5 million.
- If your buyer assumes a mortgage, subtract that debt from the gross sale price before figuring gain on the sale.
- If your buyer unexpectedly prepays installments, you’ll owe tax as soon as you receive them. Consider using a structured sale to avoid this unpleasant surprise.