Preface: Installment sales, when convenient and permissible, can defer payments on capital gains tax. Talk with your CPA if you are selling property that qualifies for an installment sale to determine if it is right tax plan for the deal.
Capital Gain Deferrals with Installment Sales
Credit: Donald J. Sauder, CPA | CVA
Thinking of selling property with owner financing? Maybe you’re optimized tax plan is an installment sale–a sale of property that occurs when one or more payments occur after the tax year of ownership transfer, and gain is deferred. Deferral is the key word here. If a sale qualifies for an installment sale gain recognition, the deferred gain must be reported with installment sale methods unless your tax accountant elects out of the installment method on the sale in the initial year of filing.
Here’s how an installment works. Suppose Marvin sold his Selingsgrove farmland to Will for $2 million, to be paid in equal installments over 10 years, plus interest. Let’s say Marvin’s basis in the farmland was $1 million, and the deed was mortgage free. Marvin would receive a payment for $200,000 in the first year of sale and prorate his capital gain over the 10-year payment period. This would therefore result in stretching the deferral of tax payments on capital gains of $1 million ($2 million sale price minus $1 million basis). Marvin would report the sale of property on IRS Form 6252 with the following parameters: on IRS Form 6252, Marvin’s CPA would report the sale with a description of the property and selling price, and calculate the gross profit with the contract price ratio for the gain percentage on the installment sale (50% = $2 million/$1 million). In this example, would report $100,000 (50% of $200,000) of capital gain on his tax return in the first year of sale, versus $1 million. This would reduce his tax burden from $250,000 of capital gains tax in the year of sale to say only $25,000.
Now let’s look at depreciation recapture if the property had a $1 million building. All depreciable installments sales must report the depreciation recapture in the year of sale. If Marvin sold the farmland with a building with Section 1250 Property, buildings such as a barn or house, and the depreciation accumulated on the building was $200,000, Marvin would need to pay tax on the entire depreciation recapture of $200,000 in the year of sale. This is income recapture reported on IRS Form 4797.
Special caution: if you sell property with payment from an irrevocable escrow fund for the remaining payments, the gain must be reported and capital gains tax paid in the year of sale because payment is guaranteed. Installment sales to related parties with depreciable property is permitted only under the exception that no benefit will be derived from the sale.
In certain instances, partnership interests can be sold with the installment sale methods as a single capital asset. The gain or loss on accounts receivable and inventory will be deferred, but the ordinary income or loss and depreciation recapture will be taxed in the year of sale. The capital assets such as goodwill can be sold on the installment basis with deferred gain. To optimize tax planning, talk with your CPA before beginning to sell your business.
Installment sales cannot be used for sales of inventory, dealer sales, stock or securities traded on an exchange or installment obligations, such as a purchaser’s obligation to make future payments that can be in form of notes, mortgages, or other evidence of debt.
In summary, installment sales, when convenient and permissible, can defer payments on capital gains tax. Talk with your CPA if you are selling property that qualifies for an installment sale to determine if it is right for the deal.