Deferring Taxes with Installment Sales: What Real Estate Sellers Need to Know

Important Facts About Installment Notes

An installment sale is a sale where the seller receives at least one payment after the tax year in which the sale occurs. For example, an investor who is selling property for $5 million in 2017 receives $1 million in cash at the closing and a note from the buyer agreeing to pay the remaining $4 million over the next four years, plus interest at the rate of 6% per annum.

The two main advantages of an installment sale is that it may facilitate a sale if the buyer cannot find third party financing, and it allows the seller to defer paying tax on a portion of the gain because the gain is spread out over the term of the installment note. There are a few important things to remember when structuring an installment sale transaction.

What and How Is It Taxed?

The interest portion is taxed as ordinary income. Even if the note does not provide for interest, the tax laws may re-characterize some of the payments as interest.

The gain from appreciation of the property is spread out over the term of the installment note. There is a formula for computing which portion of each payment is considered gain, and you will need to pay tax on that portion of each payment at the applicable capital gains tax rate.

How is Depreciation Recapture Taxed?

When selling property, in addition to owing tax on the gain due to appreciation in the value of the property, taxpayers must pay tax on the “recapture of depreciation.” If the investor has taken depreciation deductions (or could have taken them), he pays tax on these deductions when he sells the property. All taxes on recapture of depreciation are due in the year of sale and cannot be deferred using an installment note. For some taxpayers in the current market, this is an important point to remember, because they may have as much recapture of depreciation gain as gain due to appreciation. For those taxpayers, an installment sale can only defer some of the gain (although a 1031 exchange could defer all gain if structured properly).

When I Start an Exchange in One Tax Year and Complete It in the Next, Can I Get Installment Sale Treatment on Any Excess Funds?

Some exchanges start in one tax year and are completed (or fail) in the next tax year. If there is excess cash after the completion of the exchange, the taxpayer won’t owe tax on that cash until he has a right to receive it. For example, assume an investor sells his relinquished property on November 30, 2017, and identifies and closes on the acquisition of replacement property early in 2018. Although the investor uses up some of his exchange funds, he has excess funds that are not used in the exchange and he receives those funds in 2018. Although his transaction will be partially taxable, the tax attributable to the cash received in 2018 is considered 2018 income and will not be due until 2019, when he files his 2018 tax return.

Can I Elect To Pay All of the Tax in the Year of Closing Rather Than Over Time?

Yes. It is possible to elect to pay all of the tax in the year of closing, even if some payments will be received in future years. To make this election,

• you must report the sale on Schedule D of Form 1040 and/or Form 4797, rather than the Installment Sale Form 6252,

• you must make this election by the due date, including extensions, for filing your tax return, and

• if you file your tax return without making this election, you can still make the election by filing an amended return within six months of the due date.

Once you make the election to be taxed in the year of closing, you will owe tax on all of the gain, even that gain that is attributable to payments you will receive in the future, and you cannot easily change your election so that you are taxed over time using the installment method. Once you elect to treat the transaction as taxable in the year of sale, you can revoke your election and go back to installment sale treatment only with IRS approval.