Preface: Installment sales can defer capital gain taxes. When and how can installment sales work for your. Read further…

 

Capital Gain Deferrals with Installment Sales

 

Thinking of selling property with owner financing? Maybe you’re looking at 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 Jacob sold his farmland to Will for $2,000,000, to be paid in equal installments over 10 years, plus interest. Let’s say Jacob’s basis in the farmland was $1,000,000, and the deed was mortgage free. Jacob 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 therefore would result in stretching the deferral of tax payments on capital gains of $1,000,000 ($2m sale price – $1m basis). Jacob would report the sale or property on IRS Form 6252 with the following parameters. On IRS Form 6252 Jacob’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 of 50% ($1m/$2m). In this example Jacob would report $100,000 (50% of $200,000) of capital gain on his tax return in the first year of sale, versus $1,000,000. This would reduce his tax burden from say a $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 $1,000,000 building. All depreciable installments sales must report the depreciation recapture in the year of sale. If Jacob sold the farmland with a building with Section 1250 Property, i.e. buildings such as a barn or house, and the depreciation accumulated on the building was $200,000. Jacob would need to pay tax on the entire depreciation recapture $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, e.g. avoidance of federal income tax, was not the principal purpose of the sale.

In certain instances partnerships interests can be sold with the installment sale methods as a single capital asset. The gain or loss on accounts receivable and inventory will not be deferred. They along with 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. Talk with your CPA before beginning to sell your business, to optimize tax planning.

Installment sales cannot be used for sales of inventory, dealer sales, stock or securities traded on an exchange or installment obligations, i.e. purchaser’s obligation to make future payments that can be in form of notes, mortgages or other evidence of debt.

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.