What is an Installment Sale and When is it a Good Option?
Jan 25, 2013
Most businesses and private citizens must secure financing from a banking institution in order to purchase real estate. When the economy is growing at a solid pace and outlook is strong, it is relatively easy for persons with solid or even average credit to obtain such financing. However, when economic conditions worsen and it becomes more difficult to secure bank financing, sellers have another option for selling a piece of real estate. the installment sale.
An installment sale is an option for someone selling property, for a gain, where at least one payment is scheduled to be received after the tax year in which the sale occurs.
For example, if someone sold a piece of property in December of 2007 but were scheduled to receive payments in the following tax year (2008 and beyond), they would be eligible for an installment sale. This option does not apply to losses but can be a great way for someone to spread their tax liability over an extended period of time. However, the installment sale cannot be used to report gains from the sale of inventory or stocks/securities and is only used on real estate transactions.
The only exception to this rule occurs when the seller chooses to "elect out" and thus report all income as gain in the year of the sale rather than spreading it out over time. Otherwise, the seller must use the installment method where the income recognized for any taxable year is proportional to the payments received in that year. The payments themselves are taxed in three components, including:
To determine tax liability in any given year, it is important to calculate the gross profit ratio for the transaction. To calculate the gross profit ratio, the initial cost of the property is subtracted from the contract price and then divided by the contract price.
Assume that a buyer made an initial down
payment of $100,000 on a $225,000 property. The remaining $125,000 is carried back by the seller and amortized over 30 years with an interest rate of 7% and monthly payments of $830.00. In this scenario, the buyer makes the initial down payment and pays for six months in the year of the sale.
To calculate the tax liability of the seller, the gross profit ratio needs to be determined:
Contract Price = $225,000 (Total selling price of property)
Cost = -$50,000 (Original cost of property plus maintenance costs)
Gross Profit = +$175,000
Gross Profit Ratio = $175,000/$225,000 or 77.8%.
Thus, 77.8% of the $100,630 would be subject to capital gains tax in every single calendar year in which the seller receives payment for the property. In addition to the capital gains tax on the sale of the property, the seller would still need to declare the $4320 as taxable income. However, 22.2% of the principal received in any calendar year is considered tax free but all interest is taxable when received. Basically, the sale of the property created a capital gain anyway-the use of an installment sale simply spread capital gain tax liability over length of payment plan while adding an interest income tax liability.
An installment sale is a great way to spread a tax liability over an extended period of time, but it does carry a greater risk for the seller. Unlike a traditional sale where a bank loans the buyer the money necessary to purchase the property, the seller will not receive the total purchase price at once. While the installment sale does allow buyers to purchase real estate without bank financing, it also means the seller assumes greater risk regarding the buyer's creditworthiness and his ability to manage the asset responsibly. If the buyer is unable to make timely payments, the seller would be responsible for the costs of foreclosure and repossession.Source: www.investorguide.com