In today’s slower real estate market, lenders are more cautious about making loans and sellers are more inclined to agree to carry financing to sell their properties more quickly. When a seller carry’s financing, the seller bears risk that the buyer might default on the promise to pay back the loan. But if a buyer makes a substantial down payment and is sufficiently credit worthy, and if the seller either owns a property outright or has the resources to pay off any remaining mortgage, installment sales can be beneficial to both parties and the risks might be tolerable for the seller. They allow a buyer to close quickly and give a seller a way to reap a higher return on the equity while deferring income taxes. (A seller may also “elect out” of deferring gains received in an installment sale by reporting the entire gain on a timely filed tax return for the year of sale.)
How Installment Sales Work?
An installment sale of real estate allows for the deferral of gain recognition from the sale or disposition (other than real property held by a dealer) where there is at least one payment of the purchase price that will be received after the close of the year of sale. (It is beyond the scope of this article to explain the ramifications of the seller being a dealer.) In addition to producing regular income for the seller, the installment method allows the seller/taxpayer to recognize only the percentage of the overall capital gain received in any one tax year, instead of all in the year of the sale. Because the seller recognizes the gain over the taxable years in which the payments are actually received, the seller is able to defer payment of income taxes that are assessed on that gain. In addition to benefiting investor sellers, deferring taxes can be a real benefit to homeowners whose capital gain exceeds the $250,000 individual exemption on the sale of a principal residence or who have not held the home for the two-year period required. Installment sales benefit investment sellers who don’t want to use a Section1031 exchange to defer taxes.
Each installment payment on a home usually consists of three elements:
- a partial return of the seller’s adjusted basis in the property sold, which is not taxable to the seller,
- a portion of the taxpayer’s realized gain on the sale, which is taxable as a capital gain, and
- accrued interest, which is taxable as ordinary interest income.
Each year, a seller receiving payments from an installment sale must determine how much of the year’s payments is taxable as capital gains and how much is a nontaxable recovery of the seller’s cost basis. The tax payer multiplies the non-interest portion of the total payments received in that year by the gross profit ratio for the sale.
The gross profit ratio is the taxpayer’s total anticipated gross profit, divided by the total contract price. The anticipated gross profit is the contract price less the taxpayer’s adjusted basis. The taxpayer’s adjusted basis starts with the original purchase price, including initial closing costs: then increased by any capital improvements and the selling expenses incurred in the sale: then reduced by any depreciation taken, or that could have been taken, during the time of the seller’s ownership.
The “contract price” is equal to the selling price, reduced by the amount of any qualifying indebtedness which is assumed or taken subject to by the buyer. Qualifying indebtedness may include any a mortgage or other debt encumbering the property, plus any debt that is incurred or assumed by the buyer incident to the buyers’ acquisition.
Qualifying indebtedness is, however, limited to the seller’s adjusted basis in the property. Thus, if the seller has refinanced the property and taken cash in an amount that creates indebtedness greater than the seller’s adjusted basis, the qualified indebtedness for purposes of calculating the contract price is limited to the adjusted basis. In other words, the gross profit percentage can never be greater than 100%. Note that the lender holding any existing mortgage must approve any loan assumption.
Consider the following example of the sale of raw land. In Year 1, Seller sold Black Acre to Buyer. Buyer paid $200,000 in cash at closing and agreed to assume the current $200,000 mortgage. Seller agreed to seller-finance $800,000 of the purchase price over a five-year installment note, with the first installment being due in Year 2.
|Selling price for Property||$1,200,000|
|Less: Mortgage assumed by Buyer||(200,000)|
|The “contract price”||$1,000,000|
|Selling price for Property||$1,200,000|
The gross profit of $400,000 is divided by the contract price of $1,000,000 to determine a gross profit ratio of 40 percent. In applying the gross profit percentage of 40 percent to the $200,000 of cash received in Year 1, the Seller will recognize $80,000 of gain in the year of the sale. If the principal portion of the payments received by Seller in Year 2 is equal to $160,000, Seller will recognize gain in Year 2 equal to 40 percent of $160,000, or $64,000. (An example for real property that depreciates (such as an office building) would be more complicated because the IRS taxes the gain from appreciation at a maximum rate of 15% and the gain resulting from the tax depreciation at 25%.)
An installment note must include an adequate stated rate of interest to be paid by the buyer to the seller. An adequate rate of interest is one that is equal to, or greater than, the Applicable Federal Rate (“AFR”) published by the IRS on a monthly basis. (It is beyond the scope of this article to address the consequences of the stated rate of interest being less than the AFR.)
Any installment seller should consult an attorney to better understand the risks of default by the buyer, and means to reduce the risk of a buyer default.