The concept of paying for something on an installment plan is familiar to almost everybody. Instead of paying the entire cost of an item upfront, you pay a little over time, over several months or years. People commonly purchase items such as furniture and appliances on an installment plan. However, this method of payment is not limited to such household items. Consumers can purchase almost anything on an installment plan, including real estate. Installment sales of real estate have been around forever.
Installment sales of real estate are a form of seller financing. Instead of borrowing money from a bank or other financial institution to pay the seller, the buyer borrows from the seller. The buyer and seller enter into an installment agreement in which the buyer agrees to make a down payment and pay the remainder of the sales price over a term of years. It can be one year or a hundred; it's up to the buyer and seller to decide. The buyer also agrees to pay interest on the payments. Again, it's up to the buyer and seller to agree on the interest rate—it can be higher or lower than the rates mortgage lenders charge. The seller ordinarily takes back a purchase money mortgage from the buyer. This way, the buyer's promise to pay the seller is secured by the property—that is, if the buyer doesn't pay, the seller can foreclose and get the property back.
Any sale in which at least one payment is not due until the following year qualifies as an installment sale for tax purposes. Such sales must be reported to the IRS using the installment method unless the seller opts out of using this method by filing an election with the IRS.
Under the installment method, the payments received by the seller are divided into two classes:
Taxes need not be paid on the portion of the payments representing return of basis—the amount the seller originally paid for the property. Tax must be paid on the portion representing the gain from the sale; this is paid at capital gains rates, which are usually lower than ordinary income tax rates. The seller must also pay regular income tax on the interest paid each year. The following example shows how this works (for simplicity's sake, the house sale price is $100,000).
Example: Liz sells her rental house to Derek for $200,000. Derek pays Liz a $20,000 down payment and agrees to pay the remainder in equal $20,000 installments over the next nine years, plus 5% interest. Liz paid $80,000 for the house and owns it free and clear; so her total gain is $200,000 - $80,000 = $120,000. This means that 60% of each payment represents gain from the sale, and the other 40% is return of Liz's basis. When Liz receives her annual $20,000 payments from Derek she'll have to pay capital gains tax on $12,000. She'll also have to pay tax at ordinary income rates on the $10,000 in interest she receives each year.
Why would a seller do this? Isn't it always better to get the entire sale price upfront? Not always. There are many instances when getting paid over several years is better for a seller. If Liz from the above example had been paid the $200,000 sale price upfront, she would have had to pay tax on her entire $120,000 gain in the year of the sale. With the installment sale, she pays tax on $12,000 each year for 10 years. She pays tax on this amount at the 15% long-term capital gains rate, for a $1,800 annual tax. But she also is receiving interest payments from Derek on $200,000. This means that after she pays her tax, she effectively has $198,200 earning interest. If Liz receives the entire $200,000 sales price upfront, she would have had to pay an $18,000 capital gains tax on her $120,000 gain the year of the sale. This leaves her with only $182,000 to earn interest.
Installment sales can also save sellers money if the income from the sale would put them in a higher tax bracket if they receive it in one year. This is especially important for higher-income sellers who could be subject to the 3.8% net investment income tax. Single taxpayers with an adjusted gross income (AGI) over $200,000, and marrieds filing jointly who have an AGI over $250,000, are subject to this tax. Depending on their income, such taxpayers end up paying an 18.8% or 23.8% capital gains tax on their gains, instead of 15% or 20%. The key to avoiding this tax is to keep your AGI below these threshold levels. Using an installment sale can help you achieve this.
Installment sales are not for everybody. For example, if you own business property on which you've taken substantial depreciation deductions, an installment sale could be a tax disaster. This is because of depreciation recapture, which requires you to pay a 25% tax on the amount of the depreciation deductions you've taken. Even if you use an installment sale, you must pay this entire tax the year you sell the property. If you don't get the entire purchase price up-front, you may not have enough money to pay this tax.
If you're selling your home and qualify for the home sale exclusion, an installment sale may not save you any taxes. The exclusion exempts $250,000 of the profit from a home sale for singles and $500,000 for married filing jointly. But, if you have substantially more equity than the applicable exclusion, an installment sale could be a good idea.
For more on the subject, see IRS Publication 537, Installment Sales. Also, be sure to consult with your tax professional, lawyer, and real estate broker before doing an installment sale. There are many issues to consider and a lot at stake, so it pays to get advice from the pros in structuring a house installment sale agreement with a buyer.