Selling a property one has owned for a long period of time will frequently result in a large capital gain. And reporting all of the gain in one year will generally expose the gain to higher than normal capital gains rates. This is and subjects the gain to the 3.8% surtax on net investment income added by Obamacare.
Long-term capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer’s regular tax bracket for the year. At the low end, if your regular tax bracket is 15% or less, the capital gains rate is zero. If your regular tax bracket is 25% to 35%, then the top capital gains rate is 15%. However, if your regular tax bracket is 39.6%, the capital gains rate is 20%. As you can see, larger gains push the taxpayer into higher capital gains rates.
Surtax On Net Investment Income
Tax law treats capital gains as investment income. Upon which higher-income taxpayers are subject to a 3.8% surtax on net investment income. The exception to this is those capital gains derived from a trade or business. A large gain generally pushes a taxpayer’s income over the threshold for this tax. For individuals, the surtax is 3.8% of the lesser of:
- The taxpayer’s net investment income or
- The excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount for his or her filing status.
The threshold amounts are:
- $125,000 for married taxpayers filing separately.
- $200,000 for taxpayers filing as single or head of household.
- $250,000 for married taxpayers filing jointly or as a surviving spouse.
This is where an installment sale could fend off these additional taxes by spreading the income over multiple years.
How does an installment sale work?
If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment that represents taxable gain. In addition, any other principal payments received in the year of sale will also be subject to capital gain. You can then collect interest on the note balance at rates near what a bank charges. For a sale to qualify as an Installment Sale, at least one payment must be received after the year in which the sale occurs. Installment sales are mostly used when the property that is sold is real estate, That real estate cannot be used to report the sale of publicly traded stock or securities.
Example of How An Installment Sale Works
Example: You own a lot for which you originally paid $10,000. You paid it off some time ago. This left you with no outstanding mortgage on the lot. You sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $9,000.
|Computation of Gain|
|Sale Price $300,000|
|Cost < $10,000>|
|Sales costs < $9,000>|
|Net Profit $281,000|
|Profit % = $281,000/$300,000 = 93.67%|
Of your $60,000 down payment, $9,000 went to pay the selling costs. This leaves you with $51,000 cash. The 20% down payment is 93.67% taxable, making $56,202 ($60,000 x .9367) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. In addition, the interest payments on the note are taxable and also subject to the investment surtax.
Thus in the example, by using the installment method the income for the year was reduced by $224,798 ($281,000 – $56,202). How that helps the taxpayer’s overall tax liability depends on the taxpayer’s other income and circumstances.
Additional Considerations When Contemplating an Installment Sale
If the property you are considering to sell is currently mortgaged, that mortgage would need to be paid off during the sale. Even if you do not have the financial resources available to pay off the existing loan. However, there might be ways to work out an installment sale by taking a secondary lending position or wrapping the existing loan into the new loan.
Tying Up Your Funds
Tying up your funds into a mortgage may not fit your long-term financial plans, even though you might receive a higher return on your investment and potentially avoid a higher tax rate and the net investment income surtax. Shorter periods can be obtained by establishing a note due date that is shorter than the amortization period. For example, the note may be amortized over 30 years, which produces a lower payment for the buyer but becomes due and payable in 5 years. However, a large lump sum payment at the end of the 5 years could cause the higher tax rate and surtax to apply to the seller in that year. Therefore, close attention needs to be paid to the tax consequences when structuring the installment agreement.
Early Payoff of the Note
The buyer of your property may decide to pay off the installment note early or sell the property, in which case your installment plan would be defeated. The balance of the taxable portion would be taxable in the year the note is paid off early or when the property is sold. The exception would be unless the new buyer assumes the note.
Tax Law Changes
Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws are changed, the tax on the installment income could increase or decrease. Based on recent history, it would probably increase.
Does an installment sale work in all situations?
Not always. To determine whether an installment sale will fit your particular needs and set of circumstances, please contact Alex Franch, BS EA at 781.849.7200 for assistance in planning your real-estate transactions. Worthtax has locations in Quincy, Weymouth and Dedham..