Defer The Tax Impact On Gains From The Sale Of Real Estate
The value of real estate has significantly increased over the past few years, which means it’s a great time to be a seller – except when it comes to that pesky tax bill. Fortunately, there are strategies available that can help you defer your tax payments over a period of time.
If you’re thinking about selling your home, and have owned and lived in it for at least two years, you may be able to exclude gains up to $250,000 (single) or $500,000 (joint) from your income. But what if you are expecting to get hit with significant gains from the sale of real estate that’s not your residence? Are there any tax-saving strategies out there for you?
This article will provide you with some insight into the installment sales agreement, which can be used as a tax strategy that will help you avoid a big tax bill during the year in which you are planning to sell. Keep reading to learn more about this method.
Why Use An Installment Sales Agreement
Rather than pay a large tax bill on the entire gain of the property, some sellers choose to utilize an installment sales agreement, which allows them to report a prorated portion of their capital gains over several years. Plus, because of the time element associated with installment sales agreements, interest will be added to the buyer’s cost, which means additional income for the seller.
How Installment Sales Agreements Work
When you use the installment sales agreement strategy, what you’re actually doing is classifying a prorated portion of each payment as a “return of principal.” For example, imagine Bill, is selling his rental property, which he originally purchased for $200,000, for $500,000. Over time, Bill reported depreciation of $60,000 to his property. Then, when the time came to sell, he found himself on the hook for $30,000 worth of selling costs. When it’s all said and done, today, Bill’s taxable basis of the property is equal to $170,000.
But, instead of reporting the entire gain of $330,000 ($500,000 – $170,000 = $330,000) during in the year the property was sold, Bill chooses to enter into an installment sales agreement. In doing so, he will still receive the $500,000 from the sale of his property, just over a 10-year period – or $50,000/annually.
How To Report Installment Sale Income
Now comes the fun part … taxes.
Because Bill chose to enter into an installment sales agreement, he will have to report his capital gains income every year throughout the course of the agreement. Here’s what Bill can expect to happen.
Bill will receive principal payments of $50,000 every year for 10 years. Of that amount, a portion must be reported as capital gains income each year he receives an installment. This means Bill must report the gross profit percentage from the sale multiplied by the principal he receives annually. In Bill’s case, the gross profit percentage equals 66 percent, which is the gain that’s recognized on the sale of $330,000 (as shown above), divided by the selling price of $500,000. Which means, in this scenario, the capital gain Bill must report to the IRS is $33,000.
Capital gains from the sale of your property aren’t the only income you’ll have to report to the IRS every year. When entering into an installment sales agreement, you’ll also receive income in the form of interest payments. This income can be used to help offset taxes associated with the annual installment from sale of your property. Just remember that this income will be subject to regular income tax rates.
So, back to Bill. Say he charges an interest rate of 5 percent to the buyer. Every year, he would receive (and would have to report) interest income of approximately $2,500 annually.
Taking advantage of an installment sales agreement can be a great way to defer tax payments from the sale of property. Give me a call at 216.573.9055 to find out if this method makes sense for you, or email Rea & Associates to speak with a member of our construction and real estate team.
By Jeanine Mooren, CPA (Cleveland office)