Need to sell real property? Try an installment sale.

Is an installment sale right for you?

TJCIf you or your company owns real property, you may not always be able to dispose of it as quickly as you’d like. One avenue for perhaps finding a buyer a little sooner is by financing it yourself through an installment sale.

Benefits and risks
An installment sale occurs when you transfer property in exchange for a promissory note and receive at least one payment after the tax year of the sale. Doing so allows you to receive interest on the full amount of the promissory note, often at a higher rate than you could earn from other investments.  The installment sale rules allow the seller to defer the recognition of gain on the sale of the property in a manner that mirrors the receipt of the installment payments.

This deferral can be a very favorable tax benefit for sellers, but there may be some risks as well. For instance, the buyer may default on the loan, and you may have to deal with foreclosure.

Methodology
You generally must report an installment sale on your tax return under the “installment method.” Each installment payment typically consists of interest income, return of your adjusted basis in the property and gain on the sale. For every taxable year in which you receive an installment payment, you must report as income the interest and gain components.

Calculating taxable gain involves multiplying the amount of payments, excluding interest, received in the taxable year by the gross profit ratio for the sale. The gross profit ratio is equal to the gross profit (the selling price less your adjusted basis) divided by the total contract price (the selling price less any qualifying indebtedness — mortgages, debts and other liabilities assumed or taken by the buyer — that doesn’t exceed your basis).

Facts:
Proceeds  $1,000,000
Basis   $650,000
Realized Gain  $350,000

Year 1 Principal $68,000
Year 1 Interest  $54,000

Gain Calculation:
Year 1 Principal $68,000
X Gross Profit Ratio 35%
Year 1 Gain   $23,800

The selling price includes the money and the fair market value of any other property you received for the sale of the property, selling expenses paid by the buyer and existing debt encumbering the property (regardless of whether the buyer assumes personal liability for it).

You may be considered to have received a taxable payment even if the buyer doesn’t pay you directly. If the buyer assumes or pays any of your debts or expenses, it could be deemed a payment in the year of the sale. In many cases, though, the buyer’s assumption of your debt is treated as a recovery of your basis, rather than a payment.

See the example below for how recognized gain is calculated.

Facts:
Proceeds  $1,000,000
Basis   $650,000
Realized Gain  $350,000

Year 1 Principal $68,000
Year 1 Interest  $54,000

Gain Calculation:
Year 1 Principal $68,000
X Gross Profit Ratio 35%
Year 1 Gain   $23,800

It is important to note that items that are required to be recaptured at a different rate on the sale still need to be recognized.  For example, Section 1245 or Unrecapture Section 1250 gain need to be recognized in the year of the sale.

Complex rules
The rules of installment sales are complex. The best advice we can offer is:  “Don’t go it alone.” The Ciuni & Panichi, Inc. team has over 40 years of experience helping business owners and individuals make sound business and financial decisions. For real estate and construction advice and/or accounting services, contact Tony Constantine, CPA, Partner, at 216-831-7171 or tconstantine@cp-advisors.com

You may also be interested in:

How to Detect and Prevent Expense Reimbursement Fraud

Are Your Business Taxes Going Up or Down?

© 2017