Posted by Tini Graff, CPA
Making a profit when selling a piece of property should be a really good thing. However, have you ever worried about how much tax you have to pay on that profit, particularly when being paid over the course of a few years? If you are not receiving all of the cash from the sale, how could you possibly afford to pay the taxes? You are in luck! You don’t have to! Long ago, Congress enacted the installment method for reporting this type of gain.
Without the installment method, you would be responsible for paying tax on the total gain on the sale of the property in the year of the sale. This would be difficult if you have low cash flow outside of the proceeds you will be receiving. While you made out well on the deal, you may only have a small percentage of the cash to show for it. This would make paying Uncle Sam very difficult. However, under the installment method, you would pay taxes over time as the cash is received. Not a bad deal!
So, how does it work? Let’s use a very basic example. Let’s say you sell your vacation home for $500,000, but you only paid $200,000 for it. Sounds like you made a good investment! Assuming the house was never rented or depreciated and no improvements were made, your total taxable gain on the sale would be $300,000 (the sales price of $500,000 less the $200,000 purchase price). Also, you have a contract with the purchaser in which he/she will make annual payments of $60,000 over the course of ten years and you will earn approximately 3.5% interest. If you chose not to use the installment method, you would be required to pay tax on the full $300,000 gain in the year of the sale. However, you would only receive the first annual payment of $60,000 in cash, of which about $17,000 is interest and $43,000 is principal. That could be tough. If you chose to use the installment method, the gain would be recognized over time as the annual payments are received.
The calculation in determining the gain on the sale for the current year is a multi-step calculation. First, the gross profit percentage from the sale is calculated. The gross profit percentage is equal to the total gross profit divided by the contact price, which in this case would be 60% ($300,000/$500,000). This is then multiplied against the total principal received during the current year to determine the gain. In year one, the gain reported on the sale would be $25,800, which is 60% (the gross profit percentage) of $43,000 (total principal payments received during the year). Therefore, instead of paying tax on $300,000, you would only pay tax on $25,800. Assuming a 20% tax bracket, we are looking at $5,160 rather than $60,000! You would also pay tax on the $17,000 of interest income you received, but that would occur regardless of which method you chose for the sale.
Of course, there are several rules and exceptions associated with the installment sale method. There are certain types of property which are not eligible for installment sale treatment, the type of income reported (capital or ordinary) varies based on the type of property being sold, and different states treat installment sales differently. However, in many cases, this option can be very beneficial. For more details, please consult with your tax advisor.