Investment Property--Planning For Installment Sales
Suppose you want to sell investment property but you cannot find a cash buyer. You may have to settle for installment payments. Even with appropriate safeguards, financing the purchase in this fashion would be unattractive if you had to pay tax on the entire profit in the year of the sale. Fortunately, the tax installment sale rules generally allow you to match the payment of tax on realized gain to your receipt of payments. These rules can be used for sales of real estate held as investment property and for sales of closely held stock. However, they are not available for sales of publicly-traded stocks or bonds.
The installment method applies automatically if you are eligible to use it and receive at least one payment after the close of the tax year in which the sale takes place. However, you can chose not to use it, and there are times when you should make this choice. This letter examines these and some other planning considerations that arise when one is considering an installment sale.
For one thing, an individual who sells property on the installment basis will want to take steps to minimize risks beyond making the buyer personally liable on the loan. But you have to be careful when structuring protection because if you go too far you will jeopardize the tax deferral that you are seeking. For example, if the note will be paid out of an escrow account, you'll generally be treated as receiving cash up front and be taxed currently. You can, however, use an escrow as long as there is a substantial restriction on your right to receive payments. Also, a third-party guarantee will not cause you to be taxed on the guaranteed amount.
Sometimes, you'll want to elect out of installment reporting. For example, if the sale would generate a big capital gain and you have large capital losses from other sources, you may choose to have the entire gain recognized in the year of the sale so you can use your losses to offset the gain. Also, installment reporting may not be desirable if the gain would be taxed as ordinary income (e.g., sale of land held for one year or less) and you expect to be in a higher tax bracket in post-sale years.
Selling property to a family member on the installment basis offers a number of advantages and, at the same time, raises a number of concerns. If you are in a high-bracket and own income-producing property, you can make an installment sale of the property to a family member in a lower bracket and thereby save family income tax. But you have to be sure that the notes carry a high enough rate of interest or interest will be imputed to you. For certain sales of land, you can use a rate as low as 6% without being charged with additional interest for income tax purposes. But, if the value of the notes and interest payments are less than the value of the property sold, you may have to set a higher rate so that you are not charged with making a gift.
The family-member buyer can resell the nondepreciable property if he or she no longer finds it suitable as an investment. However, if the sale occurs within two years of the purchase, the original seller's gain will be accelerated. And while concerns about security may be less significant if the purchaser is a family member, protective steps usually should be taken even for related party sales.
Please feel free to call if you have any questions about any of the matters addressed in this letter or about any other aspect of installment sales.