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Spreading Out Tax on Real Estate Sales
If you bought prime real estate years ago, you may realize a sizeable gain if you sell the property to an eager buyer. However, there is a flip side to this economic benefit: You may also face a huge tax liability on the sale. One possible tax solution is to sell property on the installment-sale basis. Instead of receiving the full payment in one year, you arrange to receive installments over several years. As a result, the tax you must pay is spread out over time, reducing your overall tax liability.
How it works: To qualify for installment-sale reporting, you must receive the payments over two or more years. The taxable portion of the payments calculated under the gross profit ratio is treated as capital gain in the year received. The gross profit ratio is determined by dividing the gross profit from the real estate sale by the contract price. Thanks to a 2003 tax law change, the maximum tax rate on long-term capital gain is only 15% (5% for low-income taxpayers). Therefore, you are able to defer the tax on part of your gain and benefit from the lower rate at the same time.
Hypothetical example: Mr. Brown bought commercial real estate a few years ago for $500,000. The property has an adjusted basis of $300,000. Brown agrees to sell the property for $750,000 in three annual installments of $250,000 each. Since the gross profit is $450,000 ($750,000 - $300,000), the taxable percentage of each installment received is 60% ($450,000 $750,000). When Brown reports the sale on his 2005 tax return, he pays tax on only $150,000 of the gain (60% of $250,000).
Any depreciation claimed on the property must be recaptured as ordinary income to the extent it exceeds the amount allowed under the straight-line method. The adjusted basis of the property is increased by the amount of recaptured income, thereby decreasing the gain realized in future years.
Caution: If the sale price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid on the deferred tax to the extent that your outstanding installment obligations exceed $5 million.
Note that installment-sale treatment is automatic. However, if it suits your purposes, you can elect out of installment reporting. For example, you might expect to have little other capital gain income this year and a lot next year. Similarly, you might have capital losses or suspended passive losses for this year that will offset the tax on your installment-sale gain. Thus, you may be better off reporting the entire gain in the year of the sale rather than spreading it out over a period of years.
Note: A "dealer" in real estate, such as a developer of property, generally cannot benefit from installment-sale reporting. Other special rules may apply in this area, including restrictions on sales to related parties, so be sure to seek professional tax assistance.