Installment Sales May Provide Tax Flexibility
It is Impossible to Predict the Outcome of Proposed Tax Legislation
by Scott Roper
In today’s hot real estate market, many investors own real estate that is substantially appreciated. Some investors are choosing to cash out and pocket their gain while demand for real estate and selling prices are high.
In the right circumstances, investors who sell real estate also can enjoy tax flexibility. Special tax rules apply to certain investors who sell real estate or other qualified property on an installment basis.
These investors typically structure their sales to receive at least one payment after the close of the tax year. In that situation, the investors also defer a portion of the federal income tax liability on the gain to a future year. They pay tax on the gain as they receive sales proceeds.
For example, assume that Nancy owns a second home worth $2 million in today’s hot market. Assume further that Nancy paid $800,000 to buy the home several years ago. Nancy has a $1.2 million gain embedded in her second home, and she wants to sell.
Nancy structures her sale to receive $200,000 up front and the remaining $1.8 million next year in 2022. So, she receives 10% of the sales proceeds in 2021 and the remaining 90% in 2022. As an installment sale, Nancy reports 10% of her gain as taxable income in 2021, and she reports the remaining 90% in 2022.
One benefit for Nancy is that she defers the tax liability on 90% of her gain until next year. So, she reports $120,000 (10% of her gain) on her federal income tax return in 2021, and she reports $1.08 million ($90% of her gain) on her federal income tax return in 2022. The benefit for Nancy is that she matches her tax liability to the timing that she receives sales proceeds. This is especially helpful to Nancy at year-end because she can push off her tax liability on most of the gain to next year.
Another benefit for an installment sale is that the tax rules apply automatically. Nancy gets installment sale treatment automatically, unless she makes a special election not to apply the installment sale rules when she files her 2021 federal income tax return.
Flexibility is Key
This year, Nancy actually may want to elect out of installment sale treatment and to accelerate the federal income taxation of all of her gain into 2021. Why? Because the income tax rate applicable to Nancy’s gain might increase based on proposed tax legislation currently under consideration by Congress and the Biden Administration. This proposed legislation contains numerous tax increases for individuals and businesses, including a substantial increase in the tax rate applicable to Nancy’s gain.
Lots of negotiation on new tax legislation is occurring in Congress and with the Biden Administration. But, as of the date this magazine went to print, it is impossible to predict the outcome of that legislation or the effective date of new tax provisions. That is because all of the proposed tax changes, including the effective dates, are subject to further negotiation and consensus.
It is possible that Congress and the Administration will come together and enact new tax legislation later this year. The effective dates of that legislation could be as proposed, with an increase in the federal income tax rate applicable to capital gains occurring in 2021. As an alternative, some of the effective dates could be pushed out to the future, based on negotiation and consensus that occurs later this year. As another alternative, it is possible that Congress and the Administration might just be too far apart to enact any meaningful tax legislation in 2021.
This is where flexibility benefits Nancy on the sale of her second home. If the federal income tax law stays the same in 2022, Nancy reports 10% of her gain in 2021, and she reports the remaining 90% in 2022, deferring the taxation of 90% of her gain until next year. If Congress and the Administration do not reach consensus on new legislation, the current federal income tax rate on capital gains (generally 20%) will continue to apply in both years.
On the other hand, Congress and the Administration might reach consensus on new legislation. Assume in that case that the federal income tax rate increases substantially for gain recognized in 2022 or later. In that case, Nancy might be better off electing out of installment sale treatment when she files her 2021 federal income tax return in 2022. She reports all of her capital gain on her 2021 return – at the lower 2021 rate and not the higher 2022 rate.
Of course, Nancy does not know now what Congress and the Administration might actually agree to do, if anything. But one thing that Nancy can do now is to structure the sale of her second home as an installment sale in 2021. That gives her the flexibility to time her income tax liability in 2021 or 2022, whichever timing produces the best overall result.
Readers who are interested in the installment sale rules should consult with their professional tax advisors. That is because there are additional complexities and limitations to consider. Readers also might want to review IRS Publication 537, Installment Sales, which is available on the IRS website at irs.gov.
