Selling real estate by installments could cut taxes Step defers profits, spreading out gain

September 20, 1992|By Knight-Ridder News Service

When selling land, buildings or other investment property, an effective way to defer and possibly reduce taxes is through the use of an installment sale.

An installment sale provides for part or all of the sales price to be paid in a later year. Effectively, the seller is financing the buyer's purchase instead of having the buyer obtain a bank loan.

Profits on installment sales are deferred until the seller receives payments under the installment loan. Using the installment sales method may spread the seller's gain over several years and may result in a lower total tax. By taking only a portion of the gain into income each year, you may avoid reaching a higher tax bracket.

Even if you are in the highest bracket, use of the installment-sale method may be beneficial because taxes may be deferred to later years.

For example: In 1975, Gary bought vacant real estate for $60,000, having made a $15,000 down payment and taken a $45,000 mortgage. In 1992, with the mortgage balance reduced to $30,000, Gary sold the land to Tammy for $150,000.

In accordance with the terms of the sale, Tammy assumed Gary's $30,000 mortgage and agreed to pay the remaining $120,000 in three annual installments of $40,000, plus interest on the unpaid balance. Gary will compute his gross profit as follows:

Selling price $150,000

Less adjusted basis 60,000

Gross profit 90,000

Whereas the $90,000 gross profit is fully taxable, the installment-sale method of reporting will allow Gary to defer the recognition of this gain until he receives the various cash payments from Tammy. The amount of cash Gary will collect is $120,000 (three payments of $40,000 each).

Because the gross profit ($90,000) is 75 percent of the $120,000 expected cash collections, Gary will report profits on his tax return as follows:

Year .. .. Cash collection .. .. Profit

1992 .. .. $40,000 x 75% .. ... $30,000

1993 .. .. $40,000 x 75% .. ... $30,000

1994 .. .. $40,000 x 75% .. ... $30,000

7+ Total .. . $120,000 .. .. .. .. $90,000

Note: Each year, as Tammy pays Gary $40,000 plus interest on the unpaid portion of the installment ob ligation, the interest will be subject to taxation. The interest will be taxed as ordinary income.

In contrast, the recognized portion of the profit will be reported as a long-term capital gain.

Whereas the installment method may be used for most sales of investment property, this method is not allowed for the sale of stocks, bonds or other securities that are traded on an established market. Nor is it allowed for the sale of inventory or other property held by a business for sale to customers.

If the sales price exceeds $150,000, special limitations might apply. Consult a tax professional.

(Myron Lubell is a certified public accountant and associate professor of accounting and taxation at Florida International University. Send questions in care of Business Monday, 1 Herald Plaza, Miami, Fla. 33132.)

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