Installment sales, where you receive payments in more than one tax year, let you defer tax on sales until you actually receive those payments. Tax is divided among the actual installments and due as you receive them.
Here’s how it works:
- Calculate your gain on the sale.
- Calculate the percentage of your total sale price consisting of basis and the percentage consisting of taxable gain.
- Multiply each installment by your profit percentage to figure taxable gain from that installment.
- You have to charge adequate interest on each installment. Otherwise the IRS can recharacterize part of each installment as interest, taxed at ordinary rates, instead of capital gain. The minimum rate is generally the “applicable federal rate” in effect at the time of the sale. Interest on unpaid installments is taxed as ordinary income.
For example, you buy a building for $600,000 then sell it for $1 million. 40% of your sale price is gain, so 40% of each installment is taxed as capital gain.
If you like installment sale tax advantages, but you’re worried your buyer might default on payments, consider a “structured sale,” where you take part or all of your proceeds in the form of commercial annuity payments. Here’s how it works:
- You negotiate a traditional installment sale with your buyer.
- Your buyer assigns the right to make payments to an independent third-party and pays the purchase price, in cash, to that third party. (Using a third party avoids the “constructive receipt” which would make the sale immediately taxable.)
- The third party uses the buyer’s cash to buy an immediate annuity from a top-rated life insurance company.
- You pay taxes on your gain as you receive those annuity installments.
If you have any questions on deferring your taxable gain, please do not hesitate to contact us.