Most real estate sales happen in one transaction, but sometimes, both parties agree that the buyer will make multiple payments to the seller over several months or years. Installment sales can have benefits for buyers and sellers, so if you’re planning on selling property soon, you should understand how they work.
An installment sale spreads the payment for a property out over time. Instead of making one payment to the seller to cover the entire cost of the home, the buyer makes two or more smaller payments. This has tax benefits for the seller, and it can reduce the financial burden on the buyer. There only needs to be one additional payment after the tax year of the sale for it to be considered an installment sale, but the seller and buyer could also agree on a payment plan for several installments.
How an Installment Sale Works
An installment sale is sometimes used when selling a rental property as it can be an effective way to reduce capital gains taxes. As of 2021, if you make more than $40,400 as a single filer, you may have to pay at least 15 percent of your profits on a home sale in taxes. There are exemptions that reduce or eliminate your capital gains tax burden if the home is your primary residence, but if you sell a second home or a rental property, capital gains tax can be a more pressing issue.
There are other taxes associated with selling rental properties, too. For example, you might have to pay depreciation recapture, which is a 25 percent tax that applies when you sell a property that increased in value after you previously claimed a depreciation deduction.
The most common way to sell your home in an installment sale is to use the IRS Publication 537 installment method. This allows you to claim a prorated percentage of your capital gains for multiple years instead of paying all at once after the sale of your home. You must report the gain the year it is received, so spreading out the gains can reduce your total tax burden.
This method is especially helpful if you must pay short-term capital gains on the property sale. Short-term gains apply when you owned the property for less than a year. They’re added to your ordinary income, so depending on the amount of profits and your other income, your capital gains from the sale may fall within a very high bracket and be taxed at a steep rate. The profits from your property sale may push you into the next tax bracket if you claim the gains all at once. By splitting up the profits over multiple years, you may keep all the income in a lower bracket, which reduces the total amount you’ll pay in taxes.
Reporting Your Income From an Installment Sale
The IRS has a number of specific guidelines for reporting income from installment sales. You must report the income each year you receive a pay installment.
There are three categories for installment income on the Form 1040: gain, interest, and principal. Your gain is the amount of profit you made from the sale of your property. If you owned the property for less than a year, you will claim a short-term gain on your taxes, which is treated like normal income. If you owned the property for longer than one year, you’ll claim a long-term gain. Long-term gains are taxed at lower rates than short-term gains, but the rate varies based on your income.
You’ll also have to report any interest you charged the buyer for the installment plan. The interest rate for the installment plan should be included in the sales contract, and you must report the interest you receive separately from the initial gain from the sale.
Additionally, the IRS requires you to report your principal, or adjusted basis. This is an updated cost of the property based on its increase or decrease in value plus depreciation recapture. A portion of each installment payment is considered a return of principal by the IRS. You can calculate this amount for your installment sale using Worksheet A from Publication 537.
Advantages of an Installment Sale
The biggest advantage of selling a property with the installment method is the opportunity to lower your tax rate for capital gains on the sale. Whether or not this strategy will actually decrease your total tax burden depends on your income, your profits, and whether the gains are short-term or long-term. However, if you are able to reduce your tax rate by reporting the income in installments, you could save thousands of dollars in total.
It also may be easier to find a buyer for the property if you offer an installment plan. This can be particularly beneficial if you’re selling a larger or more expensive rental property. An installment sale makes the property more financially accessible to buyers, so you may get better offers on the home or building.
Disadvantages of an Installment Sale
The biggest risk with an installment sale is that you’re entering a long-term agreement with the buyer. The success of the installment method rests on the buyer’s ability to fulfill their side of the contract. If they cease making payments, you could end up in a worse financial situation than if you’d completed the full sale in one transaction and reported all the income the year of the sale.
Another drawback is that filing taxes with the installment method can be very complex. Most people who use installment sales have a career in real estate and are closely familiar with the tax regulations. If you have never sold a home or property with the installment method, though, it’s critical that you work with a tax professional to navigate the process.
In some situations, an installment sale is the best way to reduce your tax bill after selling a property. There are many specific regulations you must abide by, though, so you should carefully research the method before you complete the sale. If you have any questions about whether an installment sale is a good option for you, consult with a real estate agent or a trusted financial advisor