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With the rocky real estate market in recent years, an owner who has a property pregnant with profit either bought at the right time way before the boom or has been blessed by lady fortune.
In either case, selling such a property can be wise to do in a way that spreads taxability over time — an installment sale. It's whenever a sale is made and any part of the purchase price is deferred to another year.
"Given the current low interest rates and stock market volatility, it would be more than prudent to consider an installment sale to maximize after-tax returns," said Jason Kesselman, a financial adviser for Estate Planning of Delaware Valley in Wilmington, Del.
Who Can Benefit
Installment sales can be particularly useful for property investors, and for homeowners who anticipate a gain of more than $250,000 from selling ($500,000 for a married couple filing a joint return).
A typical installment sale would be where a seller finances part of a purchase, normally by taking back a note — a second mortgage — that covers what the buyer's lender doesn't finance. Seller financing could also be a primary mortgage, called a purchase money primary lien, and could be for the entire purchase amount.
Sellers are normally taxed only as principal is received. IRS Form 6252 provides the formula and Richard Schank, a financial planner with PTS Brokerage in Mt. Laurel, N.J., provides an example.
"To keep the numbers simple, say a tract of raw land was purchased two years ago for $100,000 and sold in 2010 for $200,000 — with the seller taking back a note for $100,000," he said. "The total gain is $100,000. But the seller only recognizes the gain as dollars are collected, based on the gross profit percentage. In this case . .. the gross profit percentage is 50% and (so) 50% of every dollar collected is taxable."
Upon closing, the seller collects the $100,000 portion that he didn't finance (but the buyer may have with another loan) and therefore $50,000 is taxable. The other taxable $50,000 is recognized and reported as the principal of the seller's note collected over the life of the loan. As each dollar of principal is received, 50% of it is taxable.
Seller Pros And Cons
The primary advantage to a seller is deferral of the tax due. The higher inflation rises from its recent modest levels and the longer the term of the note, the lower the true tax becomes. A $50,000 tax paid 30 years from today — say on a balloon note — is worth far less on an economic basis than $50,000 paid today. Using a 5% inflation rate over the 30 years, that $50,000 tax would only have a present value of $11,570.
There's no legal limit to the deferral period. The take-back note can provide periodic payments, a balloon payment, or both. There's no tax till the dollars are actually received.
A second advantage to the seller would be the interest earned on the financing. With money market rates struggling to reach 1%, a 5% rate on a take-back loan creates five times the wealth accumulation. Providing credit also makes it easier for a buyer to fund the purchase and may help support the seller's asking price.
The advantages are not cost-free. Yes, the seller defers the tax, but the receipt of the cash from the sale is also deferred, and that bears an economic cost. While the interest rate earned on the note may be higher than what could be earned elsewhere, all interest received is fully taxable at ordinary income tax rates.
Prospective tax rate changes may also be a negative. A seller is taxed at the tax rate in effect when the dollars are received. If capital gains rates increase in the future, the seller will be paying taxes at those higher rates. The current top long-term capital gains rate is 15%. But that is scheduled to jump to as much as 23.8% in the future — 20% plus a 3.8% Medicare tax set to take effect in 2013.
Remember, that tax only applies to taxable gains. The normal rules for excluding as much as $250,000 in gain ($500,000 on a qualifying joint return) on the sale of a principal residence still apply. If a seller has minimal taxable gains, the advantages of an installment sale are reduced.
Then there's the credit risk — how creditworthy is the buyer? Sophisticated advisers refuse to let clients take back a note on a sale without what's called a "deed in lieu of foreclosure." That's an actual signed deed to the property, from the buyer back to the seller, which can only be filed if the buyer fails to timely pay the note. It eliminates the time and cost of an actual foreclosure and puts the burden on the buyer to prove that the note was timely paid.
A Friend In Deed
If there is a default, the seller merely records the deed, and the property is his, subject to any bank loans then securing the property. But be aware that if the property has fallen in value, a seller holding a second mortgage could end up owing on that primary mortgage. That's why a substantial cash payment should be obtained from the buyer at closing — as security against a potential loss in the event the seller gets the property back.
If a buyer hesitates to provide a deed in lieu of foreclosure, that's a good indication that the buyer doesn't want to commit to paying the note as required. As explained by former Cherry Hill, N.J., judge Fred Levin, now a practicing attorney, "A deed in lieu of foreclosure would provide the seller with additional security that would make the seller more comfortable taking back a mortgage."
When transferring real property, both sides would be more than prudent to get a good real estate attorney. With a mortgage take-back, the need is intensified. The attorneys will negotiate and draft the contracts, notes, mortgages and deeds. The attorney for the seller taking back a note will also need to check the credit of the borrower-buyer.
Sellers also should know that they can't always defer taxable gains by providing financing. Gains can't be deferred if a property is sold to a related party. And in an investment property sale, all gains tied to prior depreciation are taxed immediately. Requiring a substantial down payment will help the seller pay the tax bill.
Buyer Pros And Cons
The major advantage for the buyer in an installment sale is that the seller is financing part of the purchase price. Expenses normally charged by a bank or mortgage company such as application fees and points may be eliminated or substantially reduced.
In certain cases, a buyer might have difficulty getting a bank loan because of past credit problems. In the current banking environment, lenders would rather lose a good customer than risk a bad one. A motivated seller might look beyond the past problems and take that risk — especially if comforted by a deed in lieu of foreclosure. But, the buyer should pay a high rate of interest on the note.
The biggest disadvantage from the buyer's perspective is a combination of potentially overextending leverage and the lack of wiggle room if payments are not made on time. It can be a lot easier to negotiate with a bank if a payment is missed than with an angry seller who holds a deed in lieu of foreclosure.
• Schnepper is a New Jersey lawyer and CPA, personal finance columnist and the author of several books on tax strategies.
