4C — April 22 - May 19, 2022 — Owners, Developers & Managers — M id A tlantic Real Estate Journal
O wners , D evelopers & M anagers
By Andrew Murray, CPA, Withum Sell Now, Pay Later: Capital Gains Tax Deferral via Installment Sale Agreements
ith the current real estatemarket heav - ily favored towards
the transaction is structured as an installment sale. Though it may seem like a no-brainer, it is important to understand all the key factors involved before agreeing to an install - ment sale transaction. Background Generally, when real prop - erty is sold through traditional financing, the seller will pay tax on the entire gain. How - ever, if a seller finances the sale (i.e. the buy makes mort - gage payments to the seller instead of a bank), some of the capital gain can be deferred to the future.
When a real estate sale transaction is structured as an installment sale, a portion of the cash to be received by the seller is deferred. Likewise, most if not all of the pending gain from the sale is also de - ferred under Internal Revenue Code (IRC) Section 453. Conceptually, income would be recognized on the portion of cash received that is attribut - able to the gain from the sale of the property. This percent - age is calculated at the time of sale by dividing the gross profit (total sales price minus the cost basis) by the total
sales price. This percentage is applied each year to the cash received to determine the por - tion of the deferred gain to be recognized. For example, if a property is sold during 2022 for a total sales price of $500,000 that has a cost basis of $100,000, a $400,000 gain would be recog - nized. However, if the sale is structured as an installment sale, with $50,000 in principal to be paid over the next 10 years, $40,000 would be recog - nized in income each year for 10 years ($400,000 / $500,000 x $50,000).
As with most decisions sur - rounding tax strategies, an installment sale agreement is not a “one size fits all” solu - tion, even with the prospect of deferring taxes to a future year. Below are a few factors to consider before agreeing to an installment sale on the sale of real property. Depreciation Recapture If depreciation expense was taken on property that is sold, then the amount of the gain on sale may be split between ordinary and capital. Any portion of the total gain that is attributable to depreciation recapture must be recognized in the year of sale. Certain improvement prop - erty that benefits from ac - celerated depreciation deduc - tions can trigger recaptured ordinary income up to the amounts previously deducted as depreciation. Therefore, sellers should plan to pay tax in the year of sale on any depreciation recapture even if most of the capital gains will be deferred to future years. Capital Gains Tax Rates The capital gains tax rate may vary based on the seller’s overall taxable income. Cur - rently, there are three capital gains tax rates – 0%, 15%, and 20%. Certain investors may also be subject to the 3.8% net investment income tax unless the taxpayer is classified as a real estate professional. Recognizing the entire gain in the year of sale may push the seller into a higher capi - tal gains tax bracket when compared to spreading out the impact to taxable income over several years. Uncertainty with Future Tax Legislation Uncertainty in the tax law when it comes to future in - creases to the capital gains rates may be a reason to rec - ognize the entire gain in the year of sale. Also, if a taxpayer anticipates being in a higher tax bracket in future years, recognizing gains in the year of sale while at a lower rate could be more advantageous. Tax on Interest Income When the installment sale agreement is drawn up, an amortization table is also created, which lays out the payment terms for the buyer, including interest. The seller would recognize interest in - come annually, which is taxed at ordinary rates, serving continued on page 8C
sellers, prop - erty owners are looking to cash in on the appreci - ated value of their real estate hold - ings. How - e v e r , t ha t lucrative sale may come with a hefty tax bill from Uncle Sam. Fortunately, it is possible to defer a portion of the gain if Andrew Murray
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