A Smart Way to Minimize Taxes
One of the pitfalls of selling a property you’ve owned for an extended period of time is the large capital gains that you may end up owing. When you sell the property all at once, you are required to report the gain in the year of the sale, and since the introduction of Obamacare this generally triggers an even higher than normal 3.8% net investment income surtax.
The capital gains tax rates are based upon the individual taxpayer’s tax bracket for the year. Though those who are at lower tax brackets may not be impacted by capital gains, sale of a property for a large gain has the potential for elevating taxpayers into the next bracket. Those who fall into the 15% or less tax bracket face no capital gains tax, but for those whose tax bracket falls in the 25 to 35% range the capital gains rate is 15 percent. Taxpayers that fall into the highest tax bracket of 39.6% are taxed on capital gains at a rate of 20%.
When you add these taxes to the new surtax on net investment income, it is easy to see why finding a tool to minimize taxes is so appealing. Under Obamacare, tax law treats capital gains other than those that come from a trade or a business as investment income, and subjects those who are in the higher-income tax brackets to an additional 3.8% surcharge, which must be paid on the lesser of either the taxpayer’s net investment income or the excess of their modified adjusted gross income that falls above the threshold amount for their filing status.
These thresholds are as follows:
Married taxpayers filing separately - $125,000
Taxpayers filing as head of household or single - $200,000
Married taxpayers filing jointly or as a surviving spouse - $250,000
Taxpayers that are interested in avoiding these significant additional taxes may find that an installment sale that spreads their gains across a number of years offers an elegant and simple solution.
An installment sale is accomplished when the seller carries the loan on the property themselves rather than having the buyer go through another lender. By accepting a down payment on the property from the buyer followed by incremental payments, taxes are only paid on the taxable gains represented by the down payment and any other individual payments received during that tax year. The original owner, who now carries the note, is able to collect similar interest on the note balance as any bank would, and continues to receive payments until the loan is paid off.
The only requirement for a sale to be considered an installment sale is that a minimum of one payment has to be received in the year following the sale. Installment sales can be used on many different types of property but are not permitted for the sale of securities or publicly traded stock: the strategy is most frequently used for selling real estate.
For an example of how an installment sale works, a property owner that purchased a parcel of land for cash in the amount of $10,000 sells it for $300,000. Rather than selling it all at once, the owner accepts a 20% down payment of $60,000 and carries a first trust deed in the amount of $240,000, charging 3% interest. The sales costs are $9,000 and no other payments are received during the year of the sale.
After subtracting the $9,000 in sales costs from the $60,000 received, the seller is left with $51,000 cash, which is 93.67% taxable during the first year. Subsequent year principal payments received are dependent upon the terms of the installment agreement, and interest received is also taxable and subject to the investment surtax. The advantage of using the installment method of sale in this case shows that the income for the year was reduced by $224,798.
There are additional details that must be kept in mind when considering utilizing the installment sale strategy. If the property is not owned outright and there is an existing mortgage, that loan needs to be satisfied as part of the transaction. For those who do not have the cash needed to pay off the existing mortgage, there are ways to structure the transaction that tie the existing loan into the new one, or that involve taking out a second loan in order to pay off the first.
An installment loan may not be the right answer for those who are not in a position to tie up considerable funds into holding a mortgage, regardless of the fact that it may yield a way to avoid the higher tax rate and tax surcharge. Keep in mind that it is possible to establish a note for shorter durations, even while providing the buyer with the standard thirty-year amortization. This reduces the overall costs for the buyer but speeds up the amount of time in which they are required to pay off the loan.
Those considering making this type of adjustment should keep in mind that the higher the payments in a particular year, the greater the chances of being bumped into a higher tax bracket and having to pay the surtax.
It is also important to remember that there could be tax considerations if the buyer makes the decision to pay off the installment sale note early, or to sell the property to another buyer. This would effectively eliminate the structure of the installment plan, as the balance of the note would be paid all at once unless the second buyer agrees to assume the installment plan terms.
All of these strategies are based upon the tax law that is in affect when the installment sale is executed and payments are received. Tax laws are subject to frequent change, so there is always the risk that installment income could see increases in their tax liability.
Not every property sale is a good candidate for an installment sale, but in many cases it can provide valuable advantages. For more information on whether an installment sale would provide you with tax benefits, contact our office to set up a consultation.
Have a question about real estate and your taxes? Call us at (831) 462-0330 and let's discuss your financial future.