Selling Assets Via Installment Sale Could Be a Smart Move
When a business or property owner client is considering selling assets in which they have substantial appreciation (i.e., taxable gain), I am often asked if there are any strategies that might minimize the tax impact of the sale. One such strategy is the use of an installment sale.
An installment sale is basically the seller financing of the transaction in which payment is received over a number of years. Properly structured, an installment sale at a minimum will defer most or possibly all of the tax liability until payments are actually received, which can have tax advantages.
For instance, when someone sells part or all of a business or a piece of real estate at a substantial gain, because of the size of the gain it can often push the seller into a higher tax bracket in the year of sale than normally they would be, which could increase the total tax liability owed. By selling on the installment basis, it may be possible to keep the payments such that the tax bracket remains in the lower normal range each year, meaning the total ultimate tax bill will be lower than had it all been taxed in the year sold.
And depending on how large the extra gain from the sale actually is, an installment sale might also avoid the extra 3.8% net investment income tax that is imposed on net investment income above certain levels.
Another advantage of an installment sale, albeit not tax related, is that it could open up the market for your property to an expanded group of buyers, since not everyone who might wish to make the purchase may have the necessary financial resources or borrowing power to purchase it outright. It also affords the seller the opportunity to earn interest income on the unpaid balance, which may be appealing to some.
Let's look at a simple example of how this would work. Assume you sell a piece of land for $400,000 that only cost you $100,000. Your gain on sale is $300,000, and that is the amount upon which you will pay your taxes.
If an installment sale is used, that $300,000 gain will be recognized over time based on the sale's gross profit percentage, which in this case is 75% (total profit of $300,000 divided by the $400,000 sale price yields a gross profit percentage of 75%). Now assume it will be paid over eight years at $50,000 per year. For each $50,000 received, 75% of that amount, or $37,500, in gain will be recognized and taxed each year.
It's important to know that not all property qualifies for installment sale gain treatment. Specifically, if depreciation expense was previously taken on the asset, such as for personal property used in a trade or business or a rental activity, when sold such depreciation may have to be "recaptured" as ordinary income up to the lesser of the amount of depreciation previously taken or the total amount of the gain. Depreciation recapture income is immediately taxable in the year of sale at ordinary income rates regardless of whether the seller financed the deal over time or not.
So, for example, let's say you sold the assets of your business, a portion of which was the sale of real property and business goodwill, but another part of which was allocated to machinery and equipment (M&E) that had been depreciated in your business. The gain on the sale of the M&E, to the extent of the depreciation recapture income, would be taxable in the year of sale regardless of when the money is received, whereas tax on the gain associated with the sale of the real property and goodwill can be deferred and taxed as payments come in.
The moral of the story here is, if entering into such a deal, make sure you receive enough down payment or other payments in the year of sale to cover the initial year taxes that will have to be paid.
There are a few other things to know about installment sales.
For one, when selling something over time, installment sale treatment is the default treatment on your tax return, i.e., it is automatic. However, you can elect out of using that method if that is what is best for you. I have seen situations, though rare, where taxes were minimized or even eliminated entirely by electing out, due to other income being unusually low that year, the presence of a capital loss or expiring net operating loss carryover, etc.
Another thing to know is that if all your outstanding installment obligations exceed $5 million and the sale price of non-farm or non-personal property exceeds $150,000, you may have to pay some amount of interest to the IRS on the deferred tax.
Finally, seller financing is not for everyone. Many people worry about having to deal with collections and slow payers. Also, if the buyer defaults, you could be faced with foreclosure proceedings, which come with its own set of tax problems beyond the scope of this article.
And finally, there is the risk of rising tax rates. If they go up in the future, you will pay tax on future collections at the rate in effect then, negating the tax savings aspects of the strategy.
Still, all in all, installment sales are an important tool in the tax planning toolbox.