There are a number of reasons why an investor might want to sell an asset on installment—that is, with installment sale income spreading over at least two years. The investor might agree to accept installment payments when no other forms of financing are available to the buyer, or when the parties to the sale do not want to wait for financing to be arranged. It is a common practice. Because of the high level of trust needed in the transaction and its great convenience—down payments, payment size, and other conditions can be very liberal—this method is often used in related-party deals. Take caution, however, to avoid running afoul of the IRS.
An installment sale, otherwise known as a structured sale, can benefit the seller as well as the buyer. It could be the key to the sale of a relinquished property in a 1031 exchange, for example, or the seller might prefer to receive payments over a number of years for tax optimization purposes. It is a good way to spread out capital gains (and the taxes on them) when selling a property that had been part of a 1031 exchange. The seller might even want to use an installment sale as a type of interest-bearing savings plan, timing payments from the sale to provide income when it is most convenient, such as after retirement.
Declare Installment Sale Income and Interest with Form 6252
The seller in an installment sale has the option to treat the deal like any other and settle the tax bill on the full capital gains in the year of the sale. But often, it is possible to pay the capital gains tax as the payments are received by using IRS Form 6252 to declare that income. The sale has to be made at fair market value and the interest rate must be reasonable. If the IRS finds the interest rate to be too low, the seller might be compelled to figure “unstated interest” into tax calculations. Unstated interest is the difference between the amount of interest stipulated in a contract and the amount that the IRS deems appropriate or typical.
Installment sale payments have three components: the adjusted basis, the interest, and the capital gain. Taxes are paid on the latter two, with interest treated as ordinary income. In the year of the sale, the tax on the depreciation recapture income has to be paid in full, regardless of when payments begin. Depreciation recapture income is included in the adjusted basis for the installment sale—that is, the cost of the asset minus expenses involved in its purchase, such as closing costs and other incidental costs.
Installment Sale Income and Related-Party Transactions
The IRS is concerned about the price and interest being charged on installment sales because the partners in such sales are sometimes persons related to the seller. Constructive ownership rules and other restrictions apply in these cases, and depreciable property cannot be sold to a controlled entity (partnership or corporation) in an installment sale. When an installment sale takes place between related persons, the asset involved in the transaction cannot be resold to an unrelated party within two years. If such a sale occurs, the IRS will consider the seller in the first transaction, rather than the buyer, to be the seller in this transaction as well.
Transactions involving related persons are scrutinized by the IRS for signs of attempted tax evasion, and the burden of proof is on the taxpayer to show legitimate motivations. If the IRS cannot be convinced that the installment sale is legitimately motivated, the sale will be taxed like a straight sale, regardless of the actual payment conditions. That is not to say that a properly motivated installment sale could not take place, or that tax regulations are a barrier to an installment sale for a determined seller. The seller should be aware, however, that there are a number of other tax consequences to making a related-party deal. Therefore, careful planning and expert advice are necessary before concluding a deal.
At CWS Capital Partners, we are a fully-integrated multifamily real estate investment management firm that offers everything from due diligence and risk management to transaction support and property management. We specialize in assisting our clients with 1031 exchanges, acquisitions, repositioning, and development. We own and manage luxury multifamily investment communities in major markets around the country, and we employ a team of experts who can help you hone your investment strategy.
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