In slower real estate markets, lenders are more cautious about making loans and sellers are more inclined to seller-carry financing to move their properties. If a buyer makes a substantial down payment and is sufficiently credit worthy, seller-carry financing may offer the seller an acceptable risk offset by allowing a seller to i) sell a property for more than the seller otherwise could, ii) reap a higher return on the seller's equity than if the seller received cash and invested the cash in more traditional interest bearing accounts, and iii) defer income taxes. This article discusses some of the income tax benefits of an installment sale as compared to a sale where the seller receives his equity in cash at closing. (Generally, a section 1031 exchange defers more taxes than an installment sale.)

Installment Sales

An installment sale is a disposition of property where at least one payment of the purchase price will be received after the close of the year in which the disposition occurs. Under the installment method of reporting gain, a taxpayer who receives payments from a qualified installment sale will be allowed to recognize a percentage of the taxpayer's gain as each payment is received, rather than being required to recognize the entire taxable gain in the year of the sale. Because the taxpayer recognizes the gain over the taxable years in which the payments are actually received, the taxpayer is able to defer payment of income taxes that are assessed on that gain.

In general, if the disposition of the property qualifies as a installment sale, the taxpayer must utilize the installment method gain unless either i) the taxpayer "elects out" or ii) a specific exception has been provided by the Internal Revenue Code. The taxpayer may "elect out" by reporting the entire gain on a timely filed tax return for the year of sale. The tax return containing the election must be filed not later than the normal due date for the return, including any extensions, and untimely filed elections will generally not be permitted.

There are several types of taxpayers and transactions that are prohibited from utilizing the installment method. Among the prohibited taxpayers and transactions are: i) taxpayers who utilize the accrual method of accounting, ii) sales by dealers, and iii) sales involving a disposition of personal property inventory. A dealer is defined as a taxpayer who holds real property for sale to customers in the ordinary course of the taxpayer's trade or business. Thus, sales of homes by a home builder will not qualify for the installment method, subject to certain exceptions for timeshare units or unimproved residential lots.

Computation and Deferral of Gain

Each installment payment usually consists of three elements: (1) a partial return of the seller's basis in the property sold, (2) a portion of the taxpayer's realized gain on the sale, and (3) accrued interest. Each year, the taxpayer must determine the amount of installment sale gain that must be included in the taxpayer's income for that year by multiplying the total payments received in that year by the gross profit ratio for the sale.

The gross profit ratio of an installment sale is the taxpayer's total anticipated gross profit divided by the total contract price. The anticipated gross profit is calculated as the contract price less the taxpayer's adjusted basis in the property. The taxpayer's adjusted basis in the property is the taxpayer's original basis in property plus capital improvements, less accumulated depreciation, selling expenses, and other adjustments allowed under Section 1016 of the Internal Revenue Code. The contract price for the sale is equal to the selling price of the property, reduced by the amount of any qualifying indebtedness which is assumed or taken subject to by the buyer. Qualifying indebtedness may include any a mortgage or other debt which encumbers the property, plus any debt that is incurred or assumed by the purchaser incident to the purchaser's acquisition of the property.

Example:

The following serves to illustrate the application of the installment method rules to a sale of a piece of commercial real property. In Year 1, Seller sold Commercial Property to Buyer. Buyer paid $200,000 in cash at closing and agreed to assume the current mortgage on the Property. Seller agreed to seller-finance $800,000 of the purchase price over a five-year installment note, with the first installment being due in Year 2.

Selling price for Commercial Property		$1,200,000
	Less:   Mortgage assumed by Buyer	(200,000)
	Contract Price	$1,000,000




Selling price for Commercial Property		$1,200,000
	Adjusted Basis	(720,000)
	Selling Expenses	(80,000)
	Gross Profit	$400,000

The Gross Profit of $400,000 is divided by the Contract Price of $1,000,000 to determine a gross profit ratio of 40%. In applying the gross profit percentage of 40% to the $200,000 of cash received in Year 1, the Seller will recognize $80,000 of gain in the year of the sale. If the principal portion of the payments received by Seller in Year 2 is equal to $160,000, Seller will recognize gain in Year 2 equal to 40% of $160,000, or $64,000.

Character of Gain and Interest

Although use of the installment method affects the timing of the recognition of gain from an installment sale, the installment method rules do not affect the characterization of the gain as either capital gain or ordinary income. The character of the gain in each of the taxable years will depend upon the nature of the property sold, the amount of accumulated depreciation taken in prior tax years, and the Seller's holding period for the property.

Each year the taxpayer must also include in ordinary income either i) the total amount of interest either actually received during the year or ii) the amount of interest imputed under the provisions of Section 7872. In addition, if, at the end of the year, the aggregate face amount of all non-dealer installment sale obligations held by the taxpayer exceeds $5 million, the taxpayer may be required to paid interest on the deferred taxes.

Patricia A. Leighton is no longer with Frascona, Joiner, Goodman and Greenstein, P.C.

Jonathan A. Goodman is a shareholder in Frascona, Joiner, Goodman and Greenstein, P.C., a Colorado law firm.   His practice areas include Real Estate, Brokerage Law, Contracts, Land Use, Leasing, Real Estate Title, Association Law, Business Law, and Finance.   He can be reached at contact Jonathan Goodman.

Disclaimer -- Content is general information only. Information is not provided as advice for a specific matter, nor does its publication create an attorney-client relationship. Laws vary from one state to another. For legal advice on a specific matter, consult an attorney.