Installment sales are a useful tool in solving a number of problems such as business continuation, income tax deferral on transfer of appreciated assets, and estate and gift tax management.
As you probably know, an installment sale is a seller-financed, deferred-payment sale that allows a deferral of the taxable gain recognized by the seller.
One of the rules that surprise many sellers is a sale of depreciable personal property recaptures so-called gain for depreciation deductions (up to the amount of gain), and that depreciation recapture is entirely taxable in the year of sale. Sales of real estate have special, more favorable depreciation recapture rules.
To be an installment sale, at least one payment must be received by the seller after the tax year in which the sale occurs. And you can “elect out” of the installment sale and have all of the gain taxed in the year of sale.
The payments include interest and gain (probably long-term capital gain). The interest rate must be at least the minimum Applicable Federal Rate (AFR) published by IRS each month, for the month of sale. Of course, the interest rate can be more than the minimum. The parties can structure the sale to meet the goals and the financial needs or abilities of the parties.
The seller can receive all kinds of security to be sure the payments are made. For real estate, a deed of trust or even a third party can guarantee payment in the event the buyer defaults. For example a parent can put up a standby letter of credit as security for the seller in case a child doesn’t make the promised payments to the seller.
Interest is deductible if it is not considered personal. The debt for investment purposes, conduct of a trade or business or purchase of a qualified residence will have interest that is deductible (subject to other rules and limits, i.e. personal home debt).
An installment sale can be structured to begin and end according to the objectives or financial needs or abilities of the parties. It seems even a transaction that provides for 20 years of payments of interest only with a balloon payment at the end can qualify as an installment sale. That gives a lot of flexibility.
The seller must recognize gain if the debt (or part of it) is forgiven by the seller. If the seller dies before all payments have been received, the seller’s estate must report as income the untaxed portion if the promissory note is forgiven or transferred to the buyer.
There are many other factors to consider, but installment sales can be a benefit.
Did you hear? “The greener grass on the other side is just as hard to cut.”
John Bullis is a certified public accountant, personal financial specialist and certified senior adviser who has served Carson City for 45 years. He is founder emeritus of Bullis and Co. CPAs.