Avoid a large real estate income tax bill

Owning real estate is a big dream for many investors. But it’s a huge investment, which can be quite profitable. Selling a rental property for a huge profit can be a dream come true. However, to maximize profit from such a sale, you need to minimize the taxes on it. An installment sale is a strategy. Don’t worry – this is approved by the Internal Revenue Service (IRS).

Key points

  • The IRS allows taxpayers to defer a portion of the capital gain on the sale of investment property under a hire-purchase arrangement which can reduce the seller’s taxes on the profit.
  • Hire sale income is broken down into earnings, principal (or, adjusted basis in ownership), and interest. Each of these categories is treated differently on the 1040 form.
  • The gross profit percentage is then used to calculate hire-purchase income for a given tax year.
  • If the buyer takes on a mortgage or other promissory note on the property, the cost basis of the property must be reduced by the mortgage amount.

A big win equals a big tax bill

Let’s look at a common situation:

Hal Bookman looked into the buyer’s offer for his rental home and couldn’t believe the number he saw. The value of his property has increased significantly in just five years. However, when Hal gleefully told his tax adviser about the sale, the adviser was cautious: Taking the income as a lump sum payment would not have been in Hal’s best tax interest.

If Hal reports the entire sale proceeds in the same year that he sells the property, he pays 25% on the portion of the gain that matches any depreciation deductions he previously took on the rental property.

Any gain beyond recovery of depreciation is taxed at 15% for taxpayers with taxable income between $41,676 and $459,750 if single, or $83,351 and $517,200 if married jointly reported in 2022. These amounts increase to $44,625 and $492,300 for single filers, as well as $89,250 and $553,850 for married couples filing jointly in 2023. Taxpayers with income above these thresholds are taxed at 20%

Hal asks his tax adviser if there is anything he can do to reduce his taxable income for the year. The consultant only knows the tool to use: an installment sales contract.

What is an installment sale?

A hire-purchase is defined as the sale of property where at least one payment is not made until after the tax year of the sale.

The IRS allows taxpayers to defer a portion of the capital gain on the sale of investment property under a hire purchase agreement. This arrangement allows sellers to declare a pro rata portion of their capital gains over several years.

A seller is not allowed to use the hire purchase method when reporting a loss.

How the hire purchase method works

Declaring earnings in an installment sale is theoretically simple. The taxation of hire-purchase mirrors that of annuities, where a pro rata portion of each payment is considered a return of principal.

The only stipulations are that the property being sold cannot be a publicly traded security or part of a business’ normal inventory, and the taxpayer cannot be a dealer in the property being sold (with the exception of some timeshare dealers who choose for a special interest rate under the hire-purchase method).

Reporting of hire purchase income

Hire-sale income can be broken down into three separate categories: capital gain, interest, and principal. Each of these is covered separately on the 1040 form.

The gross profit percentage is then used to calculate hire-purchase income for a given tax year.

Capital gain

In the example above, Hal has to report the gain each year as long-term or short-term, whichever it was in the year of the sale. Long-term gains are taxed at a lower rate, while short-term gains are taxed as ordinary income.

Since Hal has held the house for five years, the payoff, in this case, would be long-term.

If the gain had been short-term, Hal could still be taxed on the installment income at a lower rate than if he had had to report the lump-sum gain. This is because short-term gains are taxed as ordinary income, at the taxpayer’s top marginal tax rate.

If the proportional gain doesn’t push him into the next tax bracket, this rate may be lower. The gain from a hire purchase is reported on IRS form 6252 and then reported on Schedule D on the form 1040.

Interest

Taxpayers with hire-purchase income must also declare the buyer’s interest, which is taxed at the ordinary income rates.

Interest provided in the sales contract is referred to as declared interest. If there is insufficient (or no) interest reported, part of the principal amount of the sale must be redefined as unreported interest.

Principal

Part of each hire purchase is treated by the IRS as a tax-free principal repayment. This amount can be determined by completing Worksheet A on Publication 537.

The principal (adjusted basis) for hire-purchase purposes is the total of your actual adjusted basis in the property plus any sales expenses and depreciation recovery.

In this example, Hal has $200,000 as an adjusted basis in his home. He must add $100,000 for recovery depreciation and $10,000 for sales expenses in order to calculate his he adjusted basis for hire-purchase purposes. This figure is $310,000.

Gross profit percentage

To calculate the gross profit percentage, you need to subtract the hire-purchase adjusted basis, in this example $310,000, from the sales price to calculate the total gain. In this example, the total earnings are $90,000 ($400,000 – $310,000).

Next, divide the total profit by the sales price, which in this case is 22.5% ($90,000 ÷ $400,000) and you get the gross profit percentage.

Finally, to calculate the taxable capital gain each year, multiply that percentage by the installment amount. Therefore, Hal’s taxable earnings each year are assumed to be $11,250 ($50,000 x 22.5%).

There are many rules and regulations related to hire purchases and they must be followed carefully. If in doubt, consult a tax specialist.

Mortgages and contract price

If the purchaser of the property takes on a mortgage or some other bill of exchange with the purchase, the cost basis of the property must be reduced by the amount of the mortgage or bill of exchange. To return to our example, suppose Hal has a $100,000 mortgage on the property he sold.

If the rental property that Hal sold for $400,000 has a $100,000 mortgage, the contract price is reduced to $300,000 ($400,000 – $100,000).

If the mortgage amount exceeds the property’s adjusted total basis, the difference must be reported as a payment in year one and the contract price is increased by that amount.

For example, let’s say Hal’s estate has a $250,000 mortgage. In addition to the installment payment, Hal will need to report an overpayment of $50,000 ($250,000 – $200,000) during the first year.

Example of installment sale

Using the example from above, let’s see how Hal might structure his hire purchase if he wanted to defer capital gains taxes to a future year.

Hal receives an offer of $400,000 for his rental home. He bought the property for $300,000. Over the years, he’s taken $100,000 in depreciation deductions, bringing his adjusted basis to $200,000.

Therefore, Hal has $200,000 ($400,000 – $200,000) of taxable earnings to report.

Hal’s advisor advises him to split the proceeds from the sale into eight annual installments of $50,000 each instead of declaring $400,000 in one year. As long as installments are received constructively each year, this method will allow Hal to record profits, and therefore a proportionate portion of earnings, over eight years.

What constitutes a hire purchase?

A hire purchase of an investment property is made when a buyer makes payments to a seller over an extended period of time rather than in one payment.

Specifically, under the IRS definition, at least one payment must be made after the tax year in which the sale occurs.

What are the 3 parts of a hire purchase payment?

The three parts of a hire purchase include:

  • Interest income: declared or undeclared
  • Principal – the return of your adjusted basis in the property for the purpose of hire purchase
  • Sale Gain: The short-term or long-term capital gain based on the length of ownership prior to the initial year of the sale

Which tax form should I use to report interest income from a hire purchase?

You will use Form 6252, Hire-Sell Income, to report hire-purchase interest income.

Information from your Form 6252 flows through Schedule D, Capital Gains and Losses, which flows through your Form 1040.

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