This Newsletter is designed to be of general interest. The specific techniques and information discussed may not apply to you.Before acting on any matter contained herein, you should consult with your personal legal adviser.
Under the Installment Method of reporting, gain from the sale of investment or personal use property is prorated and taxed over the years in which payments are received. Essentially, in an Installment Sale, the Seller `carries back paper.’
A simple example illustrates this concept:
Seller owns a property (investment property, or his residence) free and clear, with a tax basis of $50,000. If he sells it for $200,000, Seller’s taxable profit (capital gain) is $150,000.
Buyer pays $75,000 down; Seller carries back the remaining $125,000, payable and amortized over 30 years with interest at 7%; monthly payments are $831.63. Closing is June 1; the first payment is due July 1.
During 1996, Buyer makes 6 payments of $831.63, in addition to $75,000 down.
Seller reports the sale on his 1040, using IRS Form 6252.
The payments will be taxed in 3 components: return of capital; capital gain; and interest.
First, Form 6252 works through the “gross profit ratio” of 75% by dividing the “gross profit” by the “contract price.”
Gross Profit Ratio: $150,000 / $200,000 = 75%.
This means that 75% of every dollar of principal is profit, subject to capital gains tax whenever it is received; 25% of every dollar of principal is a tax free return of principal; all interest is taxable, whenever received.
In the first year, Seller gets $75,000 down, plus $4,989.78 (6 payments of $831.63): $4,365.96 is interest; $623.82 is principal.
IRS Form 6252 reports the downpayment plus principal as 75% taxable as capital gain; 25% is a tax free return of capital. $4,365.96 is taxable interest income.
Eventually, Seller will get $200,000 of principal, $150,000 (75%) of which is taxable, the same as if he had made an outright sale. The Installment Sale Rules allow the Seller to spread the tax liability over an extended period of time.
Now, let’s complicate matters slightly with a more realistic situation: a 6% commission and $1,000 escrow fee is required.
Now, Form 6252 computes the “gross profit ratio” as follows:
Gross Profit Ratio: $137,000 / $200,000 = 68.5%. Seller pays tax on 68.5% of every principal payment received, even though all of the costs of sale are paid in the first year.
As before, in the first year, Seller reports on IRS Form 6252 $75,000 down, plus $623.82 principal; 68.5% of this total is taxable capital gain; 31.5% is tax free return of capital. $4,365.96 is regular interest income.
Eventually, Seller will get $200,000 of principal (before payment of selling expenses of $13,000), $137,000 of which is taxable, the same as if he had made an outright sale.
It is possible that the tax due is more than the payments actually received by the Seller in the year of the sale (as all payments go first to cover expenses of sale).
Seller’s Mortgage is Paid Off
If the same property had been mortgaged for $35,000, closing costs are $13,000, and Buyer pays $50,000 down, Seller nets $2,000 at close of escrow.
|Net to Seller||$ 2,000|
Gross Profit Ratio: $137,000 / $200,000 = 68.5%. Seller must pay tax on $34,250, (68.5% x $50,000 – assuming no monthly payments are made) even though he only netted $2,000!
Seller’s Mortgage is Assumed/Subject to
If the Buyer assumes (or takes the property subject to) the Seller’s mortgage, the Contract Price is reduced. If the mortgage assumed by Buyer is $35,000, closing costs are $13,000, and Buyer pays $15,000 down, Seller nets $2,000.
Seller’s Gross Profit Ratio is:
|Gross Profit||Contract Price|
Gross Profit Ratio: $137,000 / $165,000 = 83%.
Seller pays tax on 83% of every principal payment (excluding the mortgage assumed/ subject to). Seller’s first year profit is $12,455 (83% of $15,000), even though he nets $2,000.
ECONOMIC RISKS TO SELLER: In addition to a tax analysis, the Seller must also analyze his economic risks. If the Buyer defaults, foreclosure is necessary. Although some real estate experts encourage carrybacks (especially for senior citizens who want fixed returns greater than banks will pay) it is very risky unless there is at least 20% equity to protect the Seller.
Often a Buyer puts down 10%, borrows 80% from a bank. The Seller carries back the final 10%. If the Buyer defaults, the Seller forecloses, takes the property back, and re-sells it. It seems that the Seller has protection, but look closely: the Buyer probably owes the bank (and the Seller) 4 to 6 months worth of payments, interest, and penalty. Next, the Seller has foreclosure costs. At the auction the Seller usually bids his paper and no one overbids. [If there is an overbid, the Seller gets all of his money and does not care what happens next.] Seller hires a Realtor to sell the property again. Another commission, plus carrying costs to the bank on the first mortgage (while the foreclosure is pending and until the property is sold). That 10% down by the Buyer is long gone. Then the Seller might not recoup his loss, even if the property is still in great shape and has not been trashed by an unhappy Buyer.
And, the Buyer has no personal liability on any seller carryback loan (absent fraud or waste)!
Related Party Rules: If Seller and Buyer are related, some complications occur.
Obviously, a tax and risk analysis must be made, and other options considered, such as:
- §1034 (2 year rollover for primary residence)
- Over 55 Rule (for primary residence)
- §1031(a/k/a Starker/deferred exchange)
- CRUT (often called a Capital Gains Avoidance Trust)
- Gift followed by Sale
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