By Jodi Summers

Bobby was in a quandary. He had been in the automotive business for more than 20 years. Each time he changed locations, he bought a new commercial property and he’d lease out the old location. Now he was looking to lessen his responsibilities. The issue was, when he looked into selling, he realized he’d have to give the government 15 percent capital gains tax and state withholding taxes on the sale, on top of various other tax fees.

“They were taking a huge chunk of the profits from the sale, but other than trying to find an exchange property, I didn’t really know what else I could do about it,” Bobby says.

His accountant suggested he think about an installment sale. An installment sale is a viable option for investment property holders whose net gain is more than $500,000 on the sale of their property.

“You get the use of the tax amount that you would normally pay and you get to turn interest on this,” says Donald Schmidt, a certified public accountant and real estate broker for Richland Properties. “The installment sale process should be used more.”

Real estate installment sales, which are reported on tax form 6252, work like a loan from the seller to the buyer. The two parties determine the time period of the loan and a fair interest rate for the money that will be paid out.

“The real benefit of an installment sale is that it enables a buyer who doesn’t qualify for a mortgage to purchase property,” says John W. Roth, a tax and business law analyst.

From the seller’s point of view, an installment generates a steady income stream. It also might allow a property owner to sell for a higher price to someone who might not qualify for a mortgage — or to dispose of a piece of property that has been difficult to sell.

Schmidt notes that in the current market, the seller could get a rate of about 8 percent. He also says that fees and closing costs are significantly less since lenders do not get involved.

THE DETAILS OF INSTALLMENT SALES

If you have a taxable profit on the sale of real estate, business property or personal effects, the tax law allows you to be paid in installments that may stretch out over years. The advantage is that you don’t have to report the gain on your tax return until you receive the money, so the sale won’t push you into a higher tax bracket or boost your income to a level where you lose tax benefits. The disadvantage is that you don’t get all of the money right away.

The terms of the loan or “carryback” vary, depending on the agreement between the seller and buyer. Typically, in an installment sale, the buyer puts down 20 percent to 30 percent of the sale price up front and pays the remainder in regular increments for a designated length of time, or in a lump sum at the end of the loan period. The seller collects interest on a regular basis throughout the life of the loan. As a result, he or she must pay capital gains tax on the lump sum amount in the first year, but not on the dollars still outstanding.

In each year following, the seller pays capital gains tax on the amount that came in from the sale in that particular year, plus income tax on the interest.

A very basic example is if the total sale were $400,000, with the buyer paying 25 percent, or $100,000 up front. The remaining $300,000 would be due at the end of a 10-year term and the seller would make $30,000 per year in interest income — at an annual interest rate of 10 percent.

Each interim year, the seller would get taxed only on the $30,000. In the 10th year, the seller would pay taxes on this interest income plus a capital gains tax on the $300,000 changing hands.

The major risk involved in this type of sale is the possible default by the borrower. Experts advise the seller to require 20 percent to 30 percent up front so the buyer has some equity in the property, should the borrower default — forcing the seller to foreclose. That equity could cover the cost to the seller of foreclosing and reselling the property.

The seller also might consider that if the borrower pre-pays the loan, it would defeat the purpose, since fewer dollars would be collected in interest. Many installment sales contain a clause penalizing or prohibiting pre-payment.

The installment-sale process can be applied to any income-producing property, including residential investment properties. It also could be applied to a primary residence, but it is generally more beneficial for home sellers to take the available tax deduction of either $250,000, for single taxpayers, or $500,000, for married filers, on the principal.

Another option to defer taxes is a 1031 exchange. Many owners of investment properties benefit from the 1031 tax-deferred exchange, which states that the seller can defer taxes on the sale if he rolls the gain into the purchase of another property — or if he trades his property for another seller’s property. In the first case, the seller would not be taxed on the gain from the sale until he sells the new property he just bought.

To report an installment sale, use IRS form 6252, Installment Sale Income, to report installment income each year. You will need to file form 1040, and may need to attach form 4797 and form 1040, schedule D. For additional information, refer to publication 537, “Installment Sales.” For making installment sales and other tax scenarios work for you, consult your accountant.

(Jodi Summers is director of the investment division at Boardwalk Realty Santa Monica. Contact her at jodis@boardwalkrealty.com, or call 310-309-4219. Visit her Web site at www.santamonicalandmarks.com.)