Maximize Profits With an Installment Sale

1. Introduction

As most of you know, real estate is very rarely purchased outright for cash. In most instances, the buyer makes a cash down payment and borrows the remainder to be repaid over a period of years.

Most often the buyer will borrow this balance from a commercial lending institution such as a bank or a savings and loan. On occasion the seller is willing to “carry paper” and basically act as a lending institution. The latter situation is what is commonly referred to as an installment sale.

Now there are many reasons why a seller may want to encourage an installment sale. Sometimes the only way to make the sale happen is if the seller is willing to loan the buyer the funds. This is frequently the case when:

The buyer is unable to personally qualify for a conventional loan;
The lender is not willing to loan as much as the buyer needs;
Or worst of all, The property itself will not appraise high enough for a conventional lender to make the loan.

Sometimes, however, the seller is not interested in buying anything else with the proceeds from the sale. In that situation, the seller is encouraged to take back a note for both income tax reasons as well as return on investment (ROI) reasons.

You see, an installment sale is treated quite differently for income tax purposes than a conventional sale. If you, the seller, carry back a note, then potentially you will only be taxed on a fraction of your gain during the year of sale.

2. Calculations

Unlike in an outright sale, with the installment sale the taxable gain in any year is dependent on a factor called the Profit Percentage. This Profit Percentage is the ratio of the Gross Profit to the Contract Price. The Gross Profit in most situations is calculated the same way for an installment sale as it is calculated for an outright sale.

To illustrate this let's set up an example of an installment sale and let's calculate the Gross Profit.

Illustration #1

Mark is planning to sell an apartment building in Los Angeles this year for $825,000. He owns the property free-and-clear. His projected Gross Proceeds from this sale would be calculated as follows:

(1) Sales Price	$825,000
(2) Expense of Sale (@ 7%)	$57,750
(3) Gross Proceeds (line 1 less line 2)	$767,250

Mark's property was purchased in 1978 for $267,500. Over the 18 years that Mark has owned the property he has spent approximately $48,565 in improving the property.

Over the same period of time, Mark was allowed to depreciate $143,872 of these costs for tax purposes. This year, prior to the close of escrow, Mark will be allowed to depreciate an additional $3,892. The Gross Profit for Mark's property is then calculated as follows:

(4) Purchase Price	$267,500
(5) Cost of Improvements	$48,565
(6) Depreciation Allowed	($143,872 + $3,892) $147,764
(7) Adjusted Basis (lines 4 and 5 less line 6)	$168,301

(3) Gross Proceeds (line 1 less line 2)	$767,250
(7) Adjusted Basis (line 4 and 5 less line 6)	$168,301
(8) Gross Profit (line 3 less line 7)	$598,949

The Profit Percentage, as we said before, is the ratio of the Gross Profit to the Contract Price.

Illustration #2

To illustrate this let's calculate the Profit Percentage for the previous illustration.

(8) Gross Profit	$598,949
(1) Contract Price (Sale Price)	$825,000
(9) Profit Percent (line 8 divided by line 1)	$72.6%

The Taxable Gain in any year is equal to the principal payments received during that year times the Profit Percentage.

Illustration #3

To illustrate this lets assume that the buyer put 10% down and Mark carried back a 90% note. We calculate the Taxable Gain for the year of sale as follows:

(10) Down Payment	$82,500
(9) Profit Percent	72.6%
(11) Taxable Gain (line 10 times line 9)	$59,895

The bottom line is that by carrying a 90% note (i.e. an installment sale) Mark was able to reduce his taxable gain for the year of sale to $59,895 from a potential of $598,949. In subsequent years, as the buyer pays down the principal of the note, Mark will only have to recognize 72.6% (the gross profit percentage) of that principal as gain for tax purposes.

3. Points to Consider

You have to be careful when you structure an installment sale. If the buyer assumes an underlying note as well as creating a new note to you, you might wind up with more taxable gain than you bargained for.

This problem of phantom income occurs when the buyer assumes an existing note whose outstanding principal balance is in excess of the property's adjusted basis.

In such a situation, the IRS wants you to include this difference during the year of sale as gain due to mortgage relief. On a similar vain, any mortgage acquired by the buyer (even if not assuming existing financing) is construed as income to the seller in the year of the sale.

It is advisable that before you offer a prospective buyer the opportunity to assume an underlying note that you consult your tax adviser. A preliminary calculation will quickly tell you what value of gain you will have to declare during the year of sale.

It might be in your best interest to keep the old debt and create a new note that equals the value of the existing debt plus your carryback. This is referred to as a "wrap-around" mortgage or an All Inclusive Trust Deed (AITD). This technique avoids the phantom income problem.

The return on investment feature of an installment sale can also be quite attractive. Once again if you were selling without the intent of buying a replacement property (otherwise a section 1031 exchange would be more appropriate) then most likely you would place the proceeds in some interest bearing account.

By carrying the paper yourself, you can negotiate with the buyer to pay you interest at conventional lending rates. The interest you charge on the carryback will most likely be higher than what you would earn in a savings account. Better yet, you can structure your deal so that you do not receive any principal paydown (i.e. interest only) and thus get a return on the full equity without any shrinkage due to taxable gain recognition.

There are some potential problems with installment sales that are worth noting. As is the case with most real estate investments, it is hard to predict how long the buyer will hold on to the property.

The reason that is important is that when they sell the property, most likely your note will be paid off, especially if your note has a due on sale clause. When your note gets paid off, the installment treatment disappears and you have to recognize the balance of your taxable gain.

If you created your note during a period of high interest rates, then you are also vulnerable to refinancing when conventional rates drop. Again the consequence to you is a payoff that triggers the balance of your taxable gain.

Now there are ways of minimizing the potential for payoff. For one thing you can make your note assumable. For another thing you can set the terms to be attractive and/or negotiable so as to be competitive with whatever rate conventional financing becomes.

Another potential shortcoming to the installment method of sale is that you become a creditor of the buyer. What that means is that if the buyer fails to make payments per your note, you may have to foreclose.

Foreclosure is not fun. It can be costly if you have to repossess a property that is in worst condition than it was when you sold it.

One way of minimizing the potential for foreclosure is to require a bigger down payment. This earnest money on the part of the buyer, assuming that there are not significant drops in values, will lock them into the investment.

Another way of minimizing the potential for foreclosure is to cross collateralize the carry back note with more than just the property sold. This way if the buyer defaults, they risk more than just the property sold to them by you.

Now installment sales can be incorporated into tax deferred exchanges. For example, you can use the down payment as part of an exchange and defer any gain attributable to these sums.

The note you carry will be classified as boot for tax purposes. You will still be allowed to use the installment method of reporting for recognition purposes and thus might not have to recognize any gain until you receive principal paydowns.

Be careful here as well. Your basis in the note might not amount to anything. You see in a tax deferred exchange, the residual adjusted basis will first be allocated to the replacement property. Any excess basis will then be used to calculate your gross profit percentage.

In installment sales between related parties, there are additional rules one needs to be aware of. The “two year rule” states that if you sell your property on an installment basis to a related party, and should a second sale take place within two years, then the outstanding balance of the gain of the first sale will have to be recognized as well. This rule was put in place to minimize tax avoidance strategies.

The “pledge rule” is another IRS rule to be aware of. This one simply says that should you use your note as collateral for a loan, then the amount borrowed should be deemed as a payment made on the original note and be reported on the original installment sale. When the actual payment on the note is made you will not need to recognize the gain again. No double taxation!

Those who inherit an installment note should be aware that the present value of future payments on the obligation will have to be included in the decedent's gross estate.

Now if that doesn't sound bad to you, then how about the fact that the beneficiary of the note will also have to report and pay taxes on the annual gain received as if the seller was still alive! The good news is that if the decedent actually had to pay estate taxes, then there will be a credit against the income tax obligation of the heir.

A few final things to be aware of are that the installment sale of reporting is not available to people or entities who are deemed to be “dealers.” Additionally, the installment method of reporting is mandatory unless you elect out during the year of sale.

There might be good reasons to elect out. Most notably, if you are subject to a lower tax rate during the year of sale or you have expiring tax attributes such as Net Operating Losses (NOL's), it might be in your best financial interest to recognize the entire gain in the year of sale.

RealTax professionals have the knowledge and expertise to maximize your profits with an installment sale. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.