Offering buyers an installment sale agreement can widen your buyer pool and potentially reduce your capital gains tax liability. However, while an installment sale helps defer taxes, it’s important to note that it doesn't eliminate your tax responsibility—especially when it comes to depreciation recapture.
What is an Installment Sale?
An installment sale allows you to receive payments from the buyer over time, instead of a lump sum. According to the IRS, a transaction qualifies as an installment sale if at least one payment is received in the year after the sale is made. This strategy can help spread out your capital gains taxes, making it a popular choice for those selling high-value properties.
For example, if you sell a commercial property for $500,000 and agree to receive payments over ten years, you would only pay capital gains taxes on the payments received each year. The key is to report this income using Form 6252 – Installment Sale Income.
However, depreciation recapture works differently and requires full attention during the sale process.
Understanding Depreciation Recapture
Over the course of ownership, you likely claimed depreciation deductions against your property’s income. Depreciation is a tax deduction spread over a property's useful life—27.5 years for residential properties and 39 years for commercial properties. However, when you sell, the IRS wants a portion of this back through depreciation recapture tax, which is often taxed at a rate of up to 25%.
Let’s consider an example:
You purchased the property for $400,000 and held it for 10 years, claiming approximately $14,545 annually in depreciation.
After 10 years, your adjusted cost basis is $400,000 minus $145,454 in depreciation, leaving a basis of $254,545.
If you sell the property for $500,000, your realized gain is $245,454, and the IRS will apply depreciation recapture tax to the $145,454 you deducted over the years.
The depreciation recapture tax on that amount could be 25%, which means you may owe around $36,363 in taxes.
Depreciation Recapture in an Installment Sale
Unlike capital gains tax, which can be deferred with an installment sale, depreciation recapture tax is due in full at the time of sale. So, while an installment sale helps spread out income, the depreciation recapture tax must be paid upfront, even if you haven’t received all of the payments.
In our example, even if you receive just $50,000 in the first year of your installment sale, you would still owe the entire depreciation recapture tax, requiring you to come up with additional funds to cover this expense.
Is an Installment Sale Right for You?
An installment sale can offer a significant tax benefit by deferring capital gains, but it’s crucial to understand the tax implications of depreciation recapture. Before proceeding, consult with a qualified tax advisor who can assess whether this strategy is beneficial for your specific situation.
Key Takeaways
Installment sales spread capital gains taxes over time, but not depreciation recapture taxes.
You may owe depreciation recapture tax upfront, regardless of when you receive payments.
Speak with a tax professional to understand how these strategies fit into your overall tax plan.
For more expert guidance on real estate transactions and 1031 exchanges, give us a call.
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