What Qualifies a Property for an Installment Sale?
Carl E. Sera, CMT
September 14, 2023
An installation sale can help investors who own properties with impressive appreciation sell properties without fear of incurring large capital gains tax liability. So, what qualifies properties for installment sales? Read through this brief overview of installment sales, their qualifications, and benefits.
What Is an Installment Sale?
An installment sale consists of several revenue recognition approaches under the Generally Accepted Accounting Principles (GAAP). Installment sales account for when expenses and revenue become recognized at cash collection instead of at the time of purchase. It’s a principal method of revenue recognition occurring during a sale.
Qualifications and Requirements
Installment sales can help sellers maintain their income within a preferred tax bracket by spreading out their income. The installment sales can also maintain capital gains tax in a lower tax bracket. Furthermore, installment sales can avoid higher or lower net investment income taxes, higher premiums, and alternative minimum taxes. So, what qualifies a property for installment sales?
Two requirements qualify for an installment sale. First, if an asset becomes sold and payments get made over time, at least one payment must occur after the sale’s tax year. The second method of an installment sale is recorded on Form 6252. Installment sales aren’t available with properties or assets sold at a loss or if real estate or personal properties are sold through dealers. Lastly, selling investment securities and stocks doesn’t qualify for installment sales.
Benefits of Installment Sales
Installment plans are effective tools that aid sellers who want to maintain lower income tax to defer capital gains tax. Explore some beneficial qualities of installment plans and what they can offer buyers and sellers. Some benefits include lower tax brackets, investment safety, little to no capital gains tax, lower market interest rates, and more.
Installment sales are seller financing models where original owners sell properties but don’t collect payments in one swoop. It’s similar to buying a mortgage and paying for said property in one accumulated sum but getting the mortgage from the seller instead. As a result, it’s a relatively secure income stream for the seller, as the property remains as collateral.
If the buyer rescinds their agreement to pay for the property or has no stable financial footing, sellers can take the property back, similar to a bank. Buyers also have greater safety; the property goes into foreclosure if they can’t pay a bank-backed mortgage. In many cases, there’s little recourse to negotiate better terms that permit them to keep the property. Installment plans can potentially allow buyers to renegotiate the terms of the sale with the seller, such as agreeing to pay more over time with fewer monthly payments.
Interest Rates Below Market
If buyers visit a bank or a different institutional lender to receive capital for purchasing a property, they receive an interest rate related to the overall real estate market. Even with interest rates sitting on the lower end for homebuyers, investors could have higher interest rates in loans due to the added risk. For instance, investors can easily walk away from properties if situations go negatively, especially if it isn’t their residence.
Furthermore, commercial investment loans can also receive an extension for a shorter period. Bridge or swing loans only provide capital until buyers can access more standard financing. Buyers can secure purchases at lower market interest rates when a seller-backed sale agrees to installation payments. It’s especially true for securing one below the high-interest rates of bridge and swing loans.
Lower Tax Brackets
A significant benefit to installment plans is that they can aid the buyer by placing themselves into a lower tax bracket. A sizable property or property with a sizable value sale, whether residential or commercial, can push investors into a tax bracket they’d prefer to avoid. Most investors see income changes from year to year—investors with fluctuating incomes can thus face tax rates meant for higher incomes.
Installment plans allow real estate investors to plan out their income accordingly so that they don’t face taxes that potentially pose a risk to their business in the future. Furthermore, lower tax brackets provide the benefit of saving money. Most real estate investors and business professionals utilize itemized deductions to decrease tax burdens and lower gross profits each taxable year.
Minimal to No Capital Gains Tax
Another benefit of installment sales is the limited capital gains tax. Capital gains tax is an intrusive tax that every investor wants to defer as much as possible for real estate investments. If investors have a deal exceeding $469,000, capital gains income taxation going rates reach upward of 20 percent.
It’s an incredibly staggering number—if an investor makes a million-dollar real estate sale, they must pay an estimated $200,000 in tax money. While there are instances where capital gains tax is beneficial, it’s a rare occurrence. Installment sale methods can aid investors in deferring unwieldy taxable gains. So, it’s no surprise that many investors use installment plans for real estate sales.
Top Price and Easy Sales
Both real estate sellers and buyers can benefit from seller financing. Sellers have more leverage to get the desired price due to buyers not requiring an upfront cash payment. Buyers can instead have an easier time closing real estate deals due to their direct approach to the seller and easily work out purchasing terms.
When selling property, getting the desired price can become a tricky endeavor. So, it’s common for asking prices to lower, so much so that sellers must factor it into their advertised selling price. For residential transactions, buyers will present the seller with one lump sum, reducing their ability to close the deal with the asking price they want. Sellers who finance the arrangement for the buyer via installation notes have more leverage to receive the price they asked for.
Because sellers and buyers agree to space out property payments over a set number of years, negotiation of interest rates and sale price can occur. It’s an ideal opportunity for sellers to obtain a steady income stream with locked-in interest rates, a beneficial anchor for their investment portfolio. It’s especially helpful if sellers place cash in fluctuating value investments.
For instance, real estate developers could sell off developed pieces, creating a steady income stream and providing consistent revenue over a longer period. Monetized sales installments can help sellers collect the accumulated interest payments that would’ve ended up in the possession of traditional lenders or banks. Adversely, buyers can write off the interest they pay as part of their installment plan obligations.
Sera Capital offers its expertise and knowledge to individuals who need a fee-only fiduciary. Our registered financial advisors provide investors with the tools to handle 721 and 1031 exchanges, Delaware Statutory Trusts, and other investment types. For more information, schedule a free 30-minute phone call today.