Archive for September, 2015|Monthly archive page

Back to Basics Part XXIII – Form 6252 – Installment Sale Income

Originally published in the Cedar Street Times

September 18, 2015

Let us assume you are ready to sell a personal residence or a rental property that you have held for many years and it has increased substantially in value from the time you purchased it.  If a buyer comes in with all cash or obtains a loan from a bank to buy the property from you, you will recognize the full gain in the year of sale since you get paid in full in the year of sale.

This will skyrocket your income in the year of sale and reek havoc on your taxes.  Even though the gain from sale will be considered a long term capital gain, having too much in one year could subject part of the capital gain to a 20 percent rate instead of the normal 15 percent rate.  It will also make your adjusted gross income much higher.  This will in turn effectively increase your tax on other income since many deductions and credits phase out based on your adjusted gross income.  You could also hit an additional 3.8 percent tax on investment income which you may not have been subject to without the sale.  There could be a lot of negative effects.

Spreading out income over a period of years is generally a more tax efficient strategy than having one banner year.  So how can you avoid this?  An installment sale, given the right circumstances, is your answer.

With an installment sale, you are basically telling the seller to pay you over a period of years instead of all at once.  Of course, you are generally going to want some interest from the buyer as well if it is going to take a period of years for them to pay you off.  With real estate this often takes the form of a seller financed mortgage.  You are basically the bank.

In this scenario, you get to spread the taxable gain out over a period of years, thus not creating a bunch of extra tax due to a banner year, and you also create a nice stream of interest income for a period of years.  The flip side is that you bear the risk of having to foreclose or repossess if they do not make good on their payments.  Also, should you suddenly need the money from your loan to the buyer, you may have to sell the note at a discount to someone else to get your cash out.

If you choose an installment sale, generally a portion of each payment to you will be interest income, a portion will be capital gain, and a portion will be nontaxable return of basis.

Assume you bought a second home years ago for $400,000 and you find a buyer willing to pay $1 million.  If they pay all cash or get a loan from a bank to pay you on the closing date, you have $600,000 of taxable capital gain that year and $400,000 nontaxable return of basis – that is a 60 percent gross profit.

Let us assume instead they give you a $250,000 down payment at the time of sale and you loan them the remaining $750,000 with a 15-year amortized note. The payment will be about $6,000 a month with roughly half of each payment consisting of principal and half of interest in the early years.  The interest will be taxed as ordinary income as received.  The down payment and the principal portion of all future loan payments will be 60 percent taxable capital gain and 40 percent nontaxable return of basis until the loan is paid off.

This is a wonderful way to defer taxation of the capital gains and spread it out over a period of years.

The mechanics of reporting an installment sale play out on Form 6252.  The above example is the most basic version of an installment sale, but  after reviewing the Form 6252 you will see some complicating issues which could come into play depending on the circumstances – such as sales to related parties, sales of depreciable assets subject to depreciation recapture, and buyers assuming debt(s) of the sellers.

If you dig into the instructions as well as Publication 537, dedicated to this topic, you will quickly realize that installment sales can become extremely complicated, and there are a lot of special rules to follow depending on the circumstances since the deferral of tax is enticing and could otherwise be abused.  Installment sales that involve like-kind exchanges, contingent sales, sales of businesses, securities, or other things through the installment method, unstated interest rates in the loan term, dispositions of an installment sale, etc. all add additional complications.

Since installment sales require a higher risk tolerance for the seller, you often see them between related parties where trust is greater.  There are can be some unfriendly rules for such transactions.  You should consult with a tax professional prior to entering an installment sale with a related party.

The form itself is a one page form.  The beginning asks general questions about the property including several on related party issues.

Part I of the form deals with calculating the gross profit percentage and the “contract price.”  Note that the contract price is not necessarily the sale price you agreed to, but can be affected if the buyer assumes or otherwise pays off any debt of the seller.  This section is only completed in the year of sale.

Part II deals with sorting out the capital gains versus ordinary income, versus recapture income and applying the gross profit percentage to the payments received each year.  It is prepared each year.

Part III deals with specifically with related party transactions and necessary recalculations in certain of those circumstances.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part XXII – Form 6251 – AMT

Originally published in the Cedar Street Times

September 4, 2015

AMT, or “Alternative Minimum Tax” was enacted in 1969 in response to a disturbing report by the Secretary of the Treasury that 155 taxpayers with adjusted gross incomes over $200,000 paid zero tax on their 1967 tax returns.

In its simplest form, AMT is a separate taxation system with its own set of rules that runs parallel to the regular tax system.  You are supposed to run the calculations under both systems, and if the AMT system says you owe more tax than the regular system, then you pay the incremental difference as “AMT.”  That incremental difference shows up as additional tax on Line 45 (2014) of your Form 1040.  The calculation of AMT is summarized on Form 6251 and accompanying worksheets, as well as AMT versions of traditional schedules.

The irony of the AMT system is that most of the loopholes it was originally designed to prevent, no longer exist, and it has become a tax that affects the middle and upper-middle class more than the wealthy, yet we still have it and all of its complications.  Today, those who are subject to it, despise its existence, and not many people fully understand it, tax practitioners included.

For people still preparing returns by hand, AMT is an absolute nightmare since many of your other schedules have to be calculated a second time using AMT rules.  For instance, depreciation rules differ between the AMT system and the regular system, as accelerated depreciation methods are generally not allowed.  This means you have to keep an entirely separate set of depreciation schedules just for AMT.  And to make matters more complicated, California does not conform to all of the Federal AMT rules either.  So now you end up with four sets of depreciation schedules – Federal regular, CA regular, Federal AMT, and CA AMT.

I do not think I have ever seen a hand-prepared return done correctly when AMT is involved.  (Actually, in the last ten years, I do not think I have seen any hand-prepared returns done correctly!)

So when do you hit AMT?  It depends.  AMT is calculated on taxable income under about $185,000 at a flat 26 percent rate, and income over that mark at 28 percent.  There is a $53,600-$83,400 AMT exemption amount depending on filing status.

Compared to the regular system, the standard deduction is thrown out (meaning itemizing is your only option), your normal exemptions for yourself, spouse and dependents get the boot, as do many itemized deductions such as state taxes, real estate taxes, mortgage interest on home equity debt (if the funds were not used to improve your home), unreimbursed employee business expenses, tax preparation fees, investment advisory fees and more.

As mentioned before, depreciation methods are not as generous, also ISOs and ESPPs have less tax-friendly rules, investment interest can be hacked, and a whole bunch of other specific differences that apply to certain situations.

Since some people will have more AMT adjustments and preferences than other people, there is no set dollar threshold that will trigger AMT.  That said, I feel that I rarely see it for a Married Filing Joint return with under $100,000 of adjusted gross income.  It also starts phasing out for people with high incomes.  The top AMT rate is 28 percent, but has fewer deductions than the regular system.  Besides a handful of lower brackets, the regular system also has 33, 35 and 39.6 percent brackets, but with more deductions.  At some point, however, the higher tax rates outweigh the additional deductions and the regular system results in more tax than the AMT system. You may pay no AMT once you get to $600,000 or $700,000 of income, depending on your AMT adjustments.

People in AMT that are employees often feel trapped, especially those in the sales industry that are used to generating a lot of deductions from vehicle mileage and other expenses their employers do not reimburse.  It does not matter how many unreimbursed expenses they come up with, they will all get thrown out in the AMT system.

For people that flip back and forth between years of AMT and no AMT, there can be a minimum tax credit generated by the AMT you paid that can be helpful.  If you paid AMT in one year, and the next year the regular tax system is higher than the AMT system, you can get a credit against your regular tax to the extent of the difference between the two tax systems limited to the credit amount generated by certain deferral type AMT adjustments/preferences.  Got it?  Just trust me, sometimes it can help!  There are also sometimes when flipping can be a negative…fairness is not always the result of our tax system.

The best news we have had about AMT in recent years was that in 2013 Congress finally legislated an annual inflation adjustment for the AMT exemption.  For years Congress was in a habit of passing an AMT patch in late December or January to make up for the fact that the exemption was not inflation adjusted, and would return to 1993 levels if nothing was done.

Tax professionals were biting their nails some years wondering if it would happen.  The impacts on middle class Americans would have been tremendous, and many were oblivious.  I read estimates in 2011 that 4 million taxpayers were subject to the AMT, but without a patch that number would have swelled to 31 million!  I can remember running scenarios for a family making around $100,000 and realizing they would have a surprise tax bill of an additional $2,000 or so without a patch.

The form itself is only two pages.  Part I is a summary of all the adjustments and preferences that differ from the regular tax system, to arrive at Alternative Minimum Taxable Income (AMTI).  Part II deals with calculating your AMT exemption, your Tentative Minimum Tax (tax calculation under the AMT system), and then the AMT itself (the amount your Tentative Minimum Tax exceeds the regular tax system amount).  Part III is a supplemental calculation that feeds into Part II when your return includes capital gains, qualified dividends, or the foreign earned income exclusion.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.