Archive for the ‘installment sale’ Tag

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.

When Can I Throw Out My Tax Returns?

Originally published in the Cedar Street Times

May 3, 2013

It is time to do some spring cleaning!  Do not miss your opportunity as summer is coming quickly, at which point you will be required to keep everything for another year.  Perhaps you will find that old pair of muddy tennis shoes in the garage – now the home to three indignant spiders as you turn their palace upside down.  Or maybe you will find that half-used bottle of hotel shampoo under the sink – a small, but satisfying entitlement for a $300 room charge.  Ah, and then there are those tax returns you filed way back in April – is it time to get rid of those too?!

You can do whatever you want, but my advice is to keep them.  In fact, I would say you may want to keep every tax return (and the supporting documents) you have ever filed – I know I have.  Record retention is always an interesting debate and you hear a lot of people say three, five, or seven years as a rule of thumb for many types of documents.  Regarding tax returns, the real answer is unique to each person depending on his or her tax circumstances and risk tolerance.

Someone that works a W-2 job, has no other sources of income, no investments, contributes to no retirement plans, and files the returns correctly would have little risk if discarding the returns after four years.  If you do make retirement plan contributions, depreciate any assets, have an installment sale agreement, or a host of other things, it would not really be wise to discard the returns in accordance with a rule of thumb.

The IRS generally has three years from the later of the due date (or extended due date) or the date you file to audit your returns.  The California FTB has four years from the later of the non-extended original due date or the date you file in order to audit.  You should never throw out returns or source documents until you are outside of these statutes of limitation.  If you have understated your gross income by more than 25 percent (even if by accident), then the IRS has six years to audit you.  People can get tripped up on this pretty easily if they fail to report stock sales.  I have seen this before with people preparing their own tax returns that ignore the 1099-B issued year-after-year because they did not really understand it.  If you filed a false tax return or there was any kind of fraud, there is no statute of limitations.

Even if you are outside the statute of limitations, however, you may still need prior tax returns to support positions you are taking on current tax returns that are inside the statute of limitations.  Think about someone that has been contributing to an IRA for many years and was unable to take deductions due to income limitations.  Each of these nondeductible contributions would have created basis in the IRA which would lower the taxable amount of distributions while in retirement.  If the IRS audited your returns in retirement and questioned your basis, having all the past tax returns showing the nondeductible contributions would be a saving grace.

People that have rental properties or home offices may find tax returns from twenty-five years ago helpful in proving the basis in the property when it is eventually sells due to depreciation deductions taken on each past return.  I have also had situations where clients had no idea what their cost basis was for a stock sale, and we were able to help recreate and substantiate the cost basis by reinvested dividends reported on tax returns stretching back several decades.

The safest thing to do is just keep them, or at least scan them and maintain the electronic files through the years.

One other pointer – be sure you do not throw out purchase records, refinance documents, or receipts of improvements to any type of property you own as you will likely need this information if you ever sell it.

Prior articles are republished on my website at www.tlongcpa.com/blog.

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.