If you are considering selling your rental property, you may have heard that you can defer your capital-gains taxes by conducting an “installment sale” under §453 of the Internal Revenue Code.
For example, if your buyer agrees to pay you in ten equal annual payments, you can recognize 1/10th of your total gain in each year, thereby stretching out your capital-gain tax liability over time. Of course, you still have to pay additional income tax on any loan interest you receive from the buyer along the way.
This may sound like a great idea, but there are some important drawbacks to this strategy:
Potentially lower income
Your interest income from the installment note may be less than the rental income you could earn by fully re-investing your equity in the rental property.
No depreciation deduction
Even if the interest portion of the installment payments is high, the interest likely will be fully taxable as ordinary income, without any offset for depreciation.
Limited reinvestment options
You will have limited options for reinvesting 1/10th of your sale proceeds each year, as opposed to reinvesting a lump sum at the time of sale.
Repayment / principal risk
What if the buyer fails to manage the property and then ultimately defaults on the payments? You could be forced to take back a worse version of a rental property you no longer wanted in the first place.
Year-one tax hit
If you receive a large initial down payment, or if the buyer assumes your previous debt on the property, you could pay a hefty capital-gains tax bill in the year of sale.
You WILL pay the taxes—and they may get higher
Unlike §1031 exchanges, which allow you to potentially avoid capital gains taxes altogether by deferring until your death, you cannot avoid paying tax on the installment payments you receive—and the tax rates could go up!
While there may be legitimate reasons for structuring a sale as an installment contract, you may find that the financial and tax benefits of this strategy do not quite measure up to those of a traditional §1031 exchange.
If you have any questions about investing in passive real estate exchange programs, please give 1031 Capital Solutions a call today. Thank you.
SOURCES: IRS Publication 537