A tax strategy for spreading capital gains over several years
Anyone who sells a capital asset on an installment note with the buyer making payments over time can choose to spread the income from the sale over the life of the installment note. Spreading the capital gains income over multiple years can, in some circumstances, reduce the amount of tax compared to reporting the entire gain in one year. This tax strategy is called an installment sale.
The key benefit of the installment sale strategy is spreading capital gains income over time.
Depending on a person's financial circumstances, spreading capital gains income over time can result in:
- Income being taxed at potentially lower tax rates;
- Pairing the cash flow of money coming in from the buyer with money going out for taxes;
- Preventing huge, short-lived spikes in income, adjusted gross income and tax; and
- Potentially more cash-in-hand to re-invest, save or spend on you see fit.
A secondary benefit is that the seller earns some interest on the seller-back loan to the buyer.
Installment sales require two factors.
- You agree to sell an asset to a buyer with payments made over time. At least one payment must be received in a year after the tax year of the sale.
- You choose to report this as an installment sale on Form 6252. (Alternatively, you can elect not to use the installment sale method.)
When Jorandus (not his real name) sold his business, he was able to spread the tax impact over several years using the installment sale method.
An installment sale is a transaction in which a person sells a capital asset to a buyer over time and at least one payment is received in a year after the year of the sale. For Jorandus, the sales contract specified that the buyer would pay 30% of the selling price up front, 40% in one year, and the remaining 30% in two years.
This made it possible for Jorandus to report 30% of his capital gains in the first year, 40% in the second year, and 30% in the third and final year. Additionally, because Jorandus had to wait to receive his payment, the buyer paid interest on the second and third payments.
In order to figure out whether Jorandus would be better off using the installment sale method, we will need to calculate what the tax impact would be 1) if he reported his gains over time compared to 2) if he reported all the gains in the year of sale. In order to do this comparison, we'll need to know what income and deductions he has for these years. And since some of those years are in the future, we may need to estimate what his future income and deductions might be. Jorandus will be receiving $100,000 from the sale of his business, minus selling expenses of $10,000, over three years. Plus the buyer will pay interest on the second and third installment. Additionally, Jorandus estimates he'll have about $36,000 of ordinary income each year apart from the gains from selling his business. He doesn't anticipate any significant deductions. We can now compare two tax scenarios.
Elect Out of Installment Sale
|Year 1||Year 2||Year 3||Year 1||Year 2||Year 3|
|Payment from the seller||30,000||40,000||30,000||30,000||40,000||30,000|
|Gross profit percentage||90%||90%||90%||90%||N/A||N/A|
|Taxable long-term gains||27,000||36,000||27,000||90,000||-0-||-0-|
|Other ordinary income||36,000||36,000||36,000||36,000||36,000||36,000|
|Adjusted gross income||63,000||74,000||66,000||126,000||38,000||39,000|
|Federal income tax||5,821||7,771||6,721||15,271||3,728||3,878|
|Effective tax rate||11.01%||12.17%||12.03%||13.18%||13.39%||13.44%|
|Marginal tax rate on ordinary income||25%||25%||25%||28%||15%||15%|
|Marginal tax rate on long-term gains||15%||15%||15%||15%||0%||0%|
|Tax over 3 years||20,313||22,877|
|After-tax income over 3 years||182,687||180,123|
|3-year average effective tax rate||11.84%||13.26%|
|Calculated using the 2014 tax rates, standard deduction and personal exemption. All gains are long-term. After-tax income is total income minus federal income tax. Effective tax rate is equal to the federal income tax divided by taxable income.|
Let's talk through these two scenarios. Notice the only differences we are measuring are when the taxable gains are included in income – either spread out over three years under the installment sale method (scenario 1) or all at once if the client elects out (scenario 2). All the other income and deduction inputs remain the same between the two scenarios. Over three years, Jorandus will pay approximately $20,313 in federal income tax under the installment sale method compared to paying about $22,877 if he elects out and reports all his gains in the year of sale. That's a tax savings of $2,564 for using the installment sale method. That's extra money Jorandus could use to save or spend as he sees fit.
When constructing a scenario like this, it's important to capture all the relevant information about your current and future taxes.
Different people will be impacted in different ways based on differences in their financial circumstances. Thus the inputs captured and the taxes calculated for your situation may look different than the simple scenario displayed above. So let's dig into these details, so you know what to look for.
The Big Picture: Timing of Income
Under the installment sale method, taxable gains are spread out over multiple years. Gain is measured once (gross sales proceeds minus cost basis minus selling expenses) and is expressed as a gross profit percentage. This percentage is then applied to each payment as it is received. Gains are included in income in each year for which the seller receives a payment from the buyer. In addition, the buyer pays interest to compensate the seller for waiting to receive payment. The interest is taxed separately at ordinary tax rates. The gain is taxed either at short-term or long-term rates, depending on whether the underlying asset was held for one-year or less (short-term) or held for more than one year (long-term). Long-term gains can be taxed at zero, 15%, or 20%. Long-term gains may also be subject to the 3.8% net investment income surtax for higher-income individuals.
What Else to Watch For
The installment sale method is basically a play on the timing of income. Should we spread out the income over multiple years? Or take the tax hit all at once? The "right" answer depends on the specifics of your financial situation.
As a tax strategy, installment sales are about managing the tax rates that apply to the capital gains income. Installment sales can also be used to manage other tax-related impacts. For example, spreading income out over multiple years can help a person manage their adjusted gross income, which may be important in qualifying for deductions or tax credits that are based on income. For example, keeping income underneath a certain threshold can help avoid higher Medicare Part B premiums or can help a person keep their income under the threshold where itemized deductions are phased out.
Increasing income by reporting a large capital gain in one year can potentially:
- Push ordinary income into a higher tax rate bracket;
- Push capital gains income into a higher tax rate bracket;
- Result in more Social Security benefits being subject to tax;
- Reduce or eliminate deductions that are phased out based on income, such as the student loan interest deduction, itemized deductions, & personal exemptions;
- Reduce or eliminate how much can be contributed to a Roth IRA or Coverdell Education Savings Account;
- Reduce or eliminate tax credits that are phased out based on income, such as the premium assistance tax credit, lifetime learning credit or child tax credit;
- Trigger or increase the net investment income tax;
- Trigger or increase the alternative minimum tax;
- Medicare Part B premiums can go up.
Conversely, spreading income out over multiple years can potentially:
- Help keep income within a desired tax rate bracket;
- Help keep capital gains income within the desired zero percent or 15% brackets;
- Result in fewer Social Security benefits being subject to tax;
- Help keep income within range for taking the full amount of student loan interest deduction, itemized deductions, personal exemptions, or other deductions that are limited by income;
- Help keep income within range for taking the premium assistance tax credit, or other tax credits;
- Avoid or lessen the impact of the net investment income tax;
- Avoid or lessen the impact of the alternative minimum tax;
- Avoid or lessen the impact of higher Medicare Part B premiums.
Now, these are the end results. These benefits come about by managing income levels and looking at how different levels of income trigger various tax impacts. When building your own tax planning scenario, be sure to identify all the types of income, types of deductions, types of taxes, and types of tax credits that are relevant for your situation. In other words, we're trying to solve a puzzle here by looking at how a level of income interacts with other parts of your tax return.
- To qualify as an installment sale: the seller sells property to a buyer where the seller receives at least one payment in a year after the year of sale.
- Taxpayers can elect not to use the installment sale method by including all the gains in income in the year of the sale. For this election to be valid, the tax return must be filed by the due date of the return, including extensions.
The installment sales method cannot be used in the following situations:
- Property sold at a loss. Report the entire capital loss in the year of the sale.
- Sales of inventory in the normal course of business, even if the customer pays for the merchandise in a later year.
- Sales of personal property or real property by dealers, even if the property is sold on an installment plan. (However, there's an exception for dealers of time-shares and residential lots. See Publication 537 for the details.)
- Sales of stocks, bonds and other investment securities.
Be aware there are special rules:
- When selling depreciable property to a closely-related person,
- When selling depreciable property and depreciation needs to be recaptured,
- When exchanging like-kind property with installment payments,
- When the selling price of the property is contingent on future events,
- When selling several assets as part of a single sale,
- If the interest rate is left unstated in the sales contract,
- If the installment note is subsequently sold or transferred, or
- If the seller subsequently repossesses the property,
See Publication 537, on the IRS Web site, for an in-depth discussion of these special rules.
While this list is not comprehensive, here are situations in which taxpayers may want to consider selling capital assets using an installment sale.
- Selling real estate, there's no mortgage on the property, and the seller is willing to finance the buyer's purchase. This can generate an income stream over multiple years for the seller.
- Selling a business or significant business assets.
- A large capital gain would push the taxpayer over the threshold for the 20% capital gains tax rate or for the net investment income tax.
- A large capital gain would make the taxpayer responsible for paying higher Medicare Part B premiums
- Publication 537, Installment Sales (IRS.gov)
- Form 6252 (includes instructions, pdf, IRS.gov)
- Publication 550, Investment Income and Expenses (IRS.gov)
- Publication 544, Sales and Other Dispositions of Assets (IRS.gov)