The 1980 Installment Sales Act greatly simplified tax defferal for property sellers who help finance their buyer's purchase. Now every deferred payment sales qualifies for special tax-saving benefits.
Why use an installment sale? An installment sale refers to any real or personal property sale where the entire purchase price is not paid in the year of the sale. In other words, the buyer's payments to the seller are deferred.
Real estate sellers usually secure the buyer's obligation with a mortgage, trust deed, or land contract on the property sold. If the buyer doesn't pay, the seller forcloses and gets the property back.
Benefits of installment sales include: (1) spreading out profits over several years, enabling the seller to avoid a boost into a high income tax bracket in the year of the sale, (2) easy, quick sale for top dollar due to built-in seller financing, (3) buyer payments deferred into a future tax year when the seller may be in a lower tax bracket, and (4) high interest income on the buyer's unpaid balance owed to the seller.
Of course, installment sale tax benefits are not needed if the transaction qualifies for other tax breaks such as the "over 55 rule" $100,000 home sale tax exemption, the "residence replacement rule tax deferral, or a tax-deferred "like kind" property exchange.
The 1980 Installment Sales Act makes tax deferral automatic if the property seller didn't receive full payment in the year of the sale. Of course, if a tax payer wants to pay all his profit tax in the sale year, even if all the buyer's payments won't be received until future years, Uncle Sam will accept such tax payment.
The new law makes five other major installment rule changes:
(1) The biggest change involves elimination of the 30 percent year-of-sale maximum payment. The old law limited installment sale benefits only to sales where the seller received not more than 30 percent of the property's gross sales price in the year of the sale.
That rule was abolished, retroactive to sales closed after Jan. 1, 1980. Now all installment payments are taxed since they are received by the property seller regardless of the amount received in the year of the sale.
(2) Elimination of the two-payment requirement is another major change, retoractive to Jan. 1, 1980. Now it is possible, for example, to sell a property but defer the seller's receipt of his first payment until a later year. Such "nothing-down" sales benefit sellers wishing to defer payments into future tax years when they will be in a lower tax bracket.
(3) Open-end contingency sales now qualify for installment sale tax deferrals too. Such a sale occurs, for example, if the sales price of the property is contingent upon its gross rent collected by the buyer.
(4) New rules for property sales after May 14, 1980 to relatives and controlled corporations are also part of the new law. Simplified, the new law says a property seller owes tax on any resale profit if the related buyer resells the property within two years after the original sale.
(5) Tax-deferred exchanges now can qualify for installment sale tax deferrals too. The new law excludes value of the property received by the "down trader" when computing the profit tax.
Installment sales only postpone payment of the profit taxes. Such sales are tax exempt. The result is that each payment the seller receives from the buyer is partly taxed.
After subtracting the interest portion (taxed as ordinary income) from each payment received, the principal payment is then broken down into (a) taxable profit, (a long term capital gain if the property was owned over 12 months before sale) and (b) tax-free return of capital investment.
To calculate this percentage, the net profit on the sale is divided by the contract sales price (which is gross sales price minus existing liens on the property). The resulting percentage is then applied to each principal payment received by the seller.