Q. I would like to learn more about the installment sale, and especially the tax consequences if I were to take back a mortgage when we sell our house. I purchased the property for $60,000 many years ago, and put in about $15,000 worth of improvements. I am considering selling the house for about $300,000 and need $50,000 cash. I am prepared to take back a five-year note and mortgage in the amount of $250,000. What are the taxable consequences of this arrangement?
A. In order to qualify for an installment sale, the seller has to receive at least one payment after the close of the taxable year in which the sale takes place. If the transaction qualifies as an installment sale, the seller reports gain -- and pays taxes -- as the payments are received, based on the following formula: Gross Profit
In order to determine gross profit, you take the selling price, subtract all legitimate selling expenses and then further subtract the adjusted basis (cost) of your house. In your example, you have indicated that the purchase price is $60,000 and that you have added $15,000 worth of improvements. You should also look to your original settlement sheet to determine what settlement-related costs can also legitimately be added to your basis. For our example, however, we will assume that your adjusted basis is $75,000.
You have also indicated that the selling price is $300,000. To make these calculations easy, let us assume that this is a net amount, and that you sold the property for a higher price, but when you deduct real estate commissions and other selling expenses, the selling price is now $300,000.
Under our formula, we calculate the taxes as follows: $225,000
In our example, your gross profit was $225,000. If we divide that by the selling price of $300,000, we get a 75 percent figure.
When you are in an installment sales transaction, the payments received are broken down intothree parts. First, a return of your original basis in the property; second, gain on the sale; and third, interest on the seller take-back note.
Interest will be calculated as ordinary income each year.
However, the principal payments that you receive are taxed on a yearly basis, in our example at 75 percent of the total yearly payments. In other words, when you receive the $50,000 down payment, you only have to pay tax on $37,500 of this amount (75 percent) because the balance of the payment represents a return of your original investment. As you receive principal payments yearly, 75 percent of those principal payments are taxable, and the balance again represents a return of your original investment.
You did not say whether you qualify for the once-in-a-lifetime exemption. If you do qualify, then our formula is changed as follows: $100,000
$300,000 x $50,000 = $16,666.67.
In other words, once you are eligible for the $125,000 exemption, instead of paying 75 percent tax, you only have to pay 33.3 percent. Clearly, this is a significant savings to you, and for people who are approaching the age of 55, I would urge them to give serious thought not to sell their principal residence until they reach that age.
Keep in mind that if you do qualify for the installment sale rules, you pay your formula percentage based only on the principal that you receive on a yearly basis. Thus, if you wanted to take back an interest-only loan for five years, you would pay tax at ordinary income rates on the interest, but because you are not receiving principal, you would not have to pay any percentage until the entire principal becomes due, which in your example would be five years. However, when you receive the balloon payment, you would have to pay tax on the percentage of that total payment.
A seller must report gain from the sale using the installment method, unless he or she elects not to use the installment method. This decision must be made by the due date (including extensions) for filling your tax return for the year of the sale. In other words, if you sell your house in 1990, you must make the election when you file your tax returns in 1991.
There are many complicated rules regarding the installment sales approach. This column cannot fully discuss all of the many ramifications and exclusions. You are advised to consult with your tax advisers before deciding to go down the installment sale road.
Benny L. Kass is a Washington attorney. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036. Readers may also send questions to him at that address.