Suppose the only way you can consummate the sale of real estate is to agree to an installment sale. In other words, instead of paying the full amount up front, the buyer makes payments over time. Typically, the payments are taxed to you under the installment sale rules, thereby spreading out your tax liability.
Strategy: Go ahead and close the deal this year. Then, at tax return time, you might elect to bypass installment sale treatment. This means that you “volunteer” to pay all the tax due on your 2012 return.
It may sound like a crazy idea, but it could well be the best option for your situation, especially in light of tax rate increases scheduled to take effect in 2013.
Here’s the whole story: Generally, if you receive installment payments from a real estate sale over two or more tax years, the tax on your gain is paid in the years that payments are actually received. This tax deferral treatment is automatic for most installment sales of real estate by those other than “dealers,” like real estate developers.
Usually, installment sale treatment is a good thing. But there are several possible reasons why you may forgo this tax break.
Say you expect to have significantly more income next year than this year. Because you’ll be in a lower tax bracket in 2012, you may prefer to receive all the money this year. Or you may have capital losses or suspended passive losses for this year that will offset the tax on an installment sale gain. Thus, you benefit by reporting all your gain in the year of the sale instead of spreading it out over time.
For 2012, the maximum tax rate for net long-term capital gain is generally 15%, but the rate is scheduled to increase to 20% in 2013, absent any new legislation. Furthermore, a new 3.8% Medicare surtax kicks in next year.
The surtax applies to the lesser of “net investment income,” which includes most sales of rental real estate properties, or the amount by which your modified adjusted gross income (MAGI) exceeds a threshold of $250,000 for joint filers (or a MAGI of $200,000 for single filers).
Thus, you could pay capital gains tax at a rate as high as 23.8% (20% + 3.8%) on installment sale payments received in 2013 and beyond, compared to the current 15% rate.
Keep the installment sale election in your back pocket. When you file your 2012 return, compare the tax liability under the usual way (see box below) to opting out of installment sale treatment, factoring in future tax rates and the 3.8% Medicare surtax.
Tip: If the sales price of property (other than farm or personal property) in an installment sale exceeds $150,000, interest must be paid on deferred tax to the extent that your outstanding installment obligations exceed $5 million.