It's not too often that we advise you to turn up your nose at a tax break. But if you're selling real estate this year, you may want to pay more tax than required up-front. Why? Because you'll end up ahead of the game in the end.
Strategy: Elect to bypass installment-sale treatment if it suits your needs. Instead of spreading out the tax over the years that you receive payments, you effectively "volunteer" to pay all the tax due in the year of the sale. In other words, you'll pay tax on income you haven't even received yet.
It sounds crazy, but it may be the best option for your situation, especially if an installment sale is the only way the buyer will go for the deal.
Why skip the installment-sale break?
If you receive installment payments from a real estate sale over two or more tax years, you'll pay tax on your gain in the years that payments are actually received. This tax-deferral treatment is automatic for most installment sales.
Installment-sale reporting isn't available to real estate "dealers," such as developers. Also, it can't be used for sales of securities on a public exchange, income resulting from the recapture of depreciation deductions or sales of depreciable property to related persons.
Also, the installment-sale rules only apply to gains. You can't use installment- sale reporting for property sold at a loss.
You report the installment-sale income on Form 6252 and attach it to your tax return for the year of the sale.
Note: If the selling price of your property (other than farm property or personal property) exceeds $150,000, interest must be paid on the deferred tax to the extent that outstanding installment receivables from such sales exceed $5 million.
So, why would you ever turn down the installment-sale break? Several possible reasons exist, including these two:
1. Say you expect to earn a lot more income next year than this year. Since you'll be in a higher tax bracket in 2006, you may prefer to receive all the money this year.
2. You may have capital losses or suspended passive losses for this year that will offset the tax on your installment sale gain. As a result, you benefit by reporting all your gain in the year of the sale, instead of spreading it out over time.
To compute the gain, use the fair market value (FMV) of the buyer's installment obligation that represents his or her debt to you. Notes, mortgages and land contracts are examples of obligations that are included in FMV.
Example: How to calculate the tax
As illustrated in the chart at right, say you sold a land parcel for $50,000. You received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8 percent interest.
The buyer gave you a note for $40,000. You paid a broker a 6 percent commission ($3,000) to negotiate the sale. The land cost $25,000, and you owned it for more than one year.
Say you decide to elect out of the installment method and report the entire gain in the year of sale. The $22,000 gain is taxed as long-term capital gain in the year of the sale, so you don't have to pay tax on any principal payments received in later years. You report interest on the note as ordinary income each year.
Final tip: This election is irrevocable, so be sure it's what you want. You can't undo it without special consent from the IRS. And the IRS won't be inclined to let you off the hook unless you can show extenuating circumstances.
Simply finding out that you paid more tax than you had to won't be enough.
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