Real estate remains rock-solid in this economy. If you bought property years ago, you may be sitting on a gold mine. Of course, when you finally sell, you could face a whopping tax bill, too.
Strategy: Sell the property on the installment-sale basis. Instead of receiving the full payment in one year, arrange to receive installments over several years. As a result, the tax you'd pay is spread out over time.
Even if you use the installment-sale method, a portion of your gain qualifies for the low capital gains tax rate on long-term gain. But "high rollers" need to watch out for one big potential tax pitfall. Here's the lowdown: To qualify for installment-sale reporting, you must receive principal payments over two or more years. The taxable portion of the payments (calculated under the "gross profit ratio") is treated as capital gain in the year received. The top tax rate on long-term capital gain is only 15 percent. (The gross profit ratio is determined by dividing the sale's gross profit by the contract price.)
The benefits: You're able to (1) defer the tax on part of your gain and (2) take advantage of the lower long-term capital gains rates, all in one fell swoop.
Example: Let's say you bought commercial real estate a few years ago for $500,000. The property's adjusted basis is now $300,000. You agree to sell it for $750,000 in three annual installments of $250,000 each, plus appropriate interest.
Since your gross profit is $450,000 ($750,000 minus $300,000), the taxable percentage of each installment received is 60 percent ($450,000 divided by $750,000). When you report the sale on your 2005 tax return, you must pay tax on only $150,000 of your gain (60 percent of $250,000).
You must recapture any depreciation claimed on the property as ordinary income to the extent it exceeds the amount allowed under the straight-line method. However, that rule seldom comes into play. More importantly, you face a 25 percent federal tax rate, not the usual 15 percent, for gains caused by depreciation deductions.
Tax-trap alert: If the property's sales price (other than farm property or personal property) exceeds $150,000, you must pay interest on the deferred tax to the extent that your outstanding installment receivables from such sales exceed $5 million. Best advice: Time your transactions to stay below the $5 million limit.
Taxpayers should report real-estate installment sales on IRS Form 6252, Installment Sale Income, available at www.irs.gov/pub/irs-pdf/f6252.pdf.