If you are considering selling your rental property, you may have heard that you can defer your capital-gains taxes by conducting an “installment sale” under §453 of the Internal Revenue Code.
For example, if your buyer agrees to pay you in ten equal annual payments, you can recognize 1/10th of your total gain in each year, thereby stretching out your capital-gain tax liability over time. Of course, you still have to pay additional income tax on any loan interest you receive from the buyer along the way.
This may sound like a great idea, but there are some important drawbacks to this strategy:
Potentially lower income
Your interest income from the installment note may be less than the rental income you could earn by fully re-investing your equity in the rental property.
No depreciation deduction
Even if the interest portion of the installment payments is high, the interest likely will be fully taxable as ordinary income, without any offset for depreciation.
Limited reinvestment options
You will have limited options for reinvesting 1/10th of your sale proceeds each year, as opposed to reinvesting a lump sum at the time of sale.
Repayment / principal risk
What if the buyer fails to manage the property and then ultimately defaults on the payments? You could be forced to take back a worse version of a rental property you no longer wanted in the first place.
Year-one tax hit
If you receive a large initial down payment, or if the buyer assumes your previous debt on the property, you could pay a hefty capital-gains tax bill in the year of sale.
You WILL pay the taxes—and they may get higher
Unlike §1031 exchanges, which allow you to potentially avoid capital gains taxes altogether by deferring until your death, you cannot avoid paying tax on the installment payments you receive—and the tax rates could go up!
While there may be legitimate reasons for structuring a sale as an installment contract, you may find that the financial and tax benefits of this strategy do not quite measure up to those of a traditional §1031 exchange.
If you have any questions about investing in passive real estate exchange programs, please give 1031 Capital Solutions a call today. Thank you.
SOURCES: IRS Publication 537
This information is for educational purposes only and does not constitute direct investment advice or a direct offer to buy or sell an investment, and is not to be interpreted as tax or legal advice. Please speak with your own tax and legal advisors for advice/guidance regarding your particular situation. Because investor situations and objectives vary, this information is not intended to indicate suitability for any particular investor. The views of this material are those solely of the author and do not necessarily represent the views of their affiliates.
Investing in real estate and 1031 exchange replacement properties may involve significant risks. These risks include, but are not limited to, lack of liquidity, limited transferability, conflicts of interest, loss of entire investment principal, declining market values, tenant vacancies, and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment.
Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC registered investment adviser. Insurance products offered through Concorde Insurance Agency, Inc. (CIA). 1031 Capital Solutions is independent of CIS, CAM and CIA.