Installment sales can be a great way to defer and sometimes actually reduce tax on the sale of property. If certain requirements are met, a seller can report and pay tax on the profit from an installment sale as payments are received, rather than reporting and paying tax on all of the profit at the time of sale.
However, be careful when a buyer assumes an existing loan on the property or takes a property “subject to” the loan in an installment sale because that can trigger taxable gain, even though you don't receive any cash.
If the amount of the loan exceeds your tax basis in the property, the excess of the loan assumed over the tax basis is treated as a payment received in the year of sale, which excess would all be taxable gain. In addition, all installment payments received thereafter would be 100% taxable gain.
Example: Carl sells a property to Doug for a selling price of $1.6 million. The property is subject to a loan in the principal amount of $600,000. Doug will assume or take subject to the $600,000 loan and pay the remaining $1,000,000 in 10 equal annual installments together with interest. Carl's basis in the property is $400,000. There are no selling expenses. In the year of the sale, Carl is deemed to have received payment of $200,000 ($600,000 loan assumed – $400,000 tax basis).
In transactions like this, it would be advisable, if possible, to require payment of enough cash to satisfy any tax liability arising on the sale.
Bottom Line: Bottom line: If a buyer assumes a loan in the installment sale with a balance that exceeds your tax basis, you will have taxable gain in the year of sale, and 100% of the payments received in the future will be taxable.
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