What qualifies as an installment sale?
If you are acting as the bank and financing all or a portion of the sale to the buyer, you have an installment sale. Installment sales can be great for cashflow as you get monthly payments that are usually higher than rent, without the upkeep costs of renting the property. And if used in the right instances they can create big tax advantages and minimize the risk of the Net Investment Income Tax.
When are installment sales useful?
If you have a rental property you are selling, or other property you have held for investment, this is a good way to sell as the payments will be taxed partially as a capital gain and partially as interest. For example, if you sold a house for $200,000 that your basis was $150,000 in you will have $50,000 of capital gain. If you sell on an installment sale with $10,000 down payment in the middle of the year at 5% interest rate for 15 years you will receive $15,039 principal, 25% of which, or $3,760 taxable capital gains income, and $5,479 in interest. As the total amount of taxable income received is much lower than receiving the full capital gains it often won't push your overall tax rates higher, leaving you with low capital gains rates and out of Net Investment Income Tax category, which is an extra 3.8% charge on all passive income if it gets triggered.
When are installment sales detrimental?
If you are flipping houses, selling on an installment sale is a very poor choice. Let us use the same example above, you sold a house for $200,000 that you bought and fixed up for a total of $150,000, selling it on the installment plan where you get almost $2,000 a month income for the next 15 years sounds pretty good, right? Wrong. You will be subject to paying tax on the full $50,000 income in the year of sale. If you are in a 25% tax bracket and then also have 15.3% of self-employment tax due on that amount, that means you will owe $20,150 in taxes, which is double the down payment received! No tax advanatages in selling this way, and all the risk of financing the deal.
What about lease option contracts?
Lease option sales are often also re-determined by the IRS to be an installment sale if the end of the lease is a nominal payment such as a normal monthly payment or a dollar. Generally, if you fall under the restrictions where you would be considered a dealer ("flipper") of houses, this does not benefit you. But, if structured properly this can be a way to sell the property with lower risk financially and legally as it is easier to evict a tenant than to foreclose on a mortgage in most states.
Could I use this when selling my residence?
Primary residences are exempt from tax up to $250,000 for individuals or $500,000 for married couples, if you meet the holding requirements of having lived in the property two out of the last five years. If your gains are higher than these amounts installment sales can be used to carry the gain to future years, or if the holding requirements are not met. This also can be a good strategy in a sluggish market to be able to sell a house that otherwise could not be sold. If you must foreclose or take back the property, your basis will adjust to the sale price, locking in favorable tax treatment when you resell in the future. Often a better choice than sitting on a vacant property for years.