The sale of investment real estate is often a large taxable transaction, frequently involving deferred payments. Installment sale accounting is automatic under IRC § 453, although taxpayers may elect out and recognize all of the income currently.
Usually, taxpayers would rather defer income, but right now, it may make better sense to elect out of section 453 where (1) the installment note period is short, (2) adjusted gross income falls in the $200,000 to $300,000 range for taxpayers filing jointly, and (3) the taxpayer has a greater proportion of earned income than unearned income. Our multiyear spreadsheet demonstrating these effects, available here, considers different filing statuses, numbers of exemptions, and levels of income and deductions, as well as different contracting items such as selling price, basis, down payment, length of note and interest rate.
FORECASTING IS KEY Unrelated mortgage interest is $20,000; state and local taxes are $17,000.
Empty nesters Jim and Jean decide to finance their purchase of a vacation home by selling a piece of investment land they’ve owned for many years. The land sells for $500,000 and has a $60,000 basis. Jim and Jean say that a deferred payment contract makes sense for them and for the prospective buyers. But, they ask their CPA, how should they structure the deal for tax purposes? In 2008, Jim and Jean also have $25,000 of qualified dividend income and $225,000 in earned income. In addition:
The buyer will provide a 20% down payment and a 6% note for the balance when the sale closes on Nov. 1, 2008.
Inflation, affecting nonsale income, state and local taxes and tax bracket creep, is expected to be 2.5% annually.
With this information, Jim and Jean’s CPA forecasts their after-tax cash flows over the term of the note. As with many tax-related decisions in 2008, the results depend on what Congress decides to do about the alternative minimum tax (AMT) and the extension of current tax law beyond 2010, including personal exemption and Pease limitation (itemized deduction) phaseouts, as well as rates for qualified dividends, capital gains and ordinary income tax. Although there is plenty of talk about completely revamping the AMT, we assume that Congress will continue to inflation-adjust the AMT exemption and extend the current preferential rates for dividends and capital gains but not for ordinary income. You can enter alternative assumptions in the downloadable workbook.
DIFFERENT SCENARIOS AND ASSUMPTIONS
Exhibit 1 shows that after-tax returns from electing out of the installment sale method decrease as the length of the note increases from two to 10 years. A closer look shows that the savings result primarily from the mechanics of the phaseouts of personal exemptions and Pease limitations on itemized deductions and AMT exemptions, combined with lower ordinary income tax rates in 2008 and 2009. If Jim and Jean do not elect out of section 453, income is deferred to later years, and the couple receives less benefit in those years because (1) exemptions phase out, (2) itemized deductions face limitations and (3) regular tax rates are scheduled to increase after 2010 under current law.
Notice that the double-digit rates of return do not occur without pain. Jim and Jean are forced to pay additional tax in 2008 of more than $55,000 in each situation shown in Exhibit 1. However, they received a 20% down payment on the sale of the investment property, producing $100,000 in cash in the first year—more than enough to “invest” some of the proceeds with Uncle Sam.
Exhibit 2 starts with the assumption that Jim and Jean receive a five-year note on the sale of the property. To show the relative effects of AGI on tax savings from electing out of section 453, we compare them with two other couples, one with $125,000 of AGI and the other with $375,000 of AGI. In each case, 10% of AGI is qualified dividend and capital gain income, and the remainder is salary income. We see that savings from electing out of section 453 are the greatest for Jim and Jean (that is, when AGI is $250,000). This result occurs because taxpayers with lower incomes are generally less likely to pay the AMT, and taxpayers with higher incomes are more likely to have phased out their exemptions and limited their itemized deductions due to non-installment-sale income.
Exhibit 3 shows the effects of varying the composition of earned and unearned income for the base assumption that Jim and Jean have $250,000 of AGI. The exhibit shows that the savings from electing out of section 453 are greater when earned income is equal to or greater than unearned income. However, increasing the unearned proportion of AGI over 60% to 65% decreases that benefit, and increasing it to 80% or above negates it. Most investors would love to loan the U.S. government money at after-tax rates of return of 10% or greater. Electing out of section 453 installment sale accounting in 2008 appears to provide some taxpayers with this opportunity.
By Douglas G. Chene, CPA, Ph.D., Jeffrey D. Gramlich, CPA, Ph.D., and John J. Sanders, CPA. Chene is assistant professor of accounting at the University of Southern Maine in Portland, Maine. His e-mail address is email@example.com. Gramlich is L.L. Bean/Lee Surace Endowed Chair and professor of accounting at the University of Southern Maine. His e-mail address is firstname.lastname@example.org. Sanders is associate professor of accounting at the University of Southern Maine. His e-mail address is email@example.com.