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Q. I sold my primary residence in an installment sale. The sale was subject to capital gain taxes. According to my understanding of IRS Form 6252, I need to pay all the tax upfront, although I have yet to receive a large portion of the payment and therefore am unable to pay the full tax. What are my options?
Generally speaking, if you own and occupy your principal residence for two of the five years ended on date of sale, you can exclude $250,000 of the gain from taxable income. The limit is $500,000 for married joint filers (both have to occupy the property as principal residence for two of the five years, though only one has to own it for that time). That exclusion is available whether or not you report an installment sale. See IRS Form 6252. It provides for the exclusion in computing the taxable gain from the transaction.
Your question indicates that you have a taxable gain even after taking the exclusion into account. The gain is recognized upon receipt of payments related to the contract, which means you pay tax as you receive money.
For example, you sell a house for $1 million, with $50,000 paid in commissions and closing costs, $200,000 in loan payoff, $250,000 cash to you, and a $500,000 note from buyer to seller (you). Let us assume you are single and qualify for the $250,000 gain exclusion. Further assume you have always lived in the residence since your date of purchase in 2001 and that you have always been single. Assume also that you paid $300,000 for the property and made no improvements.
The taxable gain would be computed as follows: sale price of $1 million, minus closing costs of $50,000, minus $300,000 purchase price, minus $250,000 gain exclusion, leaving a taxable gain of $400,000.
Thus, you have a “gross profit percentage” of 40 percent, which is $400,000 gain divided by $1 million purchase price.
In the year you sold the property, you received (in effect) $500,000 in cash proceeds (which was $50,000 received then paid to closing costs, $200,000 received then paid to retire the loan, and $250,000 received in cash).
Recognized gain in year of sale is 40 percent times $500,000, or $200,000. That’s gain not tax. The gain is taxed at 15 percent, 18 percent, or 20 percent for federal depending on your other income (based on the 2013 tax act). The gain is taxed as ordinary income for California. The exclusion applies for federal and California purposes.
In the foregoing example, it may seem like the net after-tax cash proceeds may be small because there’s only $250,000 received before tax and there will be tax deducted from that. In years two through maturity of the loan, the gain would be 40 percent times the loan principal received. Thus, if you received $20,000 in principal in year two, you would have $8,000 in gain.
The optimal loan (seller financing) for deferring taxes would be an interest-only loan with no principal payments until maturity. That might not be the best economic decision, depending on the value of the property, the buyer’s credit and financial status, and the foreseeable tax picture of the seller (you) in future years (e.g., are you going to retire and will that decrease your effective tax rate in future years?).
Two other things you should consider:
(1) You can elect “out” of the installment tax treatment. Say you sell in a year when you have massive taxable losses in your business, or you have massive otherwise unusable capital loss carryovers. You may wish to recognize the gain all in the year of sale, which means that you would pay no tax on principal payments after the first year. The good news is that you don’t have to make that decision until you file the tax return the following year (e.g., for tax year 2012, you can make that decision with your CPA when you file in 2013).
(2) Interest received on the installment note is taxable as interest income (reported on Schedule B by an individual).
In your question you said you are unable to pay the tax that is owed (even assuming you compute the gain and tax correctly). The taxes generally will be due April 15 of the following year (e.g., April 15, 2013, for tax year 2012). If you can’t pay, the tax agency (IRS or FTB) will permit you to file for an installment payment plan. The ease with which you can arrange such a plan will depend on your particular circumstances, though it will be generally easier if you owe less than $50,000 based on some recent changes to IRS’ program. You should file the return even though you can’t pay. The IRS and the FTB recognize that some people can’t pay, and that’s what the payment programs are intended to help. Failure to file will simply increase penalties and interest that can be avoided by filing timely (coupled with payment plan application if necessary). There are limitations and permutations of the payment plan rules, so you should seek a CPA who is familiar with taxes and with these payment plans.
G. Scott Haislet, CPA, Esq., is a qualified intermediary with the Lafayette Exchange Corporation. You can reach him at (925) 283-1031(925) 283-1031.
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