1976, March, Pg. 394. Tax Tips.

5 Colo.Law. 394

Colorado Lawyer

1976.

1976, March, Pg. 394.

Tax Tips

394Tax TipsInstallment Sales of Real Estate

In many real estate transactions, the seller's ability to report the taxable income from the transaction over a period of several years rather than in the year of sale may be crucial to the consummation of the transaction. Normally the parties can control the tax consequences of the transaction, and enter into an agreement that enables the seller to elect installment reporting. Knowledge of the legal requirements for installment reporting permits proper structuring of the transaction and may avoid a disastrous tax impact which can occur if such reporting is denied.(fn1)

Basic Rule

As a general rule, gain or loss on a sale transaction is required to be recognized at the time payment is received.(fn2) In many real estate transactions, the seller will receive the buyer's promissory notes (secured by the property being conveyed) as well as cash at closing. Since the sum of the notes and cash equal the bargained for consideration, such amount is the "payment" received at closing. If the gain is recognized in full in the year of the sale, the seller will be liable for tax on the entire gain at that time notwithstanding the fact that seller may have received only a portion of the sales price in cash.

The installment sale election provides a method whereby the seller may defer payment of tax on the gain until actual receipt of payment on buyer's notes.(fn3) Under the election, the tax is due only as payments are received, so that the percentage of the total gain reported in any year does not exceed the percentage of the total purchase price being received in such year.(fn4) For example, assume a transaction with a sales price of $50,000, a cash down payment of $5,000 (the only cash received in the year of sale), and a taxable long-term gain of $45,000. Even assuming a 25 percent maximum capital gains rate, without an installment election the tax would be $11,250, or $6,250 more than the cash received at closing. If, however, the installment election is utilized, only 10 percent of the gain would be reportable in the year of sale. The result is to reduce to $1,125 the tax due in such year with respect to the transaction. This reduction provides impetus for a seller to extend favorable terms to a buyer. It also permits the transaction to "work" for the seller as opposed to the government, since the seller otherwise would have been required to use funds from a source unrelated to the transaction to satisfy the tax liability. Such other funds remain available for other endeavors.

Election of the installment method may result in a decrease in the total tax dollars to be paid by spreading the recognition of gain over more than one year. Recognition of gain in a single year will often subject part

395of the gain to higher tax rates owing to the graduated tax structure. Spreading the recognition of gain over a number of years may cause more of the gain to be taxed in lower brackets.(fn5)

Despite the immediate tax advantages of the installment election, there are problems that should be considered. Gains are subject to the tax laws in effect in the years when payments are received, and there is always the possibility of a change in the tax rates. Dollars to be received in the future have less present value than dollars in hand, especially in inflationary periods, interest notwithstanding. Moreover, the seller runs the risk that the buyer may default.

Reporting Qualifications

The basic requirements for the election of installment sale reporting are: (a) receipt of no more than 30 percent of the sales price in the year of sale(fn6) and (b) an affirmative election...