As a real estate investor, when we hear about selling on contract terms it excites us! Selling on contract terms opens a whole new buyer pool for our business and allows us to get better pricing for our houses. When we sell on contract, we as the sellers make assumptions on how the taxes are handled on the sales transaction. Let’s take a look at two scenarios to be aware of when facing taxes on “Installment” sales.
Installment Sale: Traditional thinking on a land contract sale would be something like this: We acquire a property for $25,000 in cash, then turn around and sell the property on a land contract for $50,000 with a $5,000 down payment. From a cash flow standpoint, we are $20,000 lighter right? ($25,000 purchase price – $5,000 down payment) Not only that, but we have not realized the gain on the sale or the $25,000 profit between the purchase and sales price. Therefore we can use the Installment Sale method of recording income on the property. The only money received by you, from the buyer, would be recorded on your tax return. This method of installment sales is most effective and makes the most sense when seller financing a real estate transaction. Do too many of these transactions and you enter……
Dealer Status: Dealer Status is when your investments turn into a business. For us real estate investors, that can happen pretty quickly and easily without us even realizing it. For me, the easiest way to think about this is: If your investments turn into continual work and you rely upon the income for a living, you are a dealer. There are more detailed articles on this topic, and I suggest you talk with your tax professional to understand what side of the fence you are on. This is important as we re-visit our example above. As a dealer you would have to pay the gain on the sale in the year it occurred. In this case the gain is $25,000. Assuming a 35% tax rate, you will owe the IRS $8,750 on the sale. Not to mention, you were already $20,000 in the negative from a cash flow perspective.
This is an important topic that should be addressed as you consider selling on terms to buyers. I have had tax returns with both the installment sale status and the dealer status, and trust me, it is much better have to have the Installment status. This way you avoid running into to cash flow issues and paying taxes on unrealized gains. Stay in the installment sale status and your cash flow will thank you!
(Disclosure: I am not a tax professional or attorney. It is always best to consult your tax or legal professional on these matters)
Photo: James Thompson