TAXING TIMES, NOVEMBER 2014 EDITION
By Rick Torkelson, CPA and principal of Torkelson & Associates, LLP in Petaluma, CA
Last month, we demonstrated how to compute a gain on the sale of a rental unit that we purchased, rented to tenants for 10 years and then sold.
Here is a summary of the situation:
We put down $100,000 and financed $300,000. Our out of pocket rental expenses equaled our rent income. We made payments on the $300,000 mortgage for 10 years. After 10 years of payments, the balance of this loan would be about $244,000. We wrote off $11,000 of depreciation every year for 10 years saving us about $22,300 in taxes over those 10 years. We sold the property after 10 years for $550,000 paying $27,500 to sell it. The taxable gain on the house was $232,500 (all long term capital gain) and the income taxes on our gain was $56,500.
Here is a recap of the cash we have after these facts:
Sales Price: 550,000.
Pay-off Loan: <244,000>.
Cash After Sale 278,500.
Income Tax: <56,500>.
Net Cash After Tax: $222,000.
What can be done besides putting $222,000 in the bank? Assuming you don’t want to buy another house, one option is to sell the house – and pay the income taxes – on an installment basis.
Rather than closing the escrow and banking the cash, let’s say you tell the buyer that you will take back a note from him for $200,000. This means he needs $200K less cash or needs to borrow $200K less from a financial institution to buy the house. To pay back this 200K note, you ask for 7% annual interest and monthly payments of $1,800 per month. This will pay the loan off in 15 years.
The advantage here is that you now have a nice monthly income, you are earning 7% interest all along the way, secured by the real property you sold. Over 15 years, you will collect $324,000 on you $200K loan.
But what about the tax? The simple theory here is that on the installment basis, you pay your taxes as you collect your principal. The first step is to compute the total money you will collect in this transaction – this is called the “contract price”. In this example, the contract price is $306,000 computed by subtracting the $244,000 mortgage you owed when you sold the house from the $550,000 sales price. Next step is to develop the “Gross Profit Percentage”. This is done by dividing the taxable gain $232,500 by the contract price $306,000 to get 75.98%. This percentage carries over year after year. Each year, you take the principal you collect from the sale (or note), multiply it by 75.98% to determine the taxable income from the sale.
Since you are carrying back a note for $200,000 this means that you will be deferring the tax on $151,960 ($200,000 X .7598) of the income and will pay tax on this amount as the note payments come in over 15 years. All this is done on IRS form 6252.
The advantages are that financing part of the sale makes it easier for many people to buy your property. You typically get a greater return on your investment, 7% in my example, than you would typically get at a bank. And you get to stretch out the income taxes over several years – 15 years in my example.
Disadvantages are that the buyer may default on the note. This is only a major problem if you take very little down payment, the property drops in value and the buyer defaults almost immediately. Another possible disadvantage is that the capital gain rate you pay each year depends on the tax law in the year you collect the principal. Although capital gains have always been a tax favored gain, there is no way to know the capital gains rates in the future.
Again – Do your tax planning soon. If you’ve had an unusual year, the best way to avoid surprises is to project your taxes now – when there’s time to do something about them.
Read more about tax on the sale of rental property in part 2.