Do you own investment or commercial real estate you’re planning to sell this year? If the property has appreciated in value since you acquired it — as is usually the case — and you’ve been claiming depreciation deductions, you could owe a hefty tax on the transaction. Let’s look at one strategy that may help solve the dilemma.

By arranging an installment sale of the property, you can spread out the tax over time, thereby reducing the overall tax bite. At the same time, the buyer gets more time to foot the bill, potentially making the opportunity more attractive.

It’s important to note that the property must be investment or commercial property to qualify for the installment sale tax break. This won’t work if you’re selling your principal residence. Also, you must receive at least one payment in a tax year after the year of the sale. For instance, if you sell the property in June 2022, and you receive half of the money in June and the other half in January 2023, you’re in the clear. 

In addition, installment sale treatment isn’t available for property sold by a “dealer” (a person who regularly sells this type of property on the installment basis). Nor does it apply to an installment sale of farmland. 

Although you must wait to receive some of the money you’re owed, there are at least three tax advantages of being patient: 

1. Low-taxed capital gain. With an installment sale of real estate, the gain is taxed as tax-favored long-term gain if you’ve owned the property for longer than one year. Currently, the long-term capital gain rate is 15% — or 20% for high-income individuals. 
   
   
2. Tax deferral. Instead of paying tax on the entire gain in one year, you’re only taxed on a portion of your gain. The remainder of the tax is spread out over the years that payments are actually received. The taxable portion of each payment is based on the “gross profit ratio.” This is derived by dividing the gross profit from the real estate sale by the price. There is, however, an important caveat: The amount of gain that is attributable to depreciation recapture is taxed in the year of sale, without regard to how much is received as an installment payment that year.
   
   So, for instance, suppose the commercial building you acquired ten years ago has an adjusted basis of $1.2 million, after considering $400,000 of depreciation. You arrange to sell the building in 2022 for $3 million, with the buyer paying three annual installments of $1 million each. Because your gross profit is $1.8 million ($3 million - $1.2 million), the taxable percentage of each installment received is 60% ($1.8 million divided by $3 million). Therefore, when you report the sale on your 2022 return, you owe tax on only $600,000 of the gain (60% of $1 million). For 2022, $400,000 is taxed as recapture of depreciation with the remainder being taxed as long-term capital gain. The installment payments in 2023 and 2024 also will yield a taxable amount of $600,000 a year — although the full amount will be taxed as long-term capital gain. 
   
   
3. Reduced tax liability. Because your gain from an installment sale is spread over several years, you may benefit from the capital gain structure. For simplicity, assume you arrange a five-year installment sale where $50,000 of the gain is taxed at the 15% rate each year instead of the 20% rate. As a result, you save $2,500 ($50,000 x 5%) each year for a total savings of $12,500 ($2,500 x 5). 
   

Tax law contains some potential tax traps when property is sold on an installment basis. For example, depreciation must be recaptured as ordinary income if it exceeds the amount available under the straight-line method and interest must be paid on certain installment agreements above $5 million. 



Sales to “related parties” are prohibited if tax avoidance is the principal purpose. Also, if a related party disposes of the property within two years, either by resale or some other method, the remaining tax is immediately due. Note that a business entity in which you have a controlling interest also is considered a related party.

The installment sale tax break isn’t the right strategy in every situation. You can elect to bypass the installment sale tax break if it better suits your needs. (See “Should you elect out?” below.) As always, the best strategy is to rely on your professional tax advisor for guidance.

Installment sale reporting is automatic, but you can choose to “elect out” of installment sale treatment on your tax return. Why would you do that? Maybe you expect 2022 to be a low-tax year and the following years to be high-tax years. Or perhaps you have capital losses or suspended passive losses that will offset the tax on an installment sale gain. 



In these situations, you’ll likely come out ahead by reporting all your gain in the year of the sale instead of spreading it out over time. Remember: You don’t have to decide until you file your tax return for the year of the sale.