Want to eliminate or reduce your capital gains tax when selling a property?

If you sell property, you can avoid or reduce your capital gains tax by structuring the deal as an installment sale. Here’s who it works:

In a traditional sale, the seller receives all the funds in one lump sum at the time of closing. Any amount that exceeds the IRS’s capital gain exemption is subject to capital gains tax.

With an installment sale, the buyer does not pay the full sales price at closing. Instead, the parties draw up a contract under which the buyer pays the seller over a certain period of months or years. The IRS defines an installment sale as any sale of real property where at least one payment is received by the seller after the year in which the sale is closed.

The most common example of an installment sale is the seller-financed sale, where the buyer agrees to make a down payment and then monthly payments of a certain number of months or years.

Instead of realizing all the gains – and a potentially significant capital gains tax – at closing, the seller in an installment sale receives gains over time, which lowers the seller’s tax bill.

In an installment sale, the IRS uses the seller’s percentage of gain to determine how much of each installment payment to treat as taxable. For example, if the seller’s gain on the sale equals 20 percent, then 20 percent of each installment payment is counted as gain. Interest the buyer pays to the seller is also treated as income to the seller.

An installment sale cannot be used when:

• The sale results in a loss to the seller.

• The seller operates a trade or business in real estate. For example, a house flipper cannot take advantage of this tax benefit.

• The property sold is a security, such as a stock or bond.

The primary advantage of an installment sale to the seller is the deferral of gain on the property, spreading it over years beyond the tax year in which the sale was closed. Instead of a capital gain received in one lump, it is spread as income over one or more years. For buyers, an installment plan helps make it possible to buy property without a mortgage.

The seller faces potential risk if the buyer at some point defaults. As part of the terms of the installment sale, the seller should always require the buyer to put up the property as collateral to secure the note.

Because the IRS rules on installment sales can be complicated, it’s important to hire a qualified tax attorney or other professional to help you.