We had a reader ask the following question:
“I plan to sell some land this year. Will my tax liability be less if I take payments from the buyer over several years?”
Before answering this question, lets review how an installment sale works. Instead of owing all of the tax in the year of sale, the tax laws allow you to spread your gain over the installment period and report the gain as principal is collected. Interest income is always reported as received. The tax owed is based upon your total principal received during the year times the capital gains tax rate in effect.
For example, assume a married farmer has a cost basis in his land of $100,000 and sells it for $500,000. His gain is $400,000 or 80% of the total sales price. If he collects an $100,000 down payment in year 1, he will be tax on $80,000 and assuming a 15% long-term capital gains tax bracket, he will owe $12,000.
Before 2013 this answer was much simpler. With long-term capital gains rates capped at 15%, most of the savings from using an installment sale to report a long-term capital gain was spreading the income over several years and deferring the tax owed. In most cases, it did not reduce the tax, but simply extended the period to pay.
However, in 2013, we now have the introduction of the 3.8% net investment income tax and the higher 20% long-term capital gains tax for higher income taxpayers.
Assuming our farmer had other ordinary farm income of $150,000, his total capital gains tax bill if sold for cash would be 15% on the first $100,000 of gain, 18.8% on the next $200,000 of gain and finally 23.8% on the last $100,000 of gain for total tax owed of $76,400 (the actual tax would be slightly higher due to phaseout of itemized deductions and exemptions). However, if he spreads the gain over the next ten years and keeps his net gain in the 15% bracket (staying under $250,000 of adjusted gross income), the total tax owed on the gain would only be $60,000 for a net tax savings of $16,400. Plus, the farmer may have received an interest rate on the installment note greater than current interest rates.
Therefore, for 2013 and beyond, the use of an installment contract to sell farm land may be even more beneficial than it was in the past. If you are considering the sale of farm land, make sure to review your options with your tax advisor.
Paul Neiffer, CPA