 The
rules on installment sale of property
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 Dear
Tax Talk,
I am in the process of buying an investment property from a family
member. I am paying a down payment and the family member is then
financing the remainder of the property. Is my family member going
to reduce his capital gains tax from the property by financing rather
than selling the property outright? This is an investment property
for him as well and he has owned it for several years. Thank you.
-- Heath
 Dear
Heath,
Your family member, let's call him Uncle, is entering into an installment
sale. His gain, whether he sells it outright or over time, is the
same: It's whatever you give him, plus what you promise to pay him,
less his cost. However, in an installment sale, he only has to pay
tax in any one year on the portion of the total selling price that
he is collecting that represents his profit on the sale.
For example, let's say you give him $20,000 down and
promise to pay $80,000 more. His cost is $50,000 and his gain is
$50,000. So half of what you pay him is taxable capital gain every
time he collects principal from you. He also has to pay tax at ordinary
rates on the full amount of interest you pay him. Interest has to
be provided for in the agreement or it has to be imputed by reducing
the selling price so that adequate interest is provided for. For
example, if you omit interest from your agreement to purchase the
property, so that Uncle has all capital gains, the tax law requires
that the selling price be adjusted downward so that part of each
payment includes interest.
An installment sale with a related party has special
rules to prevent the deferral of gain by one person while the second
person minimizes gain through his increased cost in the property.
For example, if Uncle sold the property outright, he'd have $50,000
in gain. However, if you turn right around and sell the property,
you have no gain to report because you sold it for what you paid
for it (this assumes you paid fair market value for the property,
which you should do to avoid a gift situation). Under the installment
sale related-party rules, a subsequent disposition by the related
person causes the first seller to accelerate his gain.
For individuals, related persons include members of
a family, including brothers and sisters (either whole or half),
husbands and wives, ancestors and lineal descendants. Hence, an
uncle is not a related person, but a grandparent or grandchild is.
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