Dear Tax Talk,
I 100 percent financed a house I sold with a 20-year, five-year balloon payment. (Note from editor: Payments are based on a term of 20 years, but a balloon payment, or the balance of the loan, is due in five years.) The gain on the sale will be $75,000. Since I receive the bulk of this gain on year five, how do I prorate the capital gains taxes?
When a seller finances property and will receive payments beyond the close of the tax year, the sale is termed an installment sale. IRS Form 6252 is used to report installment sales. The form is filed with your annual individual income tax return for each year until all payments are received. The gain is reported ratably over the term of the financing.
For example, assume you sold the property for $200,000 with 20 percent down and it cost you $125,000 and there is no debt on the property. Since you received 20 percent of the contract price in the year of sale, 20 percent of the gain is taxed in the first year. You would report $15,000 (20 percent of $75,000 in gain) as gain from the sale of the property.
Adequate interest is required as part of the installment sale. Interest you collect would be reported on Schedule B apart from the principal collections reported on Form 6252. If you’re charging more than 4 percent interest, you shouldn’t have an issue about adequate interest.
You can elect not to use the installment rules and report the full gain in the year of sale. There are a couple of law changes that may cause you to consider this election. The long-term capital gains rates will rise to 20 percent starting in 2011 and probably won’t go back to the current 15 percent rate. Starting in 2013, high-income taxpayers will also pay a 3.8 percent Medicare tax on most types of investment income over a certain threshold, including interest, dividends, capital gains, rental income, annuities and royalties.
The Medicare tax applies to the lesser of the taxpayer’s net investment income or the amount of modified adjusted gross income that exceeds $200,000 for unmarried taxpayers and $250,000 for married couples.
If you’re in a high-income tax bracket, you may be looking at almost 9 percent in additional income tax on the collections of the installment sale, especially the large chunk due in 2015.
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