Tony's Tax Tips

The Tax Chess Board Part 6

This article originally appeared in the Pasadena Star News on May 6, 2006.
THE TAX CHESS BOARD – By owning real estate you can increase your net worth without paying any income tax. In order to pay the least amount of tax, you have to understand the tax consequences of the various methods of disposing of real estate.
C. Anthony Phillips, CPA

WHY PAY TAX? – It does not make sense to sell for cash, pay federal tax on the due date of your next tax return and risk being forced into paying alternative minimum tax because of the amount of state tax you may have to pay. Also, why would you want to make an interest free loan to the State of California when the 3 1/3% amount withheld on the sale price or cash received generally exceeds the amount of state tax due? Why pay tax when you can defer payment of the tax by selling and electing to be taxed as an installment sale, doing a 1031 exchange, setting up a private annuity trust or never paying the tax if you sell a principle residence?

INSTALLMENT SALE – Assume you elect to sell a property. Instead of the buyer obtaining a new loan and paying the full purchase price, you agree to act as the lender and finance all, or a part of the purchase price of your property. The buyer would give you a down payment and an installment note secured by a deed of trust against your old property. The installment note could provide that the buyer make monthly payments of interest and principal until the installment note is paid off.

WHY WOULD YOU WANT TO HAVE AN INSTALLMENT SALE? – The principle benefit is that you can elect to have the gain from the sale of your property deferred and reported over the period of time you collect principal payments on the installment note. This means that you also defer the payment of tax over that same period of time. Since you are earning interest on the principal balance of the installment note, you would in effect be earning interest on the deferred tax.

OTHER NON-TAX REASONS TO HAVE AN INSTALLMENT SALE – You generally can earn interest at a higher rate on the installment note than a bank certificate of deposit. The installment note will be secured by a property you are already familiar with. You don't have to deal with tenants, maintain the property, pay property tax or insurance, but generally collect more on the installment note than you collected in rent.

OTHER BENEFITS OF AN INSTALLMENT NOTE – If the buyer defaults on the installment note you get to keep the principal payments they made and repossess your property. Also, if you or your heirs ever need money, you can sell all or part of the installment note for cash.

Tony Phillips, CPA has a certified public accounting firm, Phillips & Company in Pasadena and is President of Downstream Exchange Company which helps investors save taxes when they sell their investment property.

The above is not intended to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.