In selling businesses and property, buyers and sellers sometimes discuss “seller financing”. In the context of real estate, these arrangements are sometimes casually called “land contracts”. Generally, in legal contexts, these arrangements are called “installment sales”.
Installment sales become more popular when the interest rate for borrowed money is significantly higher than the interest rate for saved/invested money, which sometimes correlates with increased interest rates overall.
For instance, the seller of personal property or real estate may be earning 4% interest on the seller’s other investments. A buyer of that property may face an interest rate of 6% for money borrowed for the purchase. In such circumstances, the seller and buyer may decide for the seller to finance the sale at an interest rate of 5%, which conceptually could be win-win for the buyer and seller.
However, there are many considerations that should be analyzed in the context of installment sales.
First, installment sales should have the same protections for the seller (loan agreements, security agreements and liens) as a traditional lender or bank would require. Sellers who do not have formal protections like these can sometimes eventually find themselves without their property and without their money.
Second, sellers are required to charge interest on the installment payments. The IRS has minimum interest rates that must be charged, and the required rates (set at the beginning of the installment sale) are different each month based upon the month within which the installment sale begins and based upon the duration of the installment payments.
If there is not sufficient interest charged, the IRS “imputes” interest (treats a part of the no-interest payment as being interest). This is because interest is income, which is typically taxed higher than capital gains. Even selling something via payments when each payment is tax-free means that some of the payment money is interest, which the IRS can and does tax.
Third, there are important tax considerations for installment sales. For the sale of real estate in installments, capital gains can often be spread out proportionally over the duration of the installment payments.
In other words, if I have $1,000 an acre of capital gains on the sale of real estate, I could sell that real estate to a buyer through ten equal, annual payments. In that circumstance, I can usually claim $100 per acre of capital gains per year.
This is handy as long as capital gains tax rates do not increase during the impending 10 years of payments.
However, very importantly, unlike real estate, depreciated property’s sale proceeds cannot be spread out over the duration of installment payments.
Thus, if I sell a fully depreciated tractor worth $100,000 via installment payments over 20 years, I have to claim all $100,000 as income in the year that the installment sale agreement is entered into.
In concept — but not always in practice — this challenge can sometimes be overcome by selling one-twentieth of the tractor over each of the next 20 years.
Installment sales of businesses are broken into components for tax purposes.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at [email protected] or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.