AGREEMENT OF SALE
Ethan R. Okura
We all know that we had a recent real estate boom and bust cycle. From the early 2000s until around 2007 or 2008 the real estate market was going gangbusters. Prices were rising, and a lot of transactions were taking place. The main reason for this was easy financing. Interest rates were low and banks were handing out mortgages like candy on Halloween! The banks were giving loans to almost anyone because they weren’t holding on to the risk that the borrower might default. After issuing the loan, the bank would sell the loan to Freddie Mac or Fannie Mae, and repeat the whole process to make more fees on the issuing of loans.
From that time until recently, the real estate market has been stagnant. The main reason for this is difficult financing. When the real estate bubble burst, lending requirements became very strict and it was much harder to qualify for a loan. Most people don’t have enough cash to pay the full purchase price outright for a house so they have to get a loan. What do you do when you’re trying to sell your home, but your buyer can’t or doesn’t want to get a loan? Enter the Agreement of Sale.
In the 1970s and early 1980s it was common for people in Hawaii to sell their property under what is commonly called an Agreement of Sale. Technically, the IRS calls this an Installment Sale, and real estate professionals usually refer to this as seller financing or “carrying the paper” (because the seller holds the promissory note and mortgage from the buyer instead of the bank doing so).
When you do an Agreement of Sale, you sign a contract to sell the property to the buyer, take payments from the buyer monthly, and record the Agreement of Sale contract, but in Hawaii you usually don’t record the Deed transferring the property to the Buyer until all the payments have been made. But you can also do this installment sale by recording the Deed transferring title to the buyer up front and also recording a mortgage where the buyer must pay you, and you have the right to foreclose if he doesn’t make payments. (It’s just like becoming a bank!)
When you sell real property, you typically recover your basis tax-free (what you paid for the property plus cost of any improvements you made to it), and you pay capital gains taxes on the difference between your basis and your sales price (your profit). When you do an Agreement of Sale, part of each payment is considered nontaxable (return of your basis), and part of each payment is considered capital gain.
There are several advantages to the Agreement of Sale:
1) It’s a way to defer taxes from the sale of your property (spreading out the taxes over time often means you stay in a lower tax bracket and pay a lower rate of tax on the gain). With new tax law changes in 2013, you have to pay a higher 20% federal capital gains tax rate if your income is over $400,000. With the sale of real property in Hawaii, the gain on the sale could easily push your income for the year over the $400,000 mark.
2) If your income is variable and somewhat predictable, it allows the seller to defer payments until a tax-advantaged year. (e.g., You just had a “bigger than usual” income year, or you’re planning on retiring in 3 years and will have significantly less income then. You can defer most of the payments until a later year when your income will be lower.)
3) The Agreement of Sale can be helpful to a buyer in other ways besides avoiding having to get a bank loan, because the buyer gets a basis in the property equal to the full purchase price, even though the buyer has given only an installment note to the seller and very little cash has left his hands yet. So, a buyer can take depreciation on investment property based on the full purchase price from year one even though he hasn’t paid for the whole thing yet.
4) You can charge interest to the buyer just like a bank would. If you don’t need all the cash right now, then instead of getting all the money and putting it in the bank at 0.5% interest, you can collect interest (3%-5% or more) on the balance of the money owed to you from the buyer.
However, there are some pitfalls to be aware of:
1) You can’t defer taxes on the sale of more than $5 million worth of property under Agreement of Sale installment notes at any one time.
2) If you’re considered a dealer in the type of property you’re selling (e.g., a real estate developer building and selling condos), then you’re not eligible to use the installment method to defer taxes.
3) The law has anti-abuse rules to prevent misuse of this technique by selling to a related party. For example, if you do an Installment Sale to your child to defer your taxes, then your child tries to immediately turn around and sell the property at full price and pay zero tax because he has no gain, the law will make the full value of your deferred sale immediately taxable to you. However, there are ways to structure related party installment sales without violating the restrictions on this method of tax reporting.
4) Most importantly, if you depreciated the property during the time you owned the property, you will be subject to “depreciation recapture” upon the sale of the property, and those amounts can’t be spread out or deferred over the term of the installment sale, but must be claimed in the year of sale. This can come as a big shock to the seller when they have a huge taxable gain upon the sale, but are only receiving monthly payments and don’t have enough cash to pay the tax bill.
In summary, the Agreement of Sale provides a potential opportunity to defer taxes in eligible situations. If you are interested in doing an Agreement of Sale, make sure you seek competent professional advice so you can maximize the advantages and minimize the pitfalls of this strategy. The Law Offices of Okura & Associates can help you with an Agreement of Sale or any of your other estate planning needs.
© OKURA & ASSOCIATES, 2013