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Realizing a large profit at the sale of an investment is the dream. However, the corresponding tax on the sale may not be. For owners of vacation rental properties, second homes, sellers with more than $250k in equity (single) or $500k in equity (married), sellers in states with high state tax rates, sellers that haven't owned the home for more than 1 year, sellers who have already used the capital gains tax exemption once in the last 2 years, and those just looking to maximize their profit, this option is the best for you. To reduce taxable income, the property owner might choose to become the bank, in which, part of the gain is deferred over time. A specific payment is generated over the term specified in the contract. Each payment consists of principal, gain, and interest, with the principal representing the nontaxable cost basis and interest taxed as ordinary income. The fractional portion of the gain will result in a lower tax than the tax on a lump-sum return of gain. How long the property owner held the property will determine how it’s taxed: long-term or short-term capital gains.

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Example of Capital Gains Tax on a Home Sale

 
Long-term capital gains treatment

 When you become the bank, any gain is taxed as tax-favored long-term gain if you’ve owned the property for longer than one year. Under current tax law, the maximum long-term capital gains rate is 15%, or 20% if you are in the top ordinary income tax bracket of 39.6%. Even if you’re also liable for the 3.8% net investment income tax (NIIT), the maximum combined federal tax rate is limited to 23.8%.

 

Tax deferral

 Instead of paying tax on the entire gain in one year, only a portion of your gain is taxable in the year of the sale. The remainder is taxable in the years payments are received.

The taxable portion of each payment is based on the “gross profit ratio.” To calculate this ratio, divide the gross profit from the sale by the price.

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For example, in November 2021, you sell your home that you acquired in 2008 with an adjusted tax basis of $400,000. The buyer agrees to pay $1.2 million in 5 annual payments of $84,000 each, with a balloon payment at the end of year 5. Because your gross profit is $800,000 ($1.2 million – $400,000), the taxable percentage of each installment received is 67% ($800,000 / $1.2 million). When you report the sale on your 2021 tax return, you have to pay tax on only $56,280 of the gain (67% x $84,000). You’ll also be taxed on $84,000 of gain until 2026, or until completely cashed out.

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Lower tax liability

Because your gain from becoming the bank is spread out over several years, you may benefit from the tax rate differential in each of those years. For simplicity, let’s assume that you arrange a five-year balloon where $84,000 of the gain is taxed at the 15% rate each year instead of the 20% rate (if the entire gain had been taxed in the year of sale). As a result, you save $4,200 ($84,000 x 5% tax rate differential) each year for a total savings of $21,000 ($4,200 x 5 years). However, keep in mind, you are also adding profit each year this continues. These rates may change in the future if tax reforms are enacted.

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Cost Savings 

Becoming the bank can also save sellers money if the income from the sale would put them in a higher tax bracket if they receive it in one year. This is especially important for higher-income sellers who could be subject to the 3.8% net investment income tax. Single taxpayers with an adjusted gross income (AGI) over $250,000, and marrieds filing jointly who have an AGI over $500,000, are subject to this tax. Depending on their income, such taxpayers end up paying an 18.8% or 23.8% capital gains tax on their gains, instead of 15% or 20%. The key to avoiding this tax is to keep your AGI below these threshold levels. Sometimes this strategy can help keep you under that threshold.