A 2-year installment Sale Can Help You Reduce Capital Gains Taxes

You can save money with a two-year installment sale if you want to sell an asset, property, or business that has significantly increased in value. Essentially, it is a double-sale method designed to generate a tax timing gap between when the asset sale funds are received and when they are taxed.

Here is how it operates: on a long-term installment sale, you can transfer the asset to your children or a separate trust (often called a “deferred sale trust”). The benefit of this is that your children or other beneficiaries get to enjoy the entire value of the property before the gain is recognized and taxed. The property can be sold for cash to a third party at that moment.

For instance, suppose you own Rareacre, a plot of property you acquired for $200,000 at the outset. Its current fair market value is $1 million. You want it to benefit your offspring, so you sell it to a non-grantor trust for a 10-year note. This non-grantor trust, a taxable entity, obtains a $1 million increased basis for the property. You get two $100,000 payments from the non-grantor trust and record an $80,000 gain on each payment. However, following the second payment, the trust sells the property to a non-related taxpayer for cash. If Rareacre’s value has climbed by $100,000 between the two selling dates, it is now worth $1.1 million. On the sale, the non-grantor trust registers a gain of $100,000. However, the family obtains the whole $1,1,000,000 in value while only paying tax on $300,000 of the $900,000 gain. Yes, the trust will continue to repay the loan for the following eight years. You recognize gains and pay taxes over eight years. However, this results in a significant disparity in timing. In addition, you may be able to reduce your taxable income and pay taxes at a lower tax level in the future.

This technique is advantageous because long-term capital gains are taxed at a lower rate than short-term capital gains, taxed as regular income. And your beneficiaries will still get the entire cash profits from the second sale in the same year. Additionally, this technique provides the chance for a significantly higher total return. If you invest the cash that you would have otherwise used to pay taxes in the year of the original sale, you may make 6% or more annually.

Without this method, capital gains taxes on the sale of assets might be pretty high. For instance, the maximum marginal capital gains tax rate for a California citizen, combining federal and state taxes, is 37.1%, whereas the highest income tax rate is around 57.5%. Consequently, reducing these taxes can be quite profitable.

Additionally, two-year installment sales can be utilized to avoid the 3.8% net investment income tax (NIIT) since they give a smaller total tax burden and allow owners to pay that liability over an extended period. Notably, this option is not accessible for selling marketable instruments such as publicly traded stocks or shares.

Unfortunately,  Section 453(e) of the Internal Revenue Code partially shut down. However, if you’re patient, you can still benefit from it. After selling the asset to your children or a trust, you must wait at least two years and one day before reselling it for cash and reaping the benefits outlined above.

Taxes on capital gains can be a significant drain on asset sale revenues. If you are willing to wait two years and one day, two-year installment sales might be an excellent way to reduce your taxes.