**1. Selling price** is the total consideration to be received by the Seller. Selling price is __not__ reduced by the amount of any mortgage, lien, selling expenses or commissions; however, selling price __is__ reduced by the amount of any imputed interest if the contract either does not provide for interest, or interest is at too low a rate. Among the items included in selling price are:

- Cash and the fair market value of other property received
- Face amount of financing carried by the Seller
- Mortgages assumed or taken “subject to” by the Buyer
- Principal scheduled or prepaid on notes from Buyer or third persons to the Seller
- Debts of the Seller paid by the Buyer
- Excess of mortgages assumed or taken “subject to” over Seller’s adjusted basis

**2. Gross Profit** is equal to *selling price* less the property’s adjusted basis.

**Example 1**

Property sold for $370,000 and there was $25,000 in commissions and other closing costs. The building was originally purchased for $80,000, and they spent $20,000 on roofing and other capital improvements. At the close of escrow, the Buyer delivered $55,500 (15%) as a down payment to the Seller, and the Seller financed $314,500 secured by a first deed of trust.

- Selling price: $370,000
- Basis: ($100,000)
**Gross profit: $270,000**

**3. Contract price **is equal to *selling price*, less certain debt that is assumed or taken “subject to” by the Buyer (not exceeding the Seller’s basis in the property) and adjusted for selling expenses.

**Example 2**

- Selling price: $370,000
- Selling expenses: ($25,000)
**Contract price: $345,000**

**Gross profit ratio:** $270,000/$345,000= **.78 **

**4. Gross profit ratio** (also called inclusion ratio) is equal to the *gross profit* on the sale divided by the contract price.

**Note:** “Gross Profit” is also equal to “Realized Gain”

**Reporting Gain**

Being able to defer capital gains is one of the most attractive features of the installment sale. The Seller will pay capital gains on the down payment received from the Buyer, but the remainder of his principal is received (and his gain realized) in small increments in subsequent years.

Additionally, not every dollar of principal received is reported as profit (gain) since a portion of the principal received really represents a return of the Seller’s basis. The percentage of principal payment that is reported as profit each year is determined as follows:

*Gross profit ratio* multiplied by *principal amount received* = **recognized gain **

**Example 3**

Our Sellers’ monthly payment is $2,199.03. The first year (after a December 1st closing) they would receive 12 payments totaling $26,388.36, but only $2,899.16 of that would be principal ($23,489.20 would be interest income and taxed at ordinary rates).

Gross profit: $270,000/Contract price: $345,000 = .78 (gross profit ratio)

Principal amount received: $2,899.16 x Ratio: .78 = **Recognized Gain: $2,261.34**

This represents a dramatic reduction in the capital gains liability, leaving most of the Sellers’ equity at work for them at 7.5% interest.

The federal capital gains rate is expected to increase to 20%, but currently, it is 15%. State capital gains are approximately 10%, so the total current capital gains liability in California is 25% of recognized gain.

**Example 4**

__Year escrow closed__:

- Principal amount received: $55,500 x Gross profit ratio: .78 = Recognized gain: $43,290
- Recognized gain $43,290 x Capital gains rate: .25 =
**Tax liability: $10,822.50**

__Year following sale__:

- Recognized gain: $2,899.16 x Capital gains rate: .25 =
**Tax liability: $724.79**

So, our Sellers only paid $10,822.50 in capital gains the year they closed escrow. That would the numbers look like if they had sold for all cash?

**Example 5**

- Principal amount received: $270,000 x Gross profit ratio: .78 = Recognized gain: $210,600
- Recognized gain: $210,600 x Capital gains rate: .25 =
**Tax liability: $52,650**

So, if they sold for all cash, they would pay $52,650 in capital gains instead of the $10,822.50 they paid by carrying paper. After closing costs and capital gains, here’s what they could do with their money:

**Example 6**

- Sales price: $370,000
- Closing costs: $25,000
- Capital gains: $52,650
**Net to Seller: $292,350**

- Amount to invest in CD: $292,350
- Yield on bank CD: 4%
**Monthly interest income: $974.50**

Hmmm . . . which would you rather have? A cash down payment now and your money growing at 7.5% for $2,199.03 a month, or $974.50 a month with only a 4% return? Now it starts to become obvious why Sellers carry paper on purpose. It’s up to you to help educate them.

**[Please consult your accountant to know how capital gains will be applied in your unique circumstances. I am not an attorney or CPA, and you don’t need any nasty surprises!]**

**Extra reading:**

**Installment Sales: Use This Method to Maximize Your Tax Position**

**Get a Deferred Sales Trust Illustration to Defer Capital Gains and Maximize Retirement Income**