Abstract In this paper we present models for both the buyer and the seller in a real estate installment sale transaction. These models can be used to determine the impact of changes in the stated interest rate on the present value of tax benefits for the buyer and tax costs to the seller. We show that once the parties agree on the timing and amount of cash flows, the tax benefits and costs in an installment sale transaction can be altered by changing the stated interest rate and thus the selling price. The optimum stated interest rate depends on several factors, including the length of the installment note and the capital gain tax rate. These models are predicated on Scholes and Wolfson's (1992) finding that installment sales have little impact on turnover and market value of real estate following the 1986 Tax Act and indicate that, absent a substantial preferential capital gain tax rate, above-market-rate installment sales often provide tax avoidance opportunities. Thus tax policy makers should consider specifying a maximum interest rate for real estate installment sale transactions if they feel the potential for tax avoidance is significant enough to warrant further regulation. In addition, the necessity of the existing imputed interest rules should be reconsidered.
Angelini et al. (Wed,) studied this question.