Installment Sales Taxation

An installment sale for tax purposes is the sale of property paid by installment payments spanning more than 1 tax year. The installment method of reporting taxes was enacted by Congress so that taxpayers can pay taxes on the sale or other disposition of property over time, when the payments from an installment sale are received. Without the installment method, a large gain would have to be reported for the year of the sale, before receiving most of the sale proceeds. The applicable tax rate applied to any gains depends on when the payment was received, not on the sale date. But depreciation claimed on the property must be recaptured and reported in the sale year, which will be taxed at the applicable rate, depending on the property type. The recaptured depreciation is then added to the basis of the property to calculate the capital gain, which will be taxed at the capital gain rate.

However, the seller may choose to report the entire gain when sold if either tax rates or their tax bracket is expected to be higher within the term of the installment payments. However, the installment sale method cannot be used for personal property sold at a loss. For business or investment property, the loss must be claimed when sold.

The installment method can be used for most types of property except for:

• publicly traded securities;
• property held for sale in the ordinary course of business except:
  • dealers of timeshare units, where only the right to use real property for 6 weeks or less each year was sold; and
  • dealers of unimproved residential lots may use the installment method if a special interest charge is paid. IRC §453 (l)

Dealers must report a gain from a sale of personal property or real estate held for resell to customers. However, dealers in timeshares of residential lots can use the installment method if they elect to pay interest on the tax deferral, as stipulated in IRC §453(l).

If property is eligible for the installment method and the property is sold on an installment basis, the installment method must be used unless the taxpayer specifically elects to report the entire amount of the installment sale when sold.

If the taxpayer decides to opt out of the installment method, but the tax return was already filed, an amended return must be filed within 6 months of the due date of the return, excluding extensions, with "Filed pursuant to §301.9100-2" written at the top.

Calculating Taxes on Installment Payments

Each installment payment consists of:

• return of adjusted basis, which is not taxable
• interest income
• capital gain on the sale

Both interest and the gain on the sale must be reported. There is no interest on the down payment, but each later installment payment must have some interest. An installment sales contract not stipulating a minimum interest rate may have to calculate unstated interest.

An installment sale has both a selling price and a contract price; often they are same, but if they differ, only the contract price determines tax liability.

Note that the contract price is the same or less than the selling price. If the debt the buyer assumes exceeds the seller's adjusted basis, the seller benefits to the extent of that excess, so the contract price is lowered by the excess amount, which increases the seller's tax liability.

Prorated gains on installments are taxed for the tax year when received. The long-term capital gains rate applies to sold property that was held longer than 1 year; otherwise, the gain is taxed as ordinary income, even if the installment sale is over several years. A lump sum payment paid in a tax year after the sale is treated as an installment sale.

The gain for each year of the installment period is calculated thus:

Note that neither the annual gain nor the total gain includes interest. So if the contract price is $96,000 and the total gain is $24,000, and the buyer pays $24,000 annually for 4 years, then the annual gain = $24,000/$96,000 × $24,000 = ¼ × $24,000 = $6000. Any interest received is taxed as ordinary income. These terms also apply to installment sales.

Gross profit, contract price, gross profit percentage, and installment sale income are figured on Form 6252, Installment Sale Income. Any assumption of a mortgage or other liabilities, such as liens on the property or sales commissions, must be included in the selling price. Interest is not included in the selling price, but the seller must report the interest separately as interest income when it is received.

The installment sale basis includes selling expenses, such as commissions or legal fees, + any recaptured depreciation.

Each annual payment is multiplied by the gross profit percentage (a.k.a. gross profit ratio) to determine taxable profits for that year.

If the mortgage exceeds the installment sale basis, the excess is considered received when sold. Additionally, the excess amount is added to the contract price, so the gross profit percentage will be 100%.

Reporting Gains on Installment Payments

Installment income from the sale of rental property or of a business is figured on Form 6252, Installment Sale Income, then transferred either to Schedule D, Capital Gains and Losses or Form 4797, Sales of Business Property. An election is made to report the entire gain by reporting the sale on Form 8949, Sales and Other Dispositions of Capital Assets, or Form 4797 or both, but not on Form 6252.

If the installment sale was of depreciable property, the depreciation recapture is taxed when sold; only the capital gain is reportable on the installment method. The depreciation recapture is figured in Part III of Form 4797 and is reported as ordinary income in Part II of that form. It is also used in Part I of Form 6252 to calculate the gross profit percentage.

The gain portion of the annual payment does not include interest, which is taxed as ordinary income to the seller. Instead, interest earned on the installment payments is reported as interest income on Form 1040, U.S. Individual Income Tax Return. The allocable gain of each annual installment payment is reported on Form 6252, then the installment income is transferred to Schedule D, Capital Gains and Losses.

Any scheme designed to increase the amount available from an installment sale, such as using escrow accounts or the installment sale as security for a loan, is reportable as a payment when the proceeds are constructively received. Any amount placed in an irrevocable escrow account for the seller's benefit is deemed constructively received by the seller when the account is funded.

If the seller uses the installment obligation to secure any debt, the net proceeds from the debt will be treated as payment on the installment obligation. However, this pledge rule only applies to selling prices exceeding $150,000 but does not apply to:

• farming property
• personal-use property
• qualifying timeshares and residential lots

The loan is considered received at the later of when it is received or when the debt becomes secured.

A wraparound mortgage, which is when the buyer makes payments to cover the seller's outstanding mortgage, but the buyer does not assume the mortgage, is treated differently. In that case, the selling price is not reduced by the amount of the wraparound mortgage.

If the liability assumed by the buyer exceeds the seller's adjusted basis + selling expenses, the difference must be added to the contract price as deemed payments, which are recognized in the sale year.

Recaptured income under §1245 or §1250 must be reported in the sale year. In calculating the annual payments, the recaptured amounts are subtracted from the sales price.

The IRS stipulates the interest rate that must be charged, equal to the lesser of 100% of the applicable federal rate or 9% compounded semiannually. If the minimum interest is not charged, part of the sale price will be treated as imputed interest.

There are related-party rules to limit tax avoidance schemes. Consider this:

• You sell to your daughter land with an adjusted basis of $20,000, worth $100,000, on the installment basis, with nothing down and a term of 10 years of equal payments of $10,000 + interest.
• Your daughter acquires the land at the new adjusted basis of $100,000, but then immediately sells to an unrelated party for $100,000 cash.
• Hence, your family has acquired $80,000 of gain ($100,000 − $20,000 adjusted basis) that will not be recognized until you receive each of the payments from your daughter.

To prevent this scenario, Congress enacted a rule that if an installment sale is between related parties, and the buyer resells the property soon afterward, the sale will be treated as if the unrelated buyer purchased the property directly from you instead of your daughter. Related parties include ancestors, descendants, siblings, controlled corporations, and any partnerships, trusts, or estates in which the seller has an interest. However, the related-party sale rule does not apply if the sale to the unrelated buyer occurs more than 2 years after the related-party sale or if the property is marketable securities.

The installment method also cannot be used to report the sale of depreciable property to a controlled entity, a partnership, or corporation where the taxpayer owns more than 50%. To further limit tax avoidance schemes, constructive ownership rules apply, where the ownership of the business and the percentage of ownership of the business entity are calculated based on the ownership interests of the taxpayer and closely related parties. So, for instance, any ownership interest held by a spouse or children will be counted as if they were all owned by the taxpayer. However, the taxpayer can still use the installment method if the IRS can be convinced that it was not part of a tax avoidance scheme.

If an installment note is disposed of, the seller must recognize any remaining gain. However, certain exceptions apply when the installment obligation transfers to the receiving party:

• if the transfers are between spouses or because of divorce,
• transfers due to the taxpayer's death,
• contributions of capital to a partnership,
• tax-free exchanges to corporations under §351, and
• certain corporate liquidations.

The entire gain may also be recognized when the installment note is canceled, thereby gifting the remaining amount to the buyer.

If the property qualifies for the installment method, the taxpayer must elect not to use that method by filing a timely return computing the gain by using the taxpayer's usual accounting method. If the taxpayer elects to report all the gain in the sale year, that election can only be revoked with IRS permission. Elect to report all gains in the sale year if the gains are expected to be taxed at a lower rate because the taxpayer expects a higher income in later tax years.

Multiple assets can be sold on a single installment contract and will qualify for the installment method only if each asset qualifies and no asset is sold at a loss. Otherwise, the installment method can only be used if the assets sold at a gain are sold in a separate contract from those sold at a loss.

Sale of the Business

Under the tax code, the sale of a business is treated as a sale of its assets. If a business is sold in installments, then the installment method can only be used if part of the selling price and each of the annual payments is allocated to real and personal property eligible for the installment method. Inventory, dealer property, financial securities, and any assets sold at a loss do not qualify for the installment method.

Like-Kind Exchanges

Gains on like-kind property exchanges are postponed until the property is finally disposed of. However, if the exchange involves boot, which is the payment of money or other types of property in addition to the like-kind exchanged property, and the additional payment is paid in installments, then the like-kind property is not considered part of the installment payments, so the contract price and the gross profit are calculated thus: