Installment Sales Taxation
An installment sale, for tax purposes, is the sale of property paid for by installment payments that span 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 actually received. Without the installment method, the taxpayer would have to report a large gain even though most of the proceeds of the sale have yet to be received, because the gain would otherwise have to be reported in the year of disposition. However, losses cannot be deferred using the installment method. The applicable tax rate applied to any gains depends on when the payment was received, not on the sale date. Any depreciation claimed on the property must be recaptured and reported in the sale year, which will be taxed at the rate that applies, depending on the type of property. 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.
The installment sale method cannot be used if the disposition of personal property would result in a loss for the seller. If the disposition is business or investment property, then the loss must be claimed in the year of the disposition.
For instance, without the installment method of reporting taxes, if you sell property for $200,000, but the buyer can only pay with a $30,000 down payment, with the rest payable over the next 5 years, then you must pay tax on the entire profit, even though you only received $30,000 in the 1st year. However, you may want to do this if you anticipate that either tax rates or your tax bracket will be higher within the term of the installment payments.
The installment method can be used for most types of property except for the following:
- 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 residential lots, as long as the seller does not improve the lot, may use the installment method if the dealer is willing to pay a special interest charge. IRC §453 (l).
Dealers must report a gain in the year of sale for personal property or real estate held for resell to customers. However, dealers in timeshares of residential lots can opt to pay taxes using the installment method if they elect to pay interest on the deferral, as stipulated in IRC §453(l) .
If property is eligible for the installment method and the property is sold on an installment basis, then the installment method must be used unless the taxpayer specifically elects to report the entire amount of the installment sale in the year of the sale.
If the taxpayer decides to elect out of the installment method, but the tax return has already been filed, then the taxpayer must file an amended return within 6 months of the due date of the return, excluding extensions. "Filed pursuant to §301.9100-2" should be written at the top the amended return.
Calculating Taxes on Installment Payments
Each installment sale consists of: return of adjusted basis, interest income, and capital gain on the sale. When reporting an installment payment, 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 consist of at least some interest. An installment sales contract that does not stipulate a minimum interest rate may have to calculate unstated interest.
The selling price equals the total of any money received, the fair market value of any property received, any debt that the buyer pays, assumes, or takes as a promissory note; plus any expenses paid by the buyer, including accrued interest or taxes.
Prorated gains on installments are taxed for the tax year in which these installments are received. If the sold property is a capital asset held for longer than 1 year, then the long-term capital gains rate applies; otherwise the gain is taxed as ordinary income, even if the installment sale is over a period of 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:
|Annual Gain||=||Total Gain |
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. The following terms also apply to installment sales:
- Selling Price = Cash Received + FMV of Any Property Received + Any Mortgage or Debt Paid or Assumed by the Buyer + Selling Expenses Paid by the Buyer
- Total Gain = Selling Price − Selling Expenses − Adjusted Basis of Property
- Contract Price = Selling Price + (Liabilities Assumed by Buyer − Adjusted Basis If > 0)
- Installment Sale Basis = Adjusted Basis + Selling Expenses + Recaptured Depreciation
- Gross Profit = Selling Price − Installment Sale Basis
Gross profit, contract price, gross profit percentage, and installment sale income is 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. However, interest is not included in the selling price, but the seller must report the interest separately as interest income in the year that it is received.
Installment sale basis includes selling expenses, such as commissions or legal fees, plus 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.
Gross Profit Percentage = Gross Profit/Contract Price
Annual Taxable Profit = Annual Payment × Gross Profit Percentage
If the mortgage exceeds the installment sale basis, then the excess is considered received in the year of the sale. Additionally, the excess amount is added to the contract price, in which case, the gross profit percentage will be 100%.
Example: Calculating Profit on an Installment Sale Where the Mortgage Exceeds the Installment Basis
You sell your land to a buyer for $25,000, who also assumes your mortgage of $20,000, with the balance of $5000 to be paid over the next 5 years of equal payments of $1000 each plus interest. Because the mortgage exceeds the installment basis, the gross profit ratio is 100%, in which case the entire amount of each annual payment must be reported as profit.
|Sum of Payments||$5,000|
|Installment Sale Basis||$12,000|
|Mortgage − Installment Basis =||$8,000||To Be Reported in Year of Sale|
|Contract price||$13,000||= Sum of Payments + Mortgage − Installment Basis |
= Selling Price − Installment Basis
= Gross Profit
Example: Calculating the Annual Gain on an Installment Sale
You sell real estate for $200,000 on an installment basis for 5 years. Using the information provided in the table below, calculate your annual gain.
|Installment Basis||$50,000||= Adjusted Basis + Selling Expenses|
|Gross Profit||$150,000||= Sale Price − Installment Basis|
|Gross Profit Ratio||75%||= Gross Profit / Sale Price|
|Tax Year||Annual Payment||Annual Gain|
|Year 1||$40,000||$30,000||= Annual Payment × Gross Profit Ratio|
The gross profit and the gross profit ratio are calculated using Form 6252, Installment Sale Income, then the annual gain is transferred to Schedule D, Capital Gains and Losses. However, if you did not want to use the installment method for claiming income, then you would calculate and pay tax on the entire gross profit on Schedule D.
Example: Calculating New Gross Profit Percentage after Reducing Selling Price
If the buyer and seller renegotiate a new price within the time frame of the installment sale, then a new gross profit ratio is calculated based on the remaining amount to be paid and the gross profit from the remaining sales.
Case #2: Based on the applicable information provided in table above, consider this new case: You decide to reduce the selling price to $180,000 with 2 years left in the installment term, so you reduce the payments for the last 2 years. Here is how you calculate your remaining gain:
|Reduced Selling Price||$180,000|
|Adjusted Gross Profit||$130,000||= Reduced Selling Price − Installment Basis|
|Gain Reported in Previous Years||$90,000||= Sum of Gain Reported in Prior Years|
|Remaining Gain||$40,000||= Adjusted Gross Profit − Prior Reported Gain|
|Total Future Installments||$60,000||= Reduced Selling Price − Sum of Payments Received in Prior Years|
|New Gross Profit Ratio||66.67%||= Remaining Gain / Total Future Installments|
|Remaining Payments||New Annual Payment||New Annual Gain|
|Year 4||$30,000||$20,000.00 = New Annual Payment × New Gross Profit Ratio|
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 to Form 4797, Sales of Business Property. An election is made to report the entire gain in the year of the sale 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, then the depreciation recapture is taxed in the year of the sale; 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, and 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 of money available from an installment sale, such as using escrow accounts or using 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 benefit of the seller is deemed constructively received by the seller when the account is established.
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
Net Debt Proceeds = Gross Debt − Direct Loan Expenses
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 plus selling expenses, then the difference must be added to the contract price as deemed payments, which are recognized in the year of the sale.
If there is any recaptured income under §1245 or §1250, then the recaptured amounts must be reported in the year of the sale. In calculating the annual payments, the recaptured amounts are subtracted from the sales price.
The IRS stipulates the amount of interest 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, then part of the sale price will be treated as interest.
There are related-party rules to limit possible tax avoidance schemes. Consider the following: you sell 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 plus 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 each of the payments is received by you from your daughter. To prevent this scenario, Congress enacted a rule that if an installment sale is between related parties, and the buyer then resells the property soon afterward, then 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, which is 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 where 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 may still be able to use the installment method if he can convince the IRS that it was not part of a tax avoidance scheme.
If an installment note is disposed of, then the seller must recognize any remaining gain on the note in the year of the disposition. However, there are certain exceptions, 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, then 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 year of the sale, then that election can only be revoked with the permission of the IRS. Generally, the taxpayer will elect to report all the gain in the year of the sale if the gain is expected to be taxed at a lower rate because the taxpayer expects to have 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 also qualifies and none of the assets are sold at a loss. Otherwise, the installment method can only be used if the assets that are being sold at a gain are sold in a separate contract from those assets being 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 are allocated to real and personal property eligible for the installment method. Inventory, dealer property, and financial securities, and any assets being sold at a loss do not qualify for the installment method.
Gains on like-kind exchanges of property 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 exchange property, and the additional payment is paid in installments, then the like-kind property is not considered as part of the installment payments, and the contract price and the gross profit are calculated thus:
Contract Price = Sale Price − Fair Market Value of Like-Kind Property
Example: Installment Sales Involving Like-Kind Exchanges
You sell property for $1,300,000 in exchange for like-kind property with a fair market value (FMV) of $300,000 and an installment note of $1 million. Based on the following information, calculate the gains that must be reported for tax years Year 1 to Year 3.
|Installment Sale Basis||$600,000|
|FMV of Like-Kind Property||$300,000|
|Installment Note||$1,000,000||= Sale Price − FMV of Like-Kind Property|
|Contract Price||$1,000,000||= Sale Price − FMV of Like-Kind Property = Installment Note|
|Gross Profit||$700,000||= Sale Price − Installment Sale Basis|
|Gross Profit Percentage||70%||= Gross Profit/(Sale Price − FMV of Like-Kind Property)|
|Year 2 Payment||$200,000||+ interest.|
|Year 3 Payment||$500,000||+ interest.|
|Year 1 Gain||0||No gain because the like-kind exchange is not treated as a payment in figuring gain.|
|Year 2 Gain||$140,000||= Year 2 Payment × Gross Profit Percentage|
|Year 3 Gain||$350,000||= Year 3 Payment × Gross Profit Percentage|