Installment Sales – Ins, Outs, Ups, & Downs

The installment method is a tax-reporting strategy that allows you to spread out the recognition of capital gains over multiple tax-years when you finance an asset sale yourself. You pay a proportional percentage of your profit as capital gains only in the years you actually receive payments. In other words, you partially defer capital gains to future tax years.

When should I use the installment method?

When you sell personal or business property for a gain, the amount of the gain is taxable income to you. If the purchaser makes payments over time rather than paying the entire purchase price at once, you may be able to pay taxes on the gain across the years you receive payments instead of paying all the tax in the year of the sale. In fact, if you receive payments on a sale and at least one of the payments is due in a later tax year, you must report the sale using the installment method. In this case, you can choose to pay tax on the full gain in the year of the sale, but if you do, you must “elect out” of installment sale treatment.

Sometimes the installment method is not permitted

In cases where you sell business or investment property at a loss, you can’t use the installment method, so must deduct the entire loss in the year of sale. If you sell personal property not used in a trade or business, you can’t take the loss on your tax return at all.

Installment method rules do not apply when you sell inventory, nor do they apply to sales of stocks and securities traded on an established securities market.

Amounts you need to know for installment sale calculations

Basis is your investment in the property. For property you buy, the basis is generally its cost. The basis of property you inherit or build yourself is calculated differently.

Adjusted basis: Some events will change your basis in property. The cost of improvements you make can increase basis, and depreciation or deductible casualty losses can decrease basis.

Selling price is the total cost to the buyer and includes the value of money or other property you receive for the sale, selling expenses paid by the buyer, and any mortgages or debts assumed by the buyer.

Contract price is generally the selling price minus any mortgages or debts the buyer assumes.

Selling expenses relate to the costs to sell a property and can include commissions, attorney fees and other expenses paid on the sale. Selling expenses are generally added to the basis of the property sold.

Interest can be stated (established in the sales contract) or unstated (not mentioned in the sales contract). If interest is unstated, the IRS will recharacterize a portion of each payment as interest. Interest is taxed as ordinary income.

Gain on sale is the amount by which the contract sales price exceeds your adjusted basis in the property.  If the contract price is less than your adjusted basis in the property, you have a loss on the sale.

Gross profit is selling price minus your adjusted basis in the property. It is the total gain you report on the installment method.

Gross profit percentage is a ratio that determines the percentage of each principal payment that must be reported as taxable gain.

Installment sale calculations – three steps

Step 1: Calculate gross profit:

Gross profit = Selling price – adjusted basis.

Step 2: Calculate the gross profit percentage:

Gross profit percentage = Gross profit/contract price

Step 3: Calculate recognized gain

Recognized gain = Principal payments received X gross profit percentage

Receipt of installment sale income

Each payment on an installment sale consists of the following three parts:

• Interest income
• Return of your adjusted basis in the property (part of the principal payment)
• Recognized gain on the sale (part of the principal payment)

In each year you receive a payment, you must include in income both the interest and the portion of the payment that represents your gain on the sale. You don’t include in income the part of the payment that represents the return of your basis in the property.

How to report installment sale income on your tax return

If you choose to use the installment method, you report installment sale income on IRS Form 6252. We recommend consulting with a tax professional if you use this form.

How to elect out of installment sale treatment

To elect out of installment sale treatment, report the entire sale and calculate total gain in the year of sale on the correct schedule of your tax return. You must make the opt-out election by the due date of your tax return (including extensions) in the year of sale. Electing out is generally binding; you cannot revoke the election without formal consent from the IRS. Taxpayers who have suspended passive losses or capital loss carryovers often choose to elect out of installment sale treatment to use these losses.

Other considerations

In some instances, taxpayers who use the installment sale method may have to pay interest on  the deferred tax related to the installment sale. These rules come into play when the property has a sales price over $150,000 and the total balance of all nondealer installment obligations at the close of the tax year is more than $5 million.

If you make changes to the original contract, the gross profit and gain on sale must be recalculated for the remaining payments. The seller of property that is repossessed must calculate gain or loss on the repossession and recalculate the basis of the repossessed property.

Be careful when selling property to a related party where payments are made in installments. When selling to a related party, the seller generally can’t report the sale on their tax return using the installment method. There are other rules you need to be aware of when sales are made to related parties.

As with all things related to tax law and the IRS, the installment sale rules can be extremely complicated.  If you sell property and plan on financing the sale yourself, we urge you to consult with a tax professional who can guide you through the tricks and traps of the installment method. If you have any questions about the installment method or any other tax related topic, call one of our tax professionals. We love hearing from you!