CARL WATTS & ASSOCIATES

June 17, 2013



From the IRS point of view, an installment sale is generally a disposition of property where at least one loan payment is to be received after the close of the taxable year in which the disposition occurs.

Installment sales are a common way to transfer control of certain assets. Both the buyer and the seller can benefit from such arrangements: the buyer does not need to accumulate as much cash before purchasing, and the seller does not have to immediately recognize the entire gain from the sale. This deferral of gain occurs if the installment method is used.

The installment method is a method of accounting that can be used by both cash and accrual-basis taxpayers. However, the tax rules surrounding the installment method can be complex, and so it is important to know them well.

Some installment sales are not allowed to use the installment method to defer income. The installment sale method is not available for :


  • Sale of inventory: the regular sale of inventory of personal property does not qualify as an installment sale even if you receive a payment after the year of sale.

  • Dealer sales:  sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan are not installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming.

  • Special rule:   dealers of time-shares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge.


  • Stock or securities:  you cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. You must report the entire gain on the sale in the year in which the trade date falls.


  • Installment obligation:  the buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you.


It is important to note that, should you choose to sell your property using this type of contract, you are the lender as well as the seller. This means there is no bank involvement and that you, as the seller should be sure that you afford to make this type of sale rather than be paid in one lump sum. The upside is that it can make a hard-to-sell property more attractive to potential purchasers.


You should also know that to sell a property in a real estate installment sale you must own the property outright.

For the buyer in a real estate installment sale, there are two possible benefits to be aware of. The first is that since the seller is also the lender, they will decide the necessary qualifications of the buyer. This can be beneficial to the buyer because the seller has the ability to be more flexible than a bank, should they choose to do so. The second benefit a buyer should be aware of is that a property can possibly be more affordable to them in a real estate installment sale.


If your sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method.


You may elect not to use the installment method. This election-out is made by reporting the entire gain in the year of sale (that is, by not using Form 6252), even though not all the sales proceeds are received in that year. Once all gain is recognized in the first year, future payments (except to the extent of interest) are tax-free. Interest income on the note continues to be paid when received and cannot be accelerated.


If your sale results in a loss, you cannot use the installment method. If the loss is on an installment sale of business or investment property, you can deduct it only in the tax year of sale.


If your sale calls for payments in a later year and the sales contract provides for little or no interest, you may have to figure unstated interest, even if you have a loss.


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Installment Sales and
Taxation
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Each payment on an installment sale usually consists of the following three parts:

  • Interest income:
  • Return of your adjusted basis in the property, and
  • Gain on the sale.

Interest is generally not included in a down payment. However, you may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount.

After you have determined how much of each payment to treat as interest, you treat the rest of each payment as if it were made up of two parts: a tax-free return of your adjusted basis in the property, and your gain.

Your adjusted basis for installment sale purposes is the total of:

  1. The adjusted basis;
  2. Selling expenses;

  3. Depreciation recapture.


Basis is your investment in the property for installment sale purposes. The way you figure basis depends on how you acquire the property. The basis of property you buy is generally its cost. The basis of property you inherit, receive as a gift, build yourself, or receive in a tax-free exchange is figured differently.


Selling expenses relate to the sale of the property and include commissions, attorney fees, and any other expenses paid on the sale. Selling expenses are added to the basis of the sold property.

If the property you sold was depreciable property, you may need to recapture part of the gain on the sale as ordinary income.


Gross profit is the total gain you report on the installment method. To figure your gross profit, subtract your adjusted basis for installment sale purposes from the selling price. If the property you sold was your home, subtract from the gross profit any gain you can exclude.


In each year you receive a payment, you must include in income both the interest part and the part that is your gain on the sale. You do not include in income the part that is the return of your basis in the property.


In order to determine what portion of the payment is return of basis and what portion is gain, the gross profit percentage must be calculated.


A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing your gross profit from the sale by the contract price.

The gross profit percentage generally remains the same for each payment you receive.

Use Form 6252 to report a sale of property on the installment method. The form is used to report the sale in the year it takes place and to report payments received in later years. Also, if you sold property to a related person, you may have to file the form each year until the installment debt is paid off, whether or not you receive a payment in that year.

If you sell two or more assets in one installment sale, you may have to separately report the sale of each asset. The same is true if you sell all the assets of your business in one installment sale.

The gain from Form 6252 is entered on Schedule D (Form 1040), Form 4797, or both.

If you are entertaining the use of a real estate installment sale on a property, you should consider consulting with a tax expert and possibly a real estate attorney so you do not experience any unexpected pitfalls due to complicated issues or terms associated with this type of sale.