Not all sales of property are paid for in full at once. In fact, most business transactions are structured so that payments are made in installments that may span several years. These are typically referred to as “installment sales.” Normally, a seller must pay federal taxes on gains made in the year of the sale.
However, federal tax law allows sellers who receive payments in installments to defer paying taxes on any gain realized until the seller actually receives the payments. If deferring payment of tax were not available, a taxpayer would have to report a large gain from a sale even though they had not yet, in reality, received the proceeds of the sale.
The applicable tax rate applied to any gain from an installment sale depends on when the payment is received, not on the date of the sale. However, depreciation claimed on the property must be recaptured and reported in the sale year. It is taxed at the rate that applies in the sale year, depending on the type of property. This recaptured depreciation is then added to the basis of the property to calculate the capital gain, which is taxed at the rate for capital gain.
The Internal Revenue Service (IRS) does not allow the use of the installment sale method 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.
What Is an Installment Sale?
For tax law purposes, an installment sale has a specific definition as follows:
- A disposition of property, e.g., a sale of it, for which at least one payment is to be received after the end of the tax year in which the disposition takes place
The seller does not have to receive any payment in the year of sale. Nor does the seller have to receive more than one payment for the sale to be called an installment sale. For example, suppose a person sells a piece of land on January 12 of Year 1 for $100,000. The contract calls for one single payment of $100,000 on June 3 of Year 2. This transaction can be characterized as an installment sale for tax purposes.
For another example, suppose a person sells an iron works business on May 17, 2021; the person has operated the business since 2010. The seller receives a $50,000 down payment and a promissory note for $70,000 from the buyer. The note payments are $10,000 each, plus 10% interest, due every June 1 and December 1, beginning in 2022. The total selling price is $120,000. The seller’s selling expenses are $11,000. The selling expenses are divided equally among all the assets sold, including the business’s inventory. The person’s selling expense for each asset is 5% of the asset’s selling price ($11,000 selling expense ÷ $120,000 total selling price.
How Much Gain Needs to Be Recognized from Each Installment?
In order to determine how much taxable gain is recognized from each installment, a taxpayer must make the following calculations:
- Compute the gross profit realized from the sale: Gross profit is the excess of the selling price over the adjusted basis of the property being sold. Selling expenses, unless the seller is in the business of selling that item as a dealer, and depreciation recapture income are added to the basis of the property. The addition of depreciation recapture income applies only if the seller has taken depreciation on their property.
- As mentioned above, the adjusted basis of the property for installment sale purposes can be calculated using IRS Worksheet A. When a person has completed the worksheet, they will also have determined the gross profit percentage necessary to figure their installment sale income, or gain, for the year;
- Compute the contract price from the sale: The contract price is the selling price reduced by any qualified indebtedness that the buyer assumes or agrees to pay. The amount of the indebtedness must be less than the basis of the property being sold;
- Determine the percentage of the gross profit: Gross profit percentage is calculated by using the ratio of the gross profit over the contract price (gross profit/contract price);
- Determine the value of the payment that is received during the tax year;
- Multiply the gross profit percentage by the total amount of payment received in the tax year. This is how much gain should be reported for tax purposes in the year.
Generally, a person uses IRS Form 6252 to report installment sale income from casual sales of real or personal property during a single tax year. A person must also report the installment sale income on Schedule D (Form 1040), Form 4797, or both. If the property was the person’s main residence, they might be able to exclude part or all of the gain.
Form 6252 is used to report the sale in the year in which the sale takes place and to report payments received in later years. Also, if a person sold property to a related person, they may have to file the form each year until the installment debt is paid off, whether or not they receive a payment in any particular year.
What Constitutes a Payment for Installment Sales?
Generally, a payment is cash or other property, including marketable foreign currencies or securities. If the buyer pays with an installment note, this is only considered payment if it is:
- Payable in full on demand; or
- Capable of being traded.
A buyer assuming the seller’s debt, e.g. mortgage loan, is not considered payment unless the debt exceeds the seller’s adjusted basis in the property being sold. In other words, the buyer must provide something with a value greater than the seller’s basis in exchange for a property.
Do I Need an Attorney to Help Me with My Tax Problems?
There can be much more complexity to calculating the federal tax liability for the installment sale of a business or business interest than the discussion above suggests. Other IRS forms may be involved, requiring complex calculations and determinations of assets and income. Forms other than those mentioned for making calculations may be involved.
The situation can be complicated if the buyer defaults on payments and you must repossess the property. If you have sold a single piece of property or a single business asset, calculating the taxes related to the transaction might be something a person who is not an expert in taxation could handle.
However, if a person has sold a business or an interest in a partnership, the transaction is more complex, and you should consult an experienced and knowledgeable tax attorney in your area. If you are unsure about determining the tax on an installment sale, or if you already have an issue with the IRS and need representation, a tax attorney can help.
Tax laws may vary frequently, sometimes from year to year. An attorney can provide you with updates on any legal developments that might affect your rights. They can answer any questions specific to your circumstances and legal needs.
