There are circumstances when property owners choose to sell an asset or property with an installment sale, which spreads the payment for the asset over time rather than in a one-time payment like a traditional sale. Selling with an installment sale can offer preferential tax treatment for sellers, lowering their federal income tax or capital gains tax.
Learn what an installment sale is, how it works, and the benefits and disadvantages of selling with an installment sale.
What is an installment sale?
According to the Internal Revenue Service (IRS), an installment sale is the sale of an asset where the seller receives at least one payment after the tax year of the sale. Rather than receiving the total contract price for the asset at one time, like in a traditional sale, the seller spreads the payment of the property over time using a specific installment sale contract like a deed of trust, note, land contract, mortgage, or other contract that specifies the terms of repayment.
What are the benefits of an installment sale?
The greatest benefit of the installment sale method is lowering your capital gain tax rate, by breaking up the gain you receive from one year to several years. Selling this way can lower your adjusted gross income and applicable federal tax rate, equating to significant tax savings over time. Rather than taking a tax hit all in one year, you spread the taxable income over multiple years.
What are the disadvantages of an installment sale?
The greatest disadvantage of selling with an installment sale is reporting. Calculating the gross profit percentage and gains earned each year can be challenging. For this reason, it is suggested a licensed tax professional assist with reporting an installment sale. In a traditional sale, the money is received at one time, allowing the seller to reinvest their profits or use them as they please. Installment sales are reliant on the buyer performing according to the terms of the installment contract, and there are no guarantees the buyer will perform.
How an installment sale works
Under the IRS Publication 537 installment method, the gain on the asset must be reported in the tax year the gain is received. The total gain is calculated by determining the tax basis of your original investment in relation to the sales price of the property, which is the fair market value you received for the sale of the property minus any debt, selling expenses, or costs the buyer pays for, takes subject to, or assumes as a part of the sale.
A specific percentage of each payment received, after interest, called gross profit percentage, is reported as installment sale income. This percentage can be calculated by dividing your gross profit from the sale by the contract price. This percentage usually remains the same for each payment you receive, such as 25% of each payment.
Income that is a part of the return basis does not need to be included in income on your income tax return. Instead the gain is reported the year the installment sale occurs and each year income is received with IRS Form 6252, Installment Sale Income. If income is charged as a part of the installment sale, income earned each tax year is taxed as ordinary income. If a business is being sold, the seller will use Form 4797, Sales of Business Property, instead.
You can elect out of reporting an installment sale, reporting it on Form 8949 or Form 4797 even if the property is sold with an installment sales contract.
How to qualify for an installment sale
An installment contract can be used for the sale of any business or real property, including residential or commercial property. However, installment sales cannot be used:
- By dealers or those who operate a trade or business in real estate (like house flippers).
- If the sale of a property or business would result in a loss.
- For the sale of securities, stocks, or bonds.
There are special rules that must be followed in certain circumstances, such as if the installment sale is to a closely related person and is depreciable property, is done with a like-kind exchange or 1031 exchange, or is contingent on future events.
Installment sales in summary
Utilizing an installment sale when selling real estate or a business can provide tax advantages and save the seller several thousands of dollars. However, this method of selling may not be right for everyone. If you intend to sell a business or property and have a large investment income tax burden, talk with a licensed tax professional to see if you would benefit from selling with an installment sale and what terms would be most advantageous for your specific needs.