An installment sale takes place when one party sells business or real property to another party and receives at least one payment in a different tax year.
If you've ever bought a capital asset and made payments on it through different tax years, you have participated in an installment sale. Learn more about installment sales and what they mean for your taxes.
Definition and Example of an Installment Sale
Anyone who sells a capital asset on an installment note can elect to spread the income from the sale over the life of the note as the buyer makes payments over time. This disperses the capital gains income over multiple years, which reduces the amount of tax owed in some circumstances. This tax strategy is known as an "installment sale."
Capital assets are items that increase or decrease in value over time, like a house, collectible art, or equipment used in a business. These are generally expensive assets, so it isn't always possible to pay for them all at once. The seller can break up the sale into installments, which acts to reduce the amount of taxes they pay in one year for any gains from the sale.
For example, suppose you owned a backhoe and used it to clear out and level land as a business. You decide to retire and need to sell it. You find a buyer who will use it for the same purpose, but they don't have the money to pay you and can't get a loan. You decide to let the buyer pay for it in four equal installments and sell it using an installment note.
Stocks, bonds, other securities, inventory, or property a dealer sells cannot be sold using the installment sales method.
Two of the payments will be made in the year you sold it, and two will be made the next year. You have made an installment sale because at least one installment is being paid in a different tax year, and the asset you sold is a capital asset. If you elect to report taxes using the installment sale, you'll pay half the taxes you owe one year and the other half the next year.
How Does an Installment Sale Work?
Taxable gains are spread out over multiple years under the installment sale method. Gains are measured once (gross sales proceeds minus cost basis minus selling expenses) and expressed as a gross profit percentage. This percentage is then applied to each payment as it's received.
Gains are included in income in each year in which the seller receives a payment from the buyer. In addition, the buyer pays interest to compensate the seller for waiting to receive payment. The interest is taxed separately at ordinary tax rates. The gain is taxed at short-term or long-term rates, depending on whether the underlying asset was held for one year or less (short-term) or more than one year (long-term).
An installment sale has a few more steps that need to be completed when the deal is struck. You'll need to ensure that the transaction follows the installment guidelines and decide whether you want to pay taxes on them as you receive the installment payments or pay all of the taxes due on the gains in the current year. That is called "electing out" of the installment sale.
Rules for Installment Sales
Installment sales require two factors:
- You agree to sell an asset to a buyer with payments made over time. At least one payment must be received within a year after the tax year of the sale.
- You report this as an installment sale on IRS Form 6252.
The installment sales method can't be used in the following situations:
- If you sell your property at a capital loss. You must report the entire loss in the year of the sale, even if you sell the property at a loss.
- If you sell inventory in the normal course of business. This applies even if the customer pays for the merchandise in a later year.
- If you use a dealer to sell personal or real property, even if the property is sold on an installment plan. However, there's an exception for dealers of time-shares and residential lots.
There are some additional special rules that might keep you from reporting the sale using the installment method:
- When selling depreciable property to a closely related person, you can only use the installment method if there is no tax deferral benefit from the sale.
- When selling depreciable property and depreciation needs to be recaptured.
- When exchanging like-kind property with installment payments.
- When the selling price of the property is contingent on future events.
- When selling several assets as part of a single sale.
- If the interest rate is left unstated in the sales contract.
- If the installment note is subsequently sold or transferred.
- If the seller subsequently repossesses the property.
Installment Sale Example
Jeremy sells his business and can spread the tax impact over several years using the installment sale method. The sales contract specifies that the buyer will pay 30% of the sales price upfront, 40% in one year, and the remaining 30% in two years. That makes it possible for Jeremy to report 30% of his capital gains in the first year, 40% in the second year, and 30% in the third and final year.
The buyer will additionally pay interest on the second and third payments, because Jeremy has to wait to receive those payments.
Calculate what the tax impact would be if:
- Jeremy reported his gains over time, or
- He reported all the gains in the year of the sale, electing out of an installment sale. The tax return must be filed by the due date of the return, including extensions, for the election to be valid.
First, we must know what income and deductions Jeremy has in the first year, and we'll have to estimate what his future income and deductions might be in those future years.
He'll be receiving $100,000 from the sale of his business, minus selling expenses of $10,000, over three years. Plus, the buyer will pay interest on the second and third installments. Jeremy estimates he'll additionally have about $36,000 in ordinary income each year, apart from the gains from selling his business. He doesn't anticipate claiming any significant tax deductions.
We can now compare the two tax scenarios.
Installment Sale vs. Electing Out
Jeremy will pay approximately $20,214 in federal income tax over three years under the installment sale method, compared to paying about $22,877 if he elects out and reports all his gains in the year of sale. That's a tax savings of $2,753 for using the installment sale method.
Notice that the only differences being measured are the taxable gains included in income—either spread out over three years under the installment sale method or all at once if the client elects out. All other income and deduction inputs remain the same between the two scenarios.
It's important to capture all the relevant information about your current and future taxes when constructing a scenario like this. Different people will be impacted in different ways based on their financial circumstances.
|Installment Sale||Elect Out|
|Year 1||Year 2||Year 3||Year 1||Year 2||Year 3|
|Payment from the seller||30,000||40,000||30,000||30,000||40,000||30,000|
|Gross profit percentage||90%||90%||90%||90%||N/A||N/A|
|Taxable long-term gains||27,000||36,000||27,000||90,000||0||0|
|Other ordinary income||36,000||36,000||36,000||36,000||36,000||36,000|
|Adjusted gross income||63,000||74,000||66,000||126,000||38,000||39,000|
|Federal income tax||5,801||7,723||6,690||15,271||3,728||3,878|
|Effective tax rate||11.5%||12.6%||12.6%||13.4%||14.6%||14.6%|
|Marginal tax rate on ordinary income||22%||22%||22%||24%||12%||12%|
|Marginal tax rate on long-term gains||15%||15%||15%||15%||0%||0%|
|Tax over 3 years||20,214||20,214||20,214||22,877||22,877||22,877|
|After-tax income over 3 years||182,786||182,786||182,786||180,123||180,123||180,123|
|3-year average effective tax rate||12.26%||12.26%||12.26%||13.8%||13.8%||13.8%|
*Calculations are based on 2021 tax rates and the 2021 standard deduction for a single individual. Standard deductions for years two and three (2022 and 2023) are estimates based on typical inflation adjustments. All gains are long-term. After-tax income is total income minus federal income tax. The effective tax rate is equal to the federal income tax divided by taxable income.
Long-term gains are taxed at zero, 15%, or 20%, depending on overall income. Long-term gains can also be subject to the 3.8% net investment income surtax for higher-income individuals.
Is an Installment Plan Worth It?
Spreading income over multiple years can help you manage your adjusted gross income (AGI), which can be important in qualifying for certain deductions or tax credits. If you increase your income by reporting a large capital gain in one year, you could potentially:
- Push your ordinary income into a higher tax rate bracket
- Push your capital gains income into a higher tax rate bracket
- Result in more of your Social Security benefits being subject to tax
- Reduce or eliminate deductions that are phased out based on income, such as the student loan interest deduction and itemized deductions
- Reduce or eliminate how much you can contribute to a Roth IRA or Coverdell Education Savings Account
- Reduce or eliminate tax credits that are phased out based on your income, such as the premium assistance tax credit, lifetime learning credit, or child tax credit
- Trigger or increase the net investment income tax
- Trigger or increase the alternative minimum tax
- Increase your Medicare Part B premiums
Conversely, spreading income out over multiple years can potentially:
- Help keep your income within a desired tax rate bracket
- Help keep your capital gains income within the desired zero or 15% brackets
- Result in fewer of your Social Security benefits being subject to tax
- Help keep your income within range for taking the full amount of student loan interest deduction, itemized deductions, personal exemptions, or other deductions that are limited by income.
- Help keep your income within range for taking the premium assistance tax credit or other tax credits.
- Avoid or reduce the impact of the net investment income tax
- Avoid or reduce the impact of the alternative minimum tax (AMT)
- Avoid or reduce the impact of higher Medicare Part B premiums
- Give you some extra income in the form of interest
- An installment sale occurs when you sell a capital asset, and the buyer pays you in installments. At least one payment must take place the following tax year.
- Installment sales have several rules and implications you should be aware of if you're considering selling an asset and allowing installments.
- The tax benefits for electing out depend on your income and tax situation for the year you sell the asset.
- It is worth using an installment sale if spreading the income from the gains over multiple years reduces your taxes enough to make a difference.
Frequently Asked Questions (FAQs)
What is Form 6252?
Form 6252 is used to report income from an installment sale. You fill in information like a description of the property, when you acquired it, when you sold it, the selling price, and the profit percentage you earned that year.
How do you report the sale of a business on your tax return?
For tax reporting purposes, each business asset is treated separately. Depending on the asset, it may be classified as a capital asset, depreciable property, real property, or property held for sale to customers like inventory. Each asset's gain or loss is figured separately and reported accordingly.