Installment Sales

A tax strategy for spreading capital gains over several years

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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 spreads the capital gains income over multiple years, and it can reduce the amount of tax owed under some circumstances. This tax strategy is known as an 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:

  • You must report the entire capital loss in the year of the sale if you sell the property at a loss
  • Sales of inventory in the normal course of business, even if the customer pays for the merchandise in a later year
  • Sales of personal property or real property by dealers, even if the property is sold on an installment plan. However, there's an exception for dealers of time-shares and residential lots
  • Sales of stocks, bonds and other investment securities

There are some additional special rules as well:

  • When selling depreciable property to a closely-related person
  • 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

Benefits of Installment Sales

The key benefit of an installment sale strategy is that it spreads capital gains out over time. This can have a few beneficial results, depending on your financial circumstances:

  • Income is potentially taxed at lower tax rates.
  • The cash flow of money coming in from the buyer is paired with money going out for taxes.
  • Large, short-lived spikes in income, adjusted gross income, and tax are prevented.
  • You'll potentially have more cash in hand to reinvest, save, or spend as you see fit.

A secondary benefit is that the seller earns some interest on the seller-back loan to the buyer.

An Example of an Installment Sale

Jeremy sells his business and is able to 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 up front, 40% in one year, and the remaining 30% in two years. This 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 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.

An Installment Sale

Scenario 1: Installment Sale Year 1 Year 2 Year 3
Payment from the seller 30,000 40,000 30,000
Gross profit percentage 90% 90% 90%
Taxable long-term gains 27,000 36,000 27,000
Interest income -0- 2,000 3,000
Other ordinary income 36,000 36,000 36,000
Adjusted gross income 63,000 74,000 66,000
Standard deduction -12,550 -12,700 -12,900
Taxable income 50,450 61,300 53,100
Federal income tax 5,801 7,723 6,690
After-tax income 57,199 66,277 59,310
Effective tax rate 11.5% 12.6% 12.6%
Marginal tax rate on ordinary income 22% 22% 22%
Marginal tax rate on long-term gains 15% 15% 15%
Tax over 3 years 20,214 20,214 20,214
After-tax income over 3 years 182,786 182,786 182,786
3-year average effective tax rate 12.26% 12.26% 12.26%

*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. Effective tax rate is equal to the federal income tax divided by taxable income.

Electing Out of an Installment Sale

Scenario 2: Elect Out of Installment Sale Year 1 Year 2 Year 3
Payment from the Seller 30,000 40,000 30,000
Gross profit percentage 90% N/A N/A
Taxable long-term gains 90,000 -0- -0-
Interest income -0- 2,000 3,000
Other ordinary income 36,000 36,000 36,000
Adjusted gross income 126,000 38,000 39,000
Standard deduction -12,550 -12,550 -12,550
Taxable income 113,450 25,450 26,450
Federal income tax 15,271 3,728 3,878
After-tax income 110,729 34,272 35,122
Effective tax rate 13.4% 14.6% 14.6%
Marginal tax rate on ordinary income 24% 12% 12%
Marginal tax rate on long-term gains 15% 0% 0%
Tax over 3 years 22,877 22,877 22,877
After-tax income over 3 years 180,123 180,123 180,123
3-year average effective tax rate 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. Effective tax rate is equal to the federal income tax divided by taxable income.

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 we're measuring are when the taxable gains are included in income—either spread out over three years under the installment sale method (scenario 1) or all at once if the client elects out (scenario 2). 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 personal financial circumstances.

Timing of Income

Taxable gains are spread out over multiple years under the installment sale method. Gain is measured once (gross sales proceeds minus cost basis minus selling expenses) and is 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 either at short-term or long-term rates, depending on whether the underlying asset was held for one year or less (short-term), or held for more than one year (long-term).

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.

Some Other Considerations

Spreading income over multiple years can help a taxpayer manage their adjusted gross income (AGI), which can be important in qualifying for certain deductions or tax credits. Increasing income by reporting a large capital gain in one year can potentially:

Conversely, spreading income out over multiple years can potentially:

  • Help keep income within a desired tax rate bracket
  • Help keep capital gains income within the desired zero or 15% brackets
  • Result in fewer Social Security benefits being subject to tax
  • Help keep 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 income within range for taking the premium assistance tax credit, or other tax credits
  • Avoid or lessen the impact of the net investment income tax
  • Avoid or lessen the impact of the alternative minimum tax
  • Avoid or lessen the impact of higher Medicare Part B premiums

You're trying to solve a puzzle by looking at how a level of income interacts with other parts of your tax return.

The Bottom Line

All these benefits come about by managing income levels and looking at how different levels of income trigger various tax impacts. Be sure to identify all the types of income, types of deductions, types of taxes, and types of tax credits that are relevant to your situation when you're building your own tax-planning scenario.