7 minute read
When an owner sells a significant asset, they can accept payment in full at the time of sale, or they can accept payment in installments. Establishing a payment schedule with the buyer may seem less than ideal — isn’t it riskier than taking the money up front? And isn’t money in your hands now better than money in your hands three years from now? Believe it or not, there are plenty of reasons why sellers may prefer (and even seek out) installment sales.
Typically, if a business sells an appreciated asset, they report that gain to the IRS in the year they finalize the sale. However, if they make that sale on installment, the IRS allows them to defer that gain and recognize it over multiple years as the installments get paid.
Let’s look at a simplified example of how the installment sale method works:
In January, Seller sells a plot of land for $100K that has an adjusted basis of $60K. Buyer will pay for the land in five annual installments at a 5% interest rate.
To calculate their recognized gain in Year 1 using the installment sale method, Seller must first calculate their total gain, also known as gross profit. In this example, their gross profit is $40K ($100K selling price less $60K adjusted basis). They then divide this number by the selling price to determine their gross profit percentage. In this example, their gross profit percentage is 40% (40K gross profit divided by $100K selling price).
Each year, they will apply this gross profit percentage to the principal payments they’ve received to determine their recognized gain. Let’s assume that in Year 1, they received $22,645 in payments, $18,055 of which was principal and $4,590 was interest. This means that in Year 1, they must recognize $7,222 of long-term capital gain ($18,055 principal payments x 40% gross profit percentage). They will also need to report $4,590 of interest income. The remaining cash they receive is considered a return of capital and does not affect their tax return.
Taxpayers who use the installment sale method should report their sale on Form 6252. They will file this form each subsequent year until all installments have been paid.
By default, all installment sales should be taxed using the installment sale method, but taxpayers who want to report the full gain in the year of sale can elect out of this method by reporting their sale on Form 8949 or Form 4797 rather than Form 6252.
The installment sale method applies to sales of all types of property except for the following:
The installment sale method also does not apply if all installment payments are made in the same tax year.
Installment sales can be great tax planning tools for businesses and individuals selling appreciated property.
Large gains can pose problems from a tax planning perspective, so having the ability to spread that gain recognition out to more than one tax year gives taxpayers better control over their tax bill and therefore their overall financial position.
Reporting a large gain in one year could bump a taxpayer into the next tax bracket. For example, once a married taxpayer’s taxable income exceeds $517,200 (in 2022), their long-term capital gains will be taxed at 20% rather than 15%. By spreading that gain out over two or more years, they may be able to keep their taxable income low enough to qualify for the 15% long-term capital gains tax rate.
Like long-term capital gains, ordinary income is taxed at higher rates as taxable income increases. Using the installment sale method may help sellers stay in a lower ordinary income tax bracket and therefore reduce their total income tax liability.
The net investment income tax (NIIT) is a 3.8% additional tax on investment income, but it only applies to high earners. If filers keep their taxable income below the NIIT income thresholds, they can avoid this tax altogether.
By keeping taxable income low, taxpayers may be eligible for deductions or credits that would be phased out if they had reported the full gain in the year of sale.
Installment sales can be used to positively impact a company’s cash flow. Not only is the company establishing a more-or-less guaranteed stream of cash, they are also earning interest. For businesses that struggle to maintain cash flows, installment sales can be a great solution.
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Installment sales do have their downsides.
When taxpayers sell depreciable property, whether they use the installment sale tax strategy or opt to recognize the full gain in Year 1, they must think about depreciation recapture. Depreciation recapture converts a portion of the capital gain — the amount that represents accumulated depreciation — into ordinary income. Let’s look at an example:
Seller purchased a building for $200K a few years ago and has since reported $50K of depreciation. If they sold the building for $275K, their gain would be $125K ($275K sales price less $150K adjusted basis). Because the seller had already deducted $50K of the building’s cost via depreciation deductions, the IRS would classify $50K of that $125K gain as ordinary income via depreciation recapture.
Depreciation recapture is a key metric to consider when tax planning because recapture income must be recognized fully in the year of sale. Even taxpayers who report their sale using the installment sale method must recognize depreciation recapture that very first year.
Sales to related parties are typically ineligible for the installment sale method. Only if the taxpayer can prove to the IRS that they did not get a significant tax deferral benefit can a taxpayer use the installment sale method with a related party.
The IRS wants taxpayers to charge adequate interest. If interest isn’t stated in the contract, the IRS will recategorize a portion of each payment as interest income. In some cases, inadequate interest may be categorized as a gift to the buyer.
Both parties have to agree to treat the purchase as an installment sale. Buyers may not want to make payments over the term directly to the seller.
You always run the risk with installments sales that the buyer will not make all the payments. Perhaps the buyer goes bankrupt before the installment sale is complete. In this case, you may not be able to recover the full sale price.
Though there are many benefits to using the installment sale method, there are plenty of reasons to opt out.
The installment sale method applies to almost all installment sales by default, but because it is optional, it’s a great tax planning strategy. Taxpayers will benefit most if they can talk to a tax advisor before selling a capital asset. Together with their advisor, they can use the installment sale method in a manner that helps keep tax liabilities low in the current year and perhaps even reduce their total tax bill in the long run.
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