Installment Sale Basics

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By Darren Morrow, CPA

Ever heard of an installment sale?  This article will help you understand the basics of installment sales, including what you need to know to help you make the best decisions when selling property.

An installment sale is the sale of a property where both parties have agreed to terms where the payments will be made over a number of years instead of receiving the entire purchase price at the time of sale. For instance, a person may choose to sell their home to someone and receive payments over a ten year period. The technical definition of an installment sale for tax purposes requires that payments must be made in at least two separate tax years.

Calculating the taxable income to be recognized under an installment sale is quite simple. The first step is to calculate the gain on sale as you normally would (sales price less tax basis). Then a percentage is calculated taking the principal portion of payments received in the current year divided that by the total sales price.  Taxable income for the current year must include this percentage of the overall gain on the sale of the property.

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There are some benefits to taxation under the installment sale rules.  One of the most obvious benefits is the deferral of capital gains taxes. Since you are only recognizing a portion of the gain in the current year you are only taxed on that amount.  The additional tax due from the sale is deferred to future years. Another benefit that is not quite as obvious is that you could possibly be in a lower tax bracket each year since you are not recognizing a large amount of income in one year. Additionally, an often overlooked benefit of the transaction is the additional interest income that can be structured into the sale. Generally sellers will receive a higher rate of interest on the deferred funds than can be realized elsewhere, and the note receivable is secured by the real property. 

Installment sales are not always an option for every transaction. Installment sales cannot be used (for tax calculation purposes) if your sale results in a loss (sales price exceeds your basis), or if it is a sale of inventory, stocks, or securities traded on an established securities market. Additionally, if you choose to do an installment sale and defer your capital gains into future years and the tax rate on capital gains goes up, you could potentially pay a higher amount of tax in the future.

Knowing how installment sales work and how to use them to your advantage is a great tool when negotiating a sale. It will let you have more control over your income and may even earn you a little extra interest income along the way. For more information about installment sales please contact us at http://www.ntcpas.com or contact our office at (714) 836-8300.

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