Qualifying as an Installment Sale
With an installment sale involving real estate, the buyer makes payments to the seller over time, rather than paying the entire purchase price at closing. “Installment sale” is specifically defined by the Code: a disposition of property where at least one payment is to be received after the close of the taxable year in which the sale occurs.
Note: installment sales do not require multiple payments over multiple years. For example, a sale by a calendar year taxpayer that is closed on 12/31/2021 and paid for on 1/1/2022 is considered an installment sale because at least one payment is made in a year after the year of sale.
Installment sales are not reserved to real estate; sales of personal property can be installment sales as well, subject to exceptions (e.g., the sale of inventory). Where an exception applies, there is no “installment sale” and thus the installment method is unavailable- all gain must be reported in the year of sale regardless of when the payments are received.
The Installment Method
Gain arising from an installment sale must be reported under the installment method, unless either the Code specifically excludes such sale from installment method reporting or the taxpayer elects out of the installment method. Under the installment method, the seller defers gain on the sale, recognizing gain in each year that a portion of the purchase price is received. This allows the tax liability to be spread over several years (if the installment payments are to be spread out that long).
Note: Where the Code excepts a type of sale from being an “installment sale”, the installment method is unavailable- all gain must be reported in the year of sale regardless of when the payments are received.
To qualify under the installment method, the otherwise eligible installment sale must produce a gain. Any losses arising from an installment sale are recognized in the year of sale—even if the sales price is paid over a number of years.
The Code allows most real estate sellers to use the installment method, with one main exception—the installment method cannot be used for dealer dispositions, unless the property being sold is farm property or certain timeshares and residential lots. By “dealer disposition” we mean, in the case of real estate, any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. A dealer disposition is not deemed to be an installment sale at all. Thus, the installment method is unavailable.
Note: A sale must be an “installment sale” for the installment method to be used, but the reverse is not always true. Not all sales that qualify as installment sales are eligible for the installment method of reporting gain.
There are a few additional types of transactions that are not eligible for installment sales, these include:
- Sale of inventory.
- Sale of stock or securities traded on an established securities market (or any other property of a kind regularly traded on an established market).
It is also important to always keep an eye out for related party sales—there are many exceptions/rules applicable in such cases.
Reporting Gain Under the Installment Method
When reporting gain under the installment method, there are several steps to be taken in order to determine the amount of gain to be reported and taxed each year. But first, some key terms must be defined:
- The selling price is the total purchase price for the property.
- If the property is encumbered by a mortgage, the unpaid balance of the mortgage at the date of sale is included in the selling price, whether the buyer assumes the mortgage or merely takes title subject to it.
- Selling expenses and commissions are not deducted in computing the selling price.
- Neither interest nor any original issue discount is included in the selling price.
- The gross profit on an installment sale is (1) the selling price minus the seller’s adjusted basis, plus (a) selling expenses, if the seller is not a dealer; and (b) any recapture income under Sections 1245 and 1250 of the Code.
- The treatment of selling expenses differs for investors and dealers.
- An investor must add selling expenses (other than state or local transfer taxes, which are treated as a reduction of the amount realized) to seller’s basis to compute gain on the sale.
- This requirement forces the investor to recover his selling expenses over the life of the installment contract; selling expenses cannot be deducted from the initial payment.
- A dealer, however, deducts selling expenses as business expenses independent of the sale.
- This permits the dealer to deduct the entire amount of these expenses in the year of sale, with the gain being postponed to the later years of the installment contract.
Each payment on an installment sale usually consists of the following three parts:
- Interest income.
- Return of seller’s adjusted basis in the property.
- Gain on the sale.
In each year the seller receives a payment, such seller must include in income both the interest part and the part that is seller’s gain on the sale. The seller does not include in income the part that is the return of the seller’s basis in the property.
The total contract price equals the selling price reduced by that portion of any qualifying indebtedness assumed, or taken subject to, by the buyer, which does not exceed the seller’s basis in the property (adjusted to reflect commissions and other selling expenses).
“Qualifying indebtedness” refers to a mortgage or other indebtedness encumbering the property, as well as indebtedness not secured by the property but incurred or assumed by the purchaser incident to the purchaser’s acquisition, holding, or operation of the property.
Gross Profit Percentage
Gross profit percentage = gross profit divided by the contract price.
Computing Reportable Gain
Even though taxable gains are spread out over multiple years under the installment method, the gain is only measured once, expressed as a gross profit percentage, and applied to each payment thereafter.
To compute gain on an installment sale, a seller must take these six steps:
- Compute the gross profit to be realized on the sale.
- Compute the contract price.
- Determine the ratio of total gain (Step 1) to total contract price (Step 2). This is the gross profit percentage.
- Determine payments received during the taxable year.
- Multiply the payments received during the taxable year (Step 4) by the gross profit percentage (Step 3). The result is the gain to be recognized for the year.
- Increase Step 5 by any recapture income.
On January 15, 2021, Sam, an investor, sells Josie an office building for $1.1 million. The building is subject to a mortgage of $150,000, which Josie assumes. Josie also makes a $250,000 down payment and gives Sam a $700,000 promissory note, providing for adequate stated interest. Sale expenses are $20,000. Sam’s adjusted basis in the property is $200,000. Assume that there is no recapture income. After the sale, but before the close of Sam’s taxable year, Sam receives an installment payment of $120,000 from Josie. Sam’s taxable gain in the year of sale is computed as follows:
Step 1: Gross Profit
|Less Adjusted Basis||$200,000|
|Less Selling Expenses||$20,000|
Step 2: Contract Price
|Less Mortgage Debt Assumed||($150,000)|
Step 3: Gross Profit Percentage
|Ratio of gross profit to Contract Price|
Step 4: Payments Received During Year
|Payments for Year||$370,000|
Step 5: Gain Recognized in Sale Year
|Gross Profit %||92.63%|
|Payment Received During Year||$370,000|
Step 6: Additional Recapture Income
|Total Income Recognized in 2021||$342,731|
Thus, while Sam sold property for a price of $1.1 million, for which she would normally have $910,000 of gain (ignore selling expenses and mortgage debt assumed), but structuring the sale as an installment sale and reporting gain under the installment method, Sam is only subject to tax on about $340,000 in the year of sale.
As mentioned above, taxpayers are permitted to elect out of using the installment method. Why would someone want to elect out of installment method reporting? In our next article we will discuss why you might consider electing out of the installment method, particularly in light of potential tax law changes coming in 2021.
If you have any questions about installment sales and the installment method, please contact your Carlile Patchen & Murphy LLP attorney.