Qualifying as an Installment Sale
With an installment sale involving real estate, the buyer pays the seller over time rather than the entire purchase price at closing. “Installment sale” is defined explicitly by the Code: as 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.
Installment sales are not reserved only for real estate; personal property sales can also be installment sales, subject to exceptions (e.g., the sale of inventory). This exception can cause the installment method to become unavailable.
Note: Where the Code excepts a type of sale from being an “installment sale,” the installment method is unavailable — all gains 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 explicitly 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 deal, recognizing gain 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).
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 real estate for sale is farm property or certain timeshares and residential lots. By “dealer disposition,” we mean, in the case of real estate, someone who owns property intending to sell it as a regular part of their business. That property is considered a disposition of real property held for sale in the ordinary course of business.
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 the 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 essential to always watch for related party sales, as there are many exceptions/rules.
Reporting Gain Under the Installment Method
When reporting gain under the installment method, several steps must be taken to determine the amount of gain to be reported and taxed annually. But first, some key terms must be defined:
When buying a property, it is crucial to understand what the selling price entails. The selling price is the total purchase price for the property, which includes the amount paid for the property and any other outstanding costs associated with it. This means that if a mortgage encumbers the property, the unpaid balance of the mortgage at the date of sale is included in the selling price, regardless of whether the buyer assumes the mortgage or takes title subject to it.
It is worth noting that selling expenses and commissions are not deducted in computing the selling price. These expenses may include real estate agent commissions, title search fees, appraisal fees, and other costs associated with the sale of the property. Therefore, the selling price reflects the total cost of the property without any deductions for these expenses.
In addition, it is essential to note that neither interest nor any original issue discount is included in the selling price. This means that any interest payments or other discounts associated with the property are not factored into the selling price. The selling price only reflects the total amount paid for the property and any associated costs. Overall, understanding what is included in the selling price is an important factor to consider when buying or selling a property.
When selling a property through an installment sale, it is vital to understand how the gross profit is calculated. The gross profit is the difference between the selling price and the seller’s adjusted basis, as well as any additional factors that may be involved. For example, if the seller is not a dealer, they may also need to add selling expenses and any recapture income under Sections 1245 and 1250 of the Code.
It’s important to note that the treatment of selling expenses can differ depending on whether the seller is an investor or a dealer. An investor must add selling expenses to their basis to compute the gain on the sale, except for state or local transfer taxes, which are treated as a reduction of the amount realized. This requirement forces the investor to recover their selling expenses over the life of the installment contract, as selling expenses cannot be deducted from the initial payment.
In contrast, a dealer can deduct 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 the sale, with the gain being postponed to the later years of the installment contract.
Overall, the treatment of selling expenses is an essential factor to consider when selling a property through an installment sale. Depending on whether the seller is an investor or a dealer, different requirements and considerations may be involved in calculating the gross profit and determining how selling expenses are handled.
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
Each year the seller receives payment, sellers must include, in income, the interest and the part that is the seller’s gain on the sale. The seller does not include 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 and debt 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 afterward.
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 recaptured income
On January 15, 2021, Sam, an investor, sold 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 adequate stated interest. Sale expenses are $20,000, and 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|
While Sam sold the property for a price of $1.1 million, for which she would usually have $910,000 of gain (ignore selling expenses and mortgage debt assumed), by 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 in 2021.
If you have questions about installment sales and the installment method, please get in touch with your Carlile Patchen & Murphy LLP attorney.