Basic Rules
An installment sale, as defined under Section 453, involves a sale of property where at least one payment is expected to be received by the seller after the tax year in which the sale occurs. This article provides details on installment sales to help you through the process.
Under the installment sale method, the seller will generally recognize gain as cash payments are received. Each payment includes a nontaxable recovery of basis in the property sold, a taxable realized gain, and taxable interest.
The gain reported in any given year is equal to the total payments received during the year, excluding interest, multiplied by the gross profit percentage.
In the year an installment sale occurs, several calculations must be made to arrive at the gross profit percentage:
- Selling Price – The selling price is the total consideration received by the seller, including any money, the fair market value of property, debt the buyer assumes, and seller expenses paid by the buyer.
- Adjusted Basis – In the case of depreciable property sold, the seller’s adjusted basis in the property is generally determined by taking the seller’s original cost of the property, plus improvements or additions and less any depreciation or amortization. Basis also is adjusted for selling expenses paid by the seller.
- Gross Profit – The gross profit is the selling price minus the seller’s adjusted basis in the property sold.
- Total Contract Price – The total contract price is the selling price minus any qualified indebtedness assumed by the buyer, but only to the extent of the seller’s adjusted basis. If the assumed debt exceeds the seller’s adjusted basis, then the excess is treated as an installment payment. Qualified indebtedness means a mortgage or other debt encumbered by the property sold or debt not secured by the property sold but assumed by the buyer incident to the acquisition.
- Gross Profit Percentage – The gross profit percentage is calculated by dividing the gross profit by the total contract price.
Payments may vary each year, but for each year that payments are received, the seller calculates the amount of gain, return of basis, and interest income. The gain is calculated by multiplying the gross profit percentage by the total payments received in the year, excluding interest, and is reported on the seller’s tax return.
Installment sales are reported on Form 6252 and must be attached to the seller’s tax return in the year of the initial sale and any subsequent tax year that payments are received. If a partnership or S corporation has an installment sale, then Form 6252 will be filed at the entity level and the gain will be passed through to the partners or shareholders.
If a sale qualifies as an installment sale, the installment sale rules apply by default, unless the taxpayer elects out on a timely filed tax return in the year of sale. To elect out of installment sale treatment, the taxpayer simply reports the full gain on Form 4797 or Form 8949/Schedule D in the tax year of the transaction.
Installment sale notes generally include stated interest; however, if there is no stated interest or the rate is too low, the buyer and seller are required to impute adequate interest using the applicable federal rate under §1274(d). The interest paid or deemed paid is deductible by the buyer and is taxable interest income to the seller.
The installment sale method is not allowed for certain types of transactions, such as:
- Sales resulting in a loss, even if the payments are made in installments, so the taxpayer needs to recognize the loss in the year of the sale;
- Dealer dispositions, which are sales of personal property held by the taxpayer for sale in the ordinary course of business (exception for farms);
- Sale of personal property that is included in the taxpayer’s inventory at the close of the year;
- Sales of marketable securities or securities that are regularly traded on an established exchange. A sale of marketable securities is taxable in the year of sale, even if they are being paid in installments. However, an exception applies if the seller cannot directly sell the stock or securities due to restrictions placed on the securities;
- Sale of depreciable property to certain related parties; or
- Portion of a gain subject to depreciation recapture under §1245 for tangible personal property, §1250 for depreciable real property, and §751 for partnership interests. Installment sales that include depreciation recapture require that the seller recognize the ordinary income in the year of sale and increase their adjusted basis by this income to determine their gross profit percentage for the remaining deferred installment payments.
Section 453A Interest Charge
Section 453A(a)(1) imposes an additional interest charge on a taxpayer’s deferred tax liability connected with installment obligations where the property’s sales price exceeds $150,000 and the total amount of all installment sale obligations that arose during the tax year and were outstanding at the end of the year exceed $5 million.
The $5 million threshold is applied and calculated at the partner or S corp shareholder level for pass-through entities, subject to certain related party attribution rules.
The interest charge is calculated by multiplying the applicable percentage by the deferred tax liability. The applicable percentage is the outstanding installment note at the end of the tax year minus the $5 million threshold and divided by the outstanding installment note at year-end. The deferred tax liability is calculated by multiplying the gross margin percentage by the outstanding installment obligation and maximum long-term capital gains rate. This calculation is completed each year until the outstanding installment obligation falls below the $5 million threshold.
The interest charge is added to the tax liability of the taxpayer in the year applied, so it is a dollar-for-dollar amount of additional tax.
Also, the IRS has ruled that married individuals are not treated as a single taxpayer for purposes of the $5 million threshold (see Technical Advice Memorandum 9853002).
Related Party Rules
Section 453(e) provides that if property is sold to a related party in exchange for an installment note and the purchased property is resold by the related party within two years of the original purchase, then the amount realized by the related party will be treated as a payment to the original seller. Thus, the deferred gain on the installment note is accelerated at the time of the second sale.
Section 453(g) provides that the installment sale method is not available for installment sales of depreciable property between certain related persons; instead, all installment payments received from the sale are treated as received by the seller in the year of the disposition.
If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.