Installment Sale

An installment sale, governed by Internal Revenue Code section 453, is a disposition of property in which the seller receives at least one payment after the close of the tax year in which the sale occurs. Under the installment method, the seller does not report the whole gain up front; instead each year's gain equals that year's payments multiplied by the sale's gross-profit percentage. The method applies automatically to an eligible sale unless the seller elects out, and it is a common way to sell a business or investment real estate while smoothing the tax over the years the buyer pays.

The engine of the installment method is the gross-profit percentage: the gross profit on the sale (the selling price minus the property's adjusted basis and selling expenses) divided by the total contract price. Each year the seller multiplies that percentage by the principal payments received to find the taxable gain for the year; the rest of each payment is a tax-free return of basis. Interest the buyer pays is reported separately as ordinary interest income, not as part of the gain. The character of the gain, capital or ordinary, and the applicable rate are determined as they would be on a normal sale.

Section 453 carries several rules that surprise sellers. The most important is section 453(i): any "recapture income," meaning the gain that would be taxed as ordinary income under section 1245 or 1250, must be recognized in full in the year of sale, no matter how small a payment the seller received that year; only the gain above that recapture rides the installment method. This bites hardest on equipment and other section 1245 property, where the full depreciation is recaptured as ordinary income and so is pulled forward immediately. It reaches real property only to the extent section 1250 produces ordinary-income recapture, which for a building depreciated on the straight-line method is usually nothing, so the depreciation-driven gain on such a building (unrecaptured section 1250 gain, taxed at a rate of up to 25%) can still be spread across the payments. A seller who took large accelerated depreciation, or who sold depreciated equipment, can therefore owe tax on the recapture immediately even while most of the cash arrives years later. Other limits narrow who can use the method at all. Section 453(k) denies the installment method for sales of stock or securities traded on an established market and for revolving-credit sales, so the gain on publicly traded shares is reported in the year of sale even if paid later. Section 453(l) excludes most "dealer dispositions," meaning sales of property a taxpayer routinely sells to customers, so a homebuilder cannot spread the gain on the houses it sells. Finally, section 453A imposes an interest charge on the deferred tax when the face amount of a taxpayer's installment obligations outstanding at year-end exceeds $5,000,000, which makes very large installment sales less attractive than they first appear. A seller can also elect out of the installment method entirely and report all the gain in the year of sale, which is sometimes better, for instance to use an expiring capital loss or a low-income year.

The seller computes the gross-profit percentage once, then applies it to the principal received each year to report that year's gain; the buyer's interest is reported separately, and any depreciation recapture is pulled forward to the year of sale.

A hypothetical example: Dana sells raw land she bought for $200,000 for a price of $500,000, with no depreciation and no selling expenses, so her gross profit is $300,000 and her total contract price is $500,000. Her gross-profit percentage is $300,000 divided by $500,000, or 60%. The buyer pays $100,000 down and $100,000 a year for four more years, plus interest. In the year of sale Dana reports 60% of the $100,000 down payment, or $60,000 of gain, and treats the other $40,000 as a return of basis; she does the same for each later $100,000 payment, reporting $60,000 of gain a year until the full $300,000 has been taxed. If the property had generated $80,000 of depreciation recapture, that $80,000 would instead be taxed in full in the year of sale, and only the remaining $220,000 of gain would ride the installment method.

Pros

• Spreads the gain and its tax over the years the seller is paid, which can keep income in lower brackets and defer the bill.
• Can make a sale possible by letting the seller finance a buyer who cannot pay all cash.
• The seller can elect out to report everything up front when that is better, such as to absorb a capital loss.

Cons

• Depreciation recapture is taxed in full in the year of sale regardless of cash received, a common and costly surprise.
• The seller carries the buyer's credit risk and may not collect the full price.
• The method is unavailable for dealer sales and for publicly traded securities.
• Deferred balances above $5,000,000 trigger an interest charge under section 453A, and future tax-rate increases can raise the cost of the deferred gain.