Installment Sale Tax Treatment and Planning Your Exit
Carl E. Sera, CMT
September 6, 2023
Installment sale (IRS Section 453 - including both Structured Installment Sales and Deferred Sales Trusts) taxation refers to the tax treatment of an installment sale, which is a type of sale in which the buyer pays the seller over time rather than paying the full purchase price upfront in the current tax year. This is not a new concept by any consideration. The tax treatment of an installment sale differs from that of a regular sale because the seller only recognizes income as payments are received over time. This allows for efficient tax planning and the possibility of savings through deferral at lower tax rates as you elect out of paying the full taxes on your assets upfront.
Under the installment sale method, the seller only recognizes income on the portion of the sale price received each year rather than recognizing all of the income in the year of the sale. The seller's gain on the sale is determined by the gross profit percentage, which is the gross profit on the sale (i.e., the sale price minus the seller's basis in the property) divided by the total contract price. The seller's basis in the property is reduced each year by the portion of the sale price allocated to principal payments.
The tax treatment of an installment sale can be complex, and it's important for you to consult with a tax professional for specific guidance on your situation. However, the installment sale method generally can benefit sellers who want to defer their tax liability on the sale because they only recognize income as payments are received.
Below are some of the basic guidelines when it comes to installment sale tax treatment.
Eligible income recognition
Under the installment sale method, the seller only recognizes income as payments are received over time. This means that the seller does not recognize all of the income from the sale in the year of the sale but instead recognizes a portion of the ordinary income each year as payments are received. The portion of the income that is recognized each year is based on the gross profit percentage.
Gross profit percentage
The gross profit percentage determines the portion of each payment that represents income. The gross profit percentage is calculated by dividing the gross profit on the sale (i.e., the sale price minus the seller's basis in the property) by the total contract price. The gross profit percentage represents the portion of the sale that is profit for the seller and is used to allocate the gain over the life of the installment sale.
The seller's basis in the property is reduced by the portion of the sale price allocated to principal payments each year. This means that the seller's gain on the sale will increase over time as the basis of the property is reduced. The basis adjustments reflect that the seller receives payments over time rather than all at once and therefore needs to adjust their basis in the property over time.
If the seller charges interest on the installment sale, the interest income is recognized as earned each year. Interest income is considered separate from the sale price and is recognized as income in the year earned. The interest income is calculated based on the interest rate charged on the installment sale and the outstanding balance each year.
The seller must report the installment sale on Form 6252, which is attached to their tax return for the year of the sale. The form includes information about the sale price, the gross profit percentage, and the payments received each year. The seller must also report any interest income earned on the installment sale on their tax return for each year.
In summary, the tax treatment of an installment sale is unique because the seller only recognizes income as payments are received over time. This means that the seller must use the gross profit percentage to allocate the profit over the life of the installment sale and must adjust their basis in the property each year to reflect the principal payments received.
Interest income earned on the installment sale is also recognized separately from the sale price and must be reported annually. It's important to consult with a tax professional for specific guidance on your situation, as the tax treatment of an installment sale can be complex and may vary depending on the circumstances of the sale.
Are you considering doing a 1031 Exchange, DST, or Installment Sale? Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1031 real estate into a securitized property while deferring capital gains taxes.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”