In recent years, the economy has been having its share of ups and downs. When businesses and private citizens want to secure financing from financial institutions to make large purchases, the economy can greatly influence the bank’s willingness to loan funds. In an unknown or down-turned economy, the installment sale lends itself as a great alternative option. An installment sale occurs when property is sold with at least one payment being made in the year of the sale, and at least one payment being made in the tax year after the sale is completed. Generally, the buyer will make regular payments to the seller to complete the debt owed on the sale. This is mostly done in the real estate environment but may also transpire in business sales as well. To qualify under the IRS definition, the property sold must be something other than publicly traded securities, and the seller cannot be a dealer of that particular piece of property.
If done correctly, this type of sale can be beneficial to the buyer and the seller. While you may have to wait a year or more to receive the full value of what was sold, installment sales offer the seller key tax advantages. Instead of paying taxes on the entire gain in one year, only a portion of the gain is taxable in the year of the sale. The remainder is taxable in the year(s) the remaining payments are received. The taxable portion of the payment is for the gross profit ratio, which can be calculated by dividing the gross profit from the sale by the price. This percentage is then applied to each payment as it is received. Since the gain is spread out over many years, you may gain the benefit of the different tax rates in each year. Additionally, if the installment sale concerns real estate that you have owned longer than one year, any gain is taxed as tax-favored long-term gain. Another advantage is that you can collect interest on the sale. The interest is taxed separately at ordinary tax rates.
With this type of arrangement, the buyer can also benefit from this transaction.
One of the biggest benefits is they do not have to come up with all the cash at one time. If they have a long enough term, they may avoid borrowing money from a traditional lender. This could allow them to keep their credit lines open and it may allow them to purchase a property if their credit is poor.
Installment sale methods cannot be used if: the property is sold at a loss; if it is for the sale of inventory in the normal course of business; if it is a sale of property by a dealer; a sale of personal property or a sale of stock, bonds or other investment securities. There are special rules concerning depreciable property, like-kind exchange property, property contingent on future events, understated interest rates, transfer of the Installment Note, or repossession of the property. If a sale does qualify as an installment sale, then the gain must be reported under the installment method. The only exception to this rule occurs when the seller chooses to “elect out” and thus report all income as gain in the year of the sale rather than spreading it out over time. There are several possible reasons why this may be of benefit. You might expect to pay lower tax rates in 2019 than 2020, given other parameters in your income sources in that year. In that case, you may prefer to pay the full amount of tax due on your 2019 tax return. Or you might have capital losses or suspended passive losses that will offset the tax on an installment sale gain. Therefore, you may benefit by reporting all your gain in the year of the sale, instead of spreading it out over time.
The installment sale method is basically a play on the timing of income. Should you spread out the income over multiple years? Should you take the tax hit all at once? The "right" answer depends on the specifics of your financial situation. As a tax strategy, installment sales are about managing the tax rates that apply to the capital gains' income. Installment sales can also be used to manage other tax-related impacts. For example, spreading income out over multiple years can help a person manage their adjusted gross income, which may be important in qualifying for deductions or tax credits that are based on income. Increasing income by reporting a large capital gain in one year can potentially move ordinary income into a higher tax rate bracket, move capital gains income into a higher tax rate bracket, result in more social security benefits being subject to tax, reduce or eliminate deductions that are based on income, reduce or eliminate how much can be contributed to a retirement or educational plan, reduce or eliminate tax credits that are phased out from income, and/or increase net investment income tax and/or alternative minimum tax. Conversely, spreading income out over multiple years can potentially keep income within a desired tax rate bracket, keep capital gains income within the desired brackets, result in fewer Social Security benefits being subject to tax, keep income within range for taking the full amount of student loan interest deduction, itemized deductions, personal exemptions, or other deductions that are limited by income, keep income within range for taking the premium assistance tax credit, or other tax credits, and/or avoid or lessen the impact of the net investment income tax and alternative minimum tax.
The bottom line is that installment sales aren’t right in every situation. But when applied correctly, they can be of great benefit. Seeking the assistance from your tax advisor will help you determine if this is the right method for you.