While I regularly help clients with installment sales transaction to defer payment of capital gains taxes, I am surprised how often I am asked by clients and their CPAs on how to properly report their installment sale transaction and any particular landmines issues to be aware of. In fact, I generally get the same questions over and over again. So, with that in mind, the following is a FAQ on some of the more generally asked questions.
Q. What is an installment sale?
While it is obvious to tax professionals, laypersons generally do not understand what an installment sale is. An installment sale is the same thing as “seller financing” or “owner carried note.”
Q. Can you elaborate further?
Not to oversimplify the obvious, as a general rule, when a taxpayer sells an asset in year X, the taxes on the gains are immediately assessed in year X. Simply, I owe taxes on an asset if I sold the asset at a higher price than I purchased it for. This is called the cash reporting method.
However, Section 453 provides an exception to this general rule that gains must be recognized immediately upon the sale of the asset, even if the seller receives only a promissory note in exchange for his property. Under Section 453, the seller is permitted, in certain circumstances, to use the “installment method” when he sells the asset in exchange for a string of payments, of at least one “payment” is to be received after the close of the taxable year in which the disposition occurs. Simply, if you sell an asset and at least $1 is received the next taxable year, a taxpayer may elect to be taxed under the installment method.
Section 453 allows for a taxpayer to defer the taxes or spread out the taxable income in order to take advantage of the progressive tax rates.
Q. Can I use the installment method for any asset that I want to sell?
Not exactly. Assets that can be disposed of under the installment method include real estate, non-public corporate stock, certain business assets, partnership and LLC interests, contract rights, a professional practice, and art collections.
However, the installment method is unavailable for dispositions that result in a loss, inventory, publically traded stock, ordinary income recapture under IRC Sections 751, 1245 and 1250, accrual method taxpayers, and unrealized receivables. Note, unrecaptured Section 1250, which is the gain that corresponds to the straight-line depreciation deductions which have been taken, can be reported under the installment method.
Q. What happens if I don’t receive my installment payments from the buyer?
If you are worried about this, you really should perform due diligence on your buyer. That being said, you may write off any uncollected amount as bad debt. But, in order to write this off, you have to either obtain a judgment against the buyer/debtor (which means you have to spend money on a lawsuit), or the buyer/debtor does everyone a favor and files for bankruptcy.
There is one wrinkle on how much you can write off as bad debt. Bad debt can only be written off to the extent of the adjusted basis on the installment obligation. In other words, you only get to write off the cost basis, less applicable depreciation, of the asset.
Q. How do I report my installment sale?
The “installment method” is the default method as prescribed by the Internal Revenue Code to report income from installment sale transactions unless the taxpayer elects not to use the installment method. Electing out of the installment method must be made no later than the due date of the tax return (including all extensions) for the taxable year in which the disposition occurs.
You must file form 6252 with your tax return in the year the disposition occurs.
Note, under the installment method, each installment payment constitutes a fractional portion of a return of capital and capital gains or the “gross profit ratio.” The gross profit ratio is equal to the “gross profit” divided by the “contract price” less any qualified indebtedness assumed or taken subject to by the buyer, to the extent of the seller’s basis in the property.
Q. Any other issues I need to be worried about?
Aside from this being an absolutely loaded question, I would want to focus on this one particular thing: the sales price of the asset that you are thinking about selling under the installment method.
There actually is a limitation on how much you can report under the installment method per year, before the IRS imposes an interest charge, on the taxpayer. Each taxpayer is allowed to report up to $5 million under the installment method each year without paying the interest charge. Note, married individuals are not treated as one person when calculating the $5 million threshold.
But, I have some good news for you. If you are selling personal property (like your home) or farmland, the $5 million threshold does not apply.
Now on to the bad news, the Code provides that the interest charge is based on the IRS underpayment rate in effect in the last month of the year in which or with which the taxpayer’s tax year ends. As of this writing, the current rate is 6%. You can look up the rates online by searching for IRC 6621(a)(2) rates.
Want even more bad news, unless you are a C-corporation, the interest charge is considered nondeductible personal interest! Remember, C-corporations are allowed to deduct the interest charge as a business expense in most circumstances in the year paid or accrued because C-corporations are not subject to the limitations on deductions for personal interest expense.
I hope this little writeup helps iron out some issues. If you are still interested in pursuing using the installment method or have further questions, please contact our offices.