All things being equal, taxpayers generally would prefer to pay taxes later rather than sooner – particularly if they are in a high tax bracket. The installment method allows taxpayers to defer taxes by recognizing profit from certain sales over several years rather than all at once. Also, the installment method gives potential buyers more flexibility, often providing just what is needed to allow a sale to go through.
The installment method is broadly available for sales of both real and personal property when at least one payment is to be received after the year of sale. If available, the installment method must be used unless the seller elects to recognize all the income in the sale year.
With the installment method, a portion of each installment payment usually consists of interest, and the rest of the payment is divided between taxable installment sale income and nontaxable return of investment (“adjusted basis”) using the ratio of the gross profit from the sale of the contract or sale price.
- Say you are selling for $300,000 a piece of land that you originally purchased for $100,000. There are no outstanding mortgages on the property. Your sale would create a $200,000 gain, and at a 15% capital gain rate, you’ll have to pay the IRS $30,000 in the year of sale. Instead, you permit the buyer to pay the purchase price in equal installments of $50,000 (plus interest) over six years.
- As a result, your $200,000 gain will be spread over six years, so only $33,333 of each installment will be considered a taxable gain. At a 15% capital gain rate, you’ve reduced your annual tax to $5,000.
Avoiding Higher Rates
Because the installment method lets you “spread out” income, it may help you avoid being pushed into a higher income-tax/capital gains tax bracket. Additionally, the capital gains are potentially subject to the additional 3.8% Medicare surtax on net investment income. Using the installment method may help lessen the impact of this tax.
The installment method may not be used for sales of publically traded securities, inventory, and certain other sales. Where depreciation has been claimed, some or all of the seller’s gain is taxed at higher rates in the year of the sale. The installment method generally isn’t available for sales of depreciable property between “related persons,” such as a company and its majority shareholder.
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