The installment sale occurs when one party sells a business or real estate to another party and receives at least one payment in a different tax year.
Definition of Installment Sale
An installment sale happens when you sell a capital asset and the buyer pays you in installments. At least one payment must be received in the following tax year. An installment sale involves several rules and implications that you should be aware of if you are considering selling an asset and allowing installments. The tax benefits from the exclusion depend on your income and tax situation for the year you sell the asset. The use of an installment sale is worthwhile if spreading income from gains over several years reduces taxes enough to make a difference.
How does the Installment Sale work?
Taxable gains are spread over several years under the installment sale method. Gains are measured once (total net sales proceeds minus cost basis minus selling expenses) and expressed as a gross profit percentage. This percentage is applied to each payment when received.
Rules of Installment Sale
Installment sales require two factors: you agree to sell an asset to a buyer with payments made over time. The first payment must be received in any year after the tax year in which the sale occurred. This is reported as an installment sale on IRS Form 6252.
Example of an Installment Sale
Amir sells his business and can spread the tax impact over several years using the installment sale method. The sales contract states that the buyer will pay 30% of the sale price upfront, 40% in the first year, and the remaining 30% over the next two years. This allows Amir to report 30% of his capital gains in the first year, 40% in the second year, and 30% in the third and final year.
Is an Installment Plan Worth It?
Spreading income over several years can help manage your Adjusted Gross Income (AGI), which can be important for qualifying for certain deductions or tax credits. If you increase your income by reporting a large capital gain in one year, you might potentially:
- Push your ordinary income into a higher tax bracket
- Push capital gains income into a higher tax bracket
- Make more of your Social Security benefits taxable
- Reduce or eliminate deductions that phase out based on income, like student loan interest deduction and itemized deductions
- Reduce or eliminate the amount you can contribute to a Roth retirement account or Coverdell education savings account
- Reduce or eliminate tax credits that phase out based on income, like the high-income tax credit, Lifetime Learning Credit, or Child Tax Credit
- Trigger or increase the Net Investment Income Tax
- Trigger or increase the Alternative Minimum Tax
- Increase Part B premiums for Medicare beneficiaries with higher incomes
In contrast, spreading income over several years could potentially:
- Help keep your income within a desirable tax bracket
- Help keep capital gains income within the zero or 15% tax brackets
- Reduce the number of taxable Social Security benefits
- Help keep your income within the required range to fully benefit from the student loan interest deduction, or itemized deductions, or personal exemptions, or other deductions that are limited based on income
- Help keep your income within the required range to benefit from the high-income tax credit or other tax credits
- Avoid or reduce the impact of the Net Investment Income Tax
- Avoid
Frequently Asked Questions (FAQs)
What is Form 6252?
Form 6252 is used to report income from installment sales. You fill out information such as a description of the property, the acquisition date, the sale date, the selling price, and the profit percentage you made that year.
How do you report the sale of businesses on your tax return?
For tax reporting, each business asset is treated separately. Depending on the asset, it can be categorized as a capital asset, depreciable asset, or property sold to customers, like inventory. The gain or loss for each asset is calculated separately and reported accordingly.
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Sources
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Source: IRS. “Topic No. 705 Installment Sales.” Accessed Feb. 8, 2022.
Source: IRS. “Publication 537 (2019), Installment Sales.” Accessed Feb. 8, 2022.
Source: IRS. “IRS Provides Tax Inflation Adjustments for Tax Year 2021.” Accessed Feb. 8, 2022.
Source: IRS. “Topic No. 409 Capital Gains and Losses.” Accessed Feb. 8, 2022.
Source: IRS. “Form 6252: Installment Sale Income.” Accessed Feb. 8, 2022.
Source: https://www.thebalancemoney.com/installment-sales-3192872
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