Definition
The Gross Profit Ratio in an installment sale is the fraction calculated by dividing the gross profit (gain) from the sale by the contract price. This ratio is then applied to periodic receipts from the buyer to determine the taxable gain for each payment received.
Calculation
\[ \text{Gross Profit Ratio} = \frac{\text{Gross Profit}}{\text{Contract Price}} \]
Example
Consider Collins, who sells a piece of land held as a capital asset.
- Sale Price (Contract Price): $10,000
- Tax Basis: $4,000
- Gross Profit: $10,000 - $4,000 = $6,000
- Gross Profit Ratio: $\frac{$6,000}{$10,000 }= 60%$
Collins accepts a $1,000 cash down payment with the remaining $9,000 to be paid over three years. Using the 60% gross profit ratio, of each principal payment received, 60% is considered taxable gain, and the remaining 40% is a nontaxable return of capital.
Frequently Asked Questions
1. What is the Gross Profit Ratio used for in real estate transactions?
The Gross Profit Ratio is primarily used in installment sales to allocate taxable gain over the payment period, allowing sellers to spread their tax liability over several years rather than recognizing all the gain in the year of the sale.
2. How does the Gross Profit Ratio benefit real estate investors?
It enables investors to defer a portion of their taxable gain, improving cash flow management by not requiring taxpayers to pay the entire capital gains tax in a single year.
3. Can the Gross Profit Ratio change over the course of an installment sale?
No, once calculated, the ratio remains constant for the life of the installment agreement. It continuously applies the same proportion of taxable gain to each installment payment.
4. Is the Gross Profit Ratio applicable to all types of property sales?
The Gross Profit Ratio is typically applied in sales of capital assets through installment sales; however, it may not be applicable to properties that do not qualify for installment sale treatment under tax laws.
Related Terms
Installment Sale
A method of sale where the buyer makes periodic payments to the seller over time. Each payment may consist of part principal and part interest, and the seller may defer recognition of part of the gain until payment is received.
Contract Price
The total selling price agreed upon between the buyer and seller, which can include cash, property, and liabilities assumed by the buyer.
Capital Asset
A significant piece of property, such as real estate or equipment, owned by a person or entity. For tax purposes, the IRS defines capital assets and their related gains and losses differently from ordinary income.
Down Payment
An initial payment made by the buyer, usually a percentage of the total purchase price, at the time of sale. It reduces the loan amount and establishes an immediate financial stake by the buyer.
Return of Capital
A nontaxable distribution to shareholders that represents a return of their investment or equity in a property, which reduces their basis in the investment.
Online Resources
- IRS Topic No. 705 - Installment Sales
- Investopedia - Gross Profit Ratio
- IRS Form 6252 - Installment Sale Income
References
- Internal Revenue Service. “Topic No. 705 Installment Sales.” IRS.
- U.S. Congress. Internal Revenue Code Section 453 (f)(1)(B)- Installment Method Applicable to Sales by Dealer of Personal Property.
Suggested Books for Further Study
- “Tax Implications of Installment Sales” by Henry Y. Shelton.
- “Real Estate Accounting and Taxation” by Stephan K. Kitzis.
- “The Ernst & Young Tax Guide” by Ernst & Young LLP.
Real Estate Basics: Gross Profit Ratio Fundamentals Quiz
