An installment sale is a method of selling property where the seller finances the buyer by accepting payments over a period of time. Under U.S. tax law, the capital gains tax is paid only as payments are received, which can help spread the tax liability for the seller.
Example of an Installment Sale
To illustrate, consider the following scenario:
Example
Collins sells a piece of land for $100,000, which she originally bought three years ago for $40,000. The total gain from the sale is $60,000. The sale terms include:
- A 10% cash down payment ($10,000)
- A 90% purchase money mortgage ($90,000)
Using the installment sale method:
- In the year of the sale, Collins reports 10% of the gain ($6,000) because of the received down payment.
- The remaining $54,000 gain will be reported over the years as she receives payments on the mortgage principal.
Collaborating this example, here’s a breakdown per payment:
- Year 1: $10,000 down payment = $6,000 reportable gain
- Subsequent Years: Gain reported as principal payments are made on the $90,000 mortgage
Frequently Asked Questions (FAQ)
What is an installment sale?
An installment sale is an arrangement where the seller allows the buyer to make payments over time. The seller pays taxes on the gain of the sale as each payment is received.
What are the benefits of an installment sale?
The primary benefit is the deferral of capital gains tax, allowing the seller to spread tax liabilities over several years, which may also place them in a lower tax bracket.
Can any property be sold using an installment sale?
Not all properties qualify for installment sale treatment. Specifically, dealer sales, sales of inventory, and stocks or securities do not qualify.
Are there risks associated with installment sales?
Yes, main risks include the potential for the buyer to default on payments, resulting in financial loss and complicating the seller’s tax reporting.
How does an installment sale affect the seller’s tax return?
Sellers must fill out IRS Form 6252 to report income from an installment sale each year they receive payments.
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Contract Price: The total selling price of the property agreed upon by the seller and buyer, including any liabilities assumed by the buyer.
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Gross Profit Ratio: The ratio of gross profit from the sale to the contract price, which helps determine the portion of each payment considered taxable gain.
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Imputed Interest: Interest that the IRS assumes should have been charged on certain installment sales even if no interest, or low interest, is charged.
Online Resources
References
Suggested Books for Further Studies
- “The Tax Guide for Real Estate Investors” by Steven Cohen
- “Real Estate Tax Strategies” by Julian Block
- “Real Estate Investment and Taxation” by David Windish
Real Estate Basics: Installment Sale Fundamentals Quiz
### What is an installment sale?
- [x] A sale where the seller accepts payments over time.
- [ ] A one-time cash transaction for the sale of property.
- [ ] Any sale involving real estate.
- [ ] A process where the buyer pays the seller in a lump-sum payment.
> **Explanation:** An installment sale is a sale method where the seller receives payments over time, allowing for tax liabilities to be spread over those years.
### How is the taxable gain calculated for an installment sale?
- [ ] All at the point of sale.
- [ ] Annually in equal amounts.
- [x] As each installment payment is received.
- [ ] Only upon the initial down payment.
> **Explanation:** The taxable gain on an installment sale is calculated as each installment payment is received, spreading the tax burden over the term of the payment schedule.
### Which IRS form is used to report installment sale income?
- [ ] Form 1099
- [ ] Form 8829
- [x] Form 6252
- [ ] Form 1040
> **Explanation:** IRS Form 6252 is specifically designed for reporting installment sale income.
### What portion of the payment typically represents gain in an installment sale?
- [ ] None until the final payment is made.
- [x] A portion based on the gross profit ratio.
- [ ] The entire payment amount.
- [ ] Only the interest portion of the payment.
> **Explanation:** A portion based on the gross profit ratio (gross profit divided by the contract price) is considered gain and taxed accordingly.
### Which of the following properties is NOT eligible for installment sale treatment?
- [x] Stocks or securities
- [ ] Residential real estate
- [ ] Commercial property
- [ ] Farmland
> **Explanation:** Stocks or securities, along with inventory items, are not eligible for installment sale treatment according to IRS rules.
### What risk is commonly associated with installment sales?
- [ ] Rapid overvaluation of the property
- [ ] Inadequate down payments
- [x] Default by the buyer
- [ ] Excessive property taxes
> **Explanation:** A notable risk in installment sales is the potential default by the buyer, which may result in the seller incurring financial losses.
### If an installment sale involves imputed interest, what does that mean?
- [ ] The property has been rented out previously.
- [ ] There is an application for a mortgage.
- [x] The IRS assumes interest should be charged even if none is stated.
- [ ] The total sale price includes home improvement costs.
> **Explanation:** Imputed interest is the interest that the IRS assumes should be charged on the sale, affecting how payments are treated for tax purposes even if no explicit interest is stated in the agreement.
### What determines the gain or loss on an installment sale?
- [ ] Local property taxes
- [x] The difference between sale price and original cost basis
- [ ] The down payment size
- [ ] Closing fees and commissions
> **Explanation:** The gain or loss is calculated as the difference between the sale price and the property’s original cost basis, including any depreciation claimed.
### What is usually required for an installment sale to be reported to the IRS?
- [ ] Property appraisal
- [ ] Title company documentation
- [x] Completion of IRS Form 6252
- [ ] Realtor’s certification
> **Explanation:** IRS Form 6252 is required to be completed and submitted as part of the reporting process for an installment sale.
### In terms of tax planning, why might a seller opt for an installment sale?
- [ ] To sell the property faster
- [ ] To receive a larger lump sum from the buyer
- [x] To spread out and possibly reduce overall tax liability
- [ ] Increase the property's market value
> **Explanation:** Sellers might choose an installment sale to spread out capital gains tax liabilities over several years, potentially reducing their overall tax burden.
