In terms of federal income tax, an installment sale occurs when the payment of proceeds from a qualified sale is postponed until after the tax year in which the sale is made. This arrangement has advantages for buyers who are unable to immediately pay the full purchase price and also offers benefits for sellers, allowing them to spread the taxable gain over several years. Let’s delve deeper into the federal income tax considerations surrounding installment sales involving businesses, business ownership interests and other eligible assets.
Tax Basics for Sellers
In an installment sale, the seller takes a note receivable for deferred payments from the buyer. The seller then recognizes taxable gain as installment payments of note receivable principal amounts are received, in proportion to the principal payments.
To illustrate, consider this simple scenario: Mario sells his 50% share in ABC Co. to a third-party buyer. The sales price is $1 million, and Mario receives $250,000 at closing. The rest is payable in equal installment payments over the next three years. He would recognize 25% of the total taxable gain in each of the four years. So, the tax bill is spread over four years.
Usually, installment sale gains will qualify as low-taxed long-term capital gain or as Section 1231 gain for sales of property held for business purposes. Section 1231 gains are usually taxed at the lower long-term capital gain rates. The 3.8% net investment income tax (NIIT) and state income tax may apply, too.
If the installment note received by the seller doesn’t charge a high enough interest rate on the deferred principal payments, the complicated original issue discount (OID) rules can transform some of the payments from principal to interest. That’s unfavorable because interest income recognized by an individual taxpayer is taxed at higher ordinary income rates, which can currently be up to 37%. The 3.8% NIIT and state income tax may apply, too.
Ineligible Transactions
The following types of sales don’t qualify for installment sale treatment:
- Sales for a taxable loss,
- Sales of real estate by real estate dealers, subject to a few exceptions,
- Sales of inventory,
- Sales of personal property under a revolving credit plan,
- Sales of stock or securities that are publicly traded on established markets,
- Sales of depreciable property to a related party, as defined by the tax code, and
- Sales to a related party who disposes of the property within a two-year period.
An installment sale also doesn’t qualify for this favorable treatment when:
- The seller’s installment note receivable is secured directly or indirectly by cash or a cash equivalent, such as a U.S. Treasury note or certificate of deposit,
- The seller pledges the installment note receivable as security for debt principal or interest payments owed by the seller, or
- The seller enters into an agreement that allows the installment note to satisfy all or part of another debt owed by the seller.
Recognizing Installment Sale Gains
To calculate installment sale gains, you’ll need to determine the following:
- Contract price. This is the sale price reduced by qualifying debt, if any, that’s effectively assumed by the buyer. But you only need to include assumed debt to the extent it doesn’t exceed the seller’s tax basis in the property. If the assumed debt exceeds the seller’s tax basis, the excess is treated as a payment received by the seller in the year of the sale.
- Gross profit percentage. This equals the realized gain divided by the contract price. When you receive an installment note principal payment, your recognized gain equals the payment amount multiplied by the gross profit percentage. This gain will usually qualify as low-taxed long-term capital gain or Section 1231 gain.
Gain from Depreciation Recapture
The seller generally recognizes taxable gain from an installment sale only when installment note principal payments are received. However, you also may be required to recognize a gain from so-called Section 1245 and Section 1250 recapture. This is caused by certain depreciation deductions previously claimed for the property. This gain must be recognized in the year of sale, regardless of the amount of installment note principal payments received in that year.
Section 1245 and Section 1250 depreciation recapture amounts are treated as high-taxed ordinary income rather than lower-taxed long-term capital gain or Section 1231 gain. The 3.8% NIIT and state income tax may apply, too.
Electing Out of Installment Treatment
If you use the installment sale tax accounting method for an eligible sale, you run the risk that deferred taxable gains that will be recognized in future years may be taxed at higher rates. You can avoid that risk by electing out of the installment sale method and recognizing the entire taxable gain in the year of the sale. However, the cost of electing out is that you’ll probably have to pay tax on some gain before you’ve received installment note payments to cover the tax.
You may be able to shelter all or part of the prematurely recognized taxable gain from electing out of installment sale treatment if you have the following items:
- Current-year net capital losses,
- Capital loss carryovers,
- Suspended passive losses,
- A net operating loss (NOL), or
- Tax credits.
Electing out can also make sense if the gain that could be deferred with installment sale treatment is relatively small and would be taxed at an acceptable rate in the event it’s recognized in the year of the sale.
If you want to elect out of installment sale treatment, you must make the choice by the due date, including any extension, for filing your federal income tax return for the year of the sale. The election can be made transaction by transaction. That means you can elect out for one sale and use installment sale treatment for another sale that occurs in the same year. But you can’t revoke an election without IRS permission.
Sales by Nondealers
Under a special rule, sellers that aren’t dealers in the type of property that’s being sold may be required to pay interest on the deferred tax liability that’s attributable to installment sale treatment.
For the special interest charge rule to apply, the seller’s year-end balance of installment notes receivable from sales of more than $150,000 in the applicable tax year (affected installment notes) must exceed $5 million. Interest is calculated and owed to the IRS on the deemed amount of deferred tax liability from affected installment notes for each succeeding year until all affected installment notes that arose from sales in the applicable tax year are collected.
The interest charge equals the rate on federal tax underpayments in effect for the last month of the seller’s tax year. For December 2023, the rate was 8%. If the seller uses the calendar year for tax purposes, that 8% rate will apply to the deemed deferred tax liability from affected installment notes from 2023 sales. The 8% rate continues to apply in future years until the affected installment notes from 2023 sales are collected.
For individual taxpayers, the interest charge is considered nondeductible personal interest. So, an individual seller must include in his or her taxable income the interest income paid by the buyer on affected installment notes. Also, the seller can’t deduct the interest paid to the IRS on the deemed deferred tax liability from affected installment notes. Interest income recognized by an individual taxpayer is taxed at higher ordinary income rates, which can currently be up to 37%. The 3.8% net investment income tax and state income tax may apply, too.
The nondealer interest charge rule is complicated. If it applies to your sale, a tax professional can often help you minimize or avoid it with proper planning.
Partner with a Tax Expert Who Specializes in Transactions
Clear as mud? There are many factors to consider and one wrong move could be costly. By partnering with a transactional tax expert at CSH, we can handle all the legwork to ensure you are making the best decisions for your situation. When you leverage our expertise you can rest assured that your transaction will be as beneficial as possible.
