Introduction

An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. In an installment sale you report part of your gain when you receive each payment. You cannot use the installment method to report a loss.

The buyer's installment obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you.

Topics

This chapter discusses:

• The installment method
• Figuring installment income
• Payments received
• Installment sale of a farm

Useful Items

You may want to see:

Publication

• 523   Selling Your Home
• 535   Business Expenses
• 537   Installment Sales
• 538   Accounting Periods and Methods

Form (and Instructions)

• 4797   Sales of Business Property
• 6252   Installment Sale Income

See chapter 21 for information about getting publications and forms.

Installment Method

An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. A farmer who is not required to maintain an inventory can use the installment method to report gain from the sale of property used or produced in farming.

If you finance the buyer's purchase of your property, instead of having the buyer get a loan or mortgage from a third party, you probably have an installment sale. It is not an installment sale if the buyer borrows the money from a third party and then pays you the total selling price.

If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using that method. See Electing out, later, for information on recognizing the entire gain in the year of sale.

When reporting a sale of depreciable property, you must include any depreciation recapture income (up to the amount of the gain) in income for the year of sale. Report any remaining gain on the installment method.

Sale at a loss.   If your sale results in a loss, you cannot use the installment method. If the loss is on an installment sale of business assets, deduct it only in the tax year of sale. You cannot deduct a loss on the sale of property owned for personal use.

Form 6252.   Each year, including the year of sale, report your income from an installment sale on Form 6252. Attach this form to your tax return.

Disposition of installment obligation.   If you sell or discount an installment obligation, generally you will have a gain or loss to report. It is considered gain or loss on the sale of the property for which you received the installment obligation. If you sell or discount the obligation during the year of sale, report your entire gain on your return for that year. If the transaction takes place in a later year, you may have a disposition of an installment obligation.

Cancellation.   If an installment obligation is canceled or otherwise becomes unenforceable, it is treated as a disposition, not a sale or exchange. Your gain or loss is the difference between your basis in the obligation and its fair market value at the time you cancel it.

Transfer due to death.   The transfer of an installment obligation (other than to a buyer) as a result of the death of the seller is not a disposition. Any unreported gain from the installment obligation is not treated as gross income to the decedent. No income is reported on the decedent's return due to the transfer. Whoever receives the obligation as a result of the seller's death is taxed on the installment payments the same as the seller would have been had the seller lived to receive the payments.

However, if the installment obligation is canceled, becomes unenforceable, or is transferred to the buyer because of the death of the holder of the obligation, it is a disposition. The estate must figure gain or loss on the disposition.

More information.   For more information on the disposition of an installment obligation, see Publication 537.

Inventory.   The sale of farm inventory items cannot be reported on the installment method. All gain or loss on their sale must be reported in the year of sale, even if you receive payment in later years. However, if you are not required to maintain an inventory, you may be able to use the installment method to report the sale of property you use or produce in your farming business. For examples of farm inventory, see Farm Inventory in chapter 3.

If inventory items are included in an installment sale, you may have an agreement stating which payments are for inventory and which are for the other assets being sold. If you do not, each payment must be allocated between the inventory and the other assets sold.

Electing out.   If you elect not to use the installment method, you generally report the entire gain in the year of sale, even though you do not receive all the sale proceeds in that year. You then do not report any gain from the payments you receive in later years.

To make this election, report the sale on Schedule D (Form 1040) or Form 4797, whichever applies, not on Form 6252.

When to elect out.   Make this election by the due date, including extensions, for filing your tax return for the year the sale takes place. Once made, the election generally cannot be revoked. However, if you timely file your return for the year the sale takes place without making the election, you can still make the election by filing an amended return within 6 months of the due date of the return (excluding extensions). Write Filed pursuant to section 301.9100-2 at the top of the amended return and file it where the original return was filed.

More information.   See Electing Out of the Installment Method in Publication 537 for more information.

You must continue to report the interest income on payments you receive in subsequent years.

Figuring
Installment Income

Each payment on an installment sale usually consists of the following three parts.

1. Interest income.
2. Return of your adjusted basis in the property.
3. Gain on the sale.

In each year you receive a payment, include the interest part in income, as well as the part that is your gain on the sale. You do not include in income the part that is the return of your adjusted basis in the property.

Interest income.   You must report interest as ordinary income. Interest is generally not included in a down payment. However, you may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. See Unstated interest, later.

Return of basis and gain on sale.   The rest of each payment is treated as if it were made up of two parts. One part is a tax-free return of your adjusted basis. The other part is your gain.

Figuring gain part of payment. To figure what part of any payment is gain, multiply the payment (less interest) by the gross profit percentage, defined later. Use the following worksheet to figure the gross profit percentage.

Selling price.   The selling price is the total cost of the property to the buyer. It includes any money and the fair market value of any property you are to receive. It also includes any debt the buyer pays, assumes, or takes, to which the property is subject. The debt could be a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes owed on the property. If the buyer pays any of your selling expenses, that amount is also included in the selling price. The selling price does not include interest, whether stated or unstated.

Installment sale basis.   Three items comprise installment sale basis.

• Adjusted basis
• Selling expenses
• Depreciation recapture

Adjusted basis.   Basis is the amount of your investment in the property for tax purposes. The way you figure basis depends on how you first acquired the property. The basis of property you bought is generally its cost. The basis of property you inherited, received as a gift, built yourself, or received in a tax-free exchange is figured differently. See chapter 7 for information on determining basis.

While you own personal-use property, various events may change your original basis. Some events, such as adding rooms or making permanent improvements, increase basis. Others, such as deductible casualty losses or depreciation previously allowed or allowable, decrease basis. The result is adjusted basis.

Selling expenses.   Selling expenses are any expenses that relate to the sale of the property. They include commissions, attorney fees, and any other expenses paid on the sale. Selling expenses are added to the basis of the sold property.

Depreciation recapture.   If you took depreciation deductions on the asset, you may need to recapture part of the gain on the sale of the asset as ordinary income. See Sale of depreciable property, later.

Gross profit.   Gross profit is the total gain you report on the installment method.

To figure your gross profit, subtract your installment sale basis from the selling price. If the property you sold was your home, subtract from the gross profit any gain you can exclude. See Publication 523 for information on excluding gain on the sale of your home.

Contract price.   The contract price is the total of all principal payments you are to receive on the installment sale. It also includes payments you are considered to receive. See Payments Received, later.

If part of the selling price is paid in cash and you hold a mortgage payable from the buyer to you for the remainder, then the contract price includes both. The selling price is the total cost of the property to the buyer.

Gross profit percentage.   A certain percentage of each payment (after subtracting interest) is reported as gain from the sale. It is called the gross profit percentage and is figured by dividing your gross profit by the contract price.

The gross profit percentage generally remains the same for each payment you receive. However, see Selling price reduced, later, for an example of changing the gross profit percentage.

Example.   You sell property at a contract price of $200,000 and your gross profit is $50,000. Your gross profit percentage is 25% ($50,000 ÷ $200,000). After subtracting interest, you report 25% of each payment, including the down payment, as gain from the sale for the tax year you receive the payment.

Amount to include in income.   Each year as you receive payments on the installment sale, multiply the payments (after subtracting interest) by the gross profit percentage to determine the amount you must include in income for the tax year.

Sale of depreciable property.   You cannot use the installment method to report any depreciation recapture income up to the gain on the sale. However, report any gain greater than the recapture income on the installment method.

The recapture income reported in the year of sale is included in your installment sale basis to determine your gross profit on the installment sale.

You generally cannot report gain from the sale of depreciable property to a related person on the installment method. See Sale to a Related Person in Publication 537.

Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the depreciation recapture income in Part II of Form 4797 as ordinary income in the year of sale.

If you sell depreciable business property, prepare Form 4797 first in order to figure the amount to enter on line 12 of Part I, Form 6252. See the Form 6252 instructions for details.

For more information on the section 179 deduction, see Section 179 Deduction in chapter 8. For more information on the section 179A deductions, see chapter 12 in Publication 535. For more information on depreciation recapture, see Depreciation Recapture in chapter 11.

Selling price reduced.   If the selling price is reduced at a later date, the gross profit on the sale will also change. You must then refigure the gross profit percentage for the remaining payments. Refigure your gross profit using the reduced sale price and then subtract the gain already reported. Spread the remaining gain over the future installments.

Example.   In 2000, you sold land with a basis of $40,000 for $100,000. Your gross profit was $60,000. You received a $20,000 down payment and the buyer's note for $80,000. The note provides for four annual payments of $20,000 each, plus 12% interest, beginning in 2001. Your gross profit percentage is 60%. You reported a gain of $12,000 on each payment received in 2000 and 2001. In 2002, you and the buyer agreed to reduce the purchase price to $85,000 and the payments for 2002, 2003, and 2004 are reduced to $15,000 for each year.