Publication 537
Installment Sales

For use in preparing 2002 Returns

Important Reminders

Accrual basis taxpayers.   For sales occurring after December 16, 1999, accrual basis taxpayers were required to report installment sales under the accrual method of accounting. The Installment Tax Correction Act of December 28, 2000, repealed that requirement.

If you entered into an installment sale after December 16, 1999, and filed an income tax return by April 16, 2001, reporting the sale on an accrual method, you have IRS approval to revoke your effective election out of the installment method. (See Electing Out of the Installment Method).

To revoke the election, you must file an amended return for the year of the installment sale (and any other year affected by the sale), reporting the gain on the installment method. (See Figuring Installment Income and Reporting Installment Income). You generally have three years from the due date of the original return to file an amended return.

Photographs of missing children.   The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child.

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.

This publication discusses the general rules that apply to all installment sales. It also discusses more complex rules that apply only when certain conditions exist or certain types of property are sold. There are two examples of reporting installment sales on Form 6252 at the end of the publication.

If you sell your home or other nonbusiness property under an installment plan, you will need to read only the General Rules. If you sell business or rental property or have a like-kind exchange or other complex situation, see the appropriate discussion under Other Rules, later.

If you sell your entire interest in a passive activity, special rules apply to the treatment of passive activity losses. See Publication 925 for information on this topic.

Comments and suggestions.   We welcome your comments about this publication and your suggestions for future editions.

You can e-mail us while visiting our web site at www.irs.gov.

You can write to us at the following address:

Internal Revenue Service
Tax Forms and Publications
W:CAR:MP:FP
1111 Constitution Ave. NW
Washington, DC 20224

We respond to many letters by telephone. Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence.

Useful Items

You may want to see:

Publication

• 523   Selling Your Home
• 538   Accounting Periods and Methods
• 541   Partnerships
• 544   Sales and Other Dispositions of Assets
• 550   Investment Income and Expenses
• 551   Basis of Assets
• 925   Passive Activity and At-Risk Rules

Form (and Instructions)

• 4797   Sales of Business Property
• 6252   Installment Sale Income

See How To Get Tax Help near the end of this publication for information about getting publications and forms.

What Is an
Installment Sale?

An installment sale is a sale of property where you receive at least one payment after the tax year of the sale. The installment sale rules do not apply to the regular sale of inventory. See Sale of a Business under Other Rules, later.

If you finance the 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.

General Rules

If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method.

See Electing Out of the Installment Method under Other Rules, later, for information on recognizing the entire gain in the year of sale.

Installment obligation.   The buyer's 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.

Stock or securities.   You cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. You must report the entire gain on the sale in the year in which the trade date falls.

Dealer sales.   Sales of personal property by a person who regularly sells or otherwise disposes of the same type of property on the installment plan cannot be reported under the installment method. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming.

Special rule.   Dealers of time-shares and residential lots can report certain sales on the installment method if they elect to pay a special interest charge. For more information, see section 453(l) of the Internal Revenue Code.

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, you can deduct it only in the tax year of sale. You cannot deduct a loss on the sale of property owned for personal use.

Unstated interest.   If your sale calls for payments in a later year and the sales contract provides for little or no interest, you may have to figure unstated interest, even if you have a loss. See Unstated Interest and Original Issue Discount, later.

Figuring Installment Income

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

• Interest income.
• Return of your adjusted basis in the property.
• Gain on the sale.

In each year you receive a payment, you must 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 basis in the property. Basis is the amount of your investment in the property for tax purposes.

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 and Original Issue Discount, 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 in the property. 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. 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. Fair market value (FMV) is discussed later. 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 you owe 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 acquire the property. The basis of property you buy is generally its cost. The basis of property you inherit, receive as a gift, build yourself, or receive in a tax-free exchange is figured differently.

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.

For more information on how to figure basis and adjusted basis, see Publication 551.

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 as ordinary income. See Depreciation Recapture Income, 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 Sale of your home, later, under Reporting Installment Income.

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.

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 from the sale by the contract price.

The gross profit percentage generally remains the same for each payment you receive. However, see the example under Selling price reduced, later, for a situation where the gross profit percentage changes.

Example.   You sell property at a contract price of $2,000 and your gross profit is $500. Your gross profit percentage is 25% ($500 ÷ $2,000). 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 (less interest) by the gross profit percentage to determine the amount you must include in income for the tax year. In certain circumstances, you may be considered to have received a payment, even though you received nothing directly. A receipt of property or the assumption of a mortgage on the property sold may be considered a payment. For a detailed discussion, see Payments Received, later.

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.