Installment sale

What Is Installment Sale?

An installment sale is a financial transaction in which a seller receives at least one payment for the sale of property after the tax year in which the sale occurs. This method falls under the broader category of consumer finance and allows for the deferral of income tax on any gain realized from the sale. Rather than recognizing the entire gain in the year of sale, the seller can spread out the reporting of the gain over the period payments are received, which can offer significant tax advantages by managing their tax liability.

This type of arrangement is common for large-ticket items or properties, such as real estate, business assets, or other valuable personal property. The core principle of an installment sale is that the seller finances the buyer's purchase, with the buyer making periodic payments over an agreed-upon term, often including interest income. The Internal Revenue Service (IRS) provides specific guidelines for reporting these sales, primarily through Publication 537.

History and Origin

The concept of buying on credit, which forms the basis of the installment sale, has roots stretching back to colonial times, where retailers often extended "open-book credit" to customers. However, the formalization and widespread adoption of installment selling began in the 19th century. One of the earliest prominent examples was the Singer Sewing Machine Company, which in the mid-1800s started selling its products on an installment plan, making expensive items more accessible to a broader consumer base. After the Civil War, manufacturers of goods such as pianos, organs, and encyclopedias quickly adopted similar plans to expand their markets.²²

The early 20th century, particularly the 1920s, saw a significant surge in installment buying, largely driven by the burgeoning automobile industry. Automakers and finance companies began offering installment plans for cars, allowing consumers to acquire vehicles with a small down payment and subsequent monthly payments.²¹,²⁰ This innovation dramatically transformed consumer access to durable goods. During World War II, the U.S. government, through the Federal Reserve, even implemented controls on installment credit to manage consumer demand and curb inflation, demonstrating its economic significance.¹⁹,¹⁸ This historical evolution highlights how the installment sale has adapted to economic conditions and consumer needs over time, making large purchases more attainable.

Key Takeaways

• An installment sale allows a seller to receive payments for property over multiple tax years.
• It permits the deferral of capital gains and associated income tax.
• The gain from an installment sale is reported proportionally as payments are received.
• Specific IRS rules and regulations govern the proper reporting of installment sales.
• This method is commonly used for selling real estate, businesses, or other high-value assets.

Formula and Calculation

The core of calculating the taxable income from an installment sale involves determining the "gross profit percentage." This percentage is then applied to each payment received (excluding interest) to calculate the portion of that payment that represents taxable gain.

The formula for the gross profit percentage is:

Where:

• Gross Profit is the selling price minus the adjusted basis and selling expenses.
• Contract Price is the total selling price minus any debt assumed by the buyer that exceeds the seller's adjusted basis in the property.

To calculate the installment sale income for a given year:

This calculation allows for the proportional revenue recognition of the gain over the payment period, effectively deferring the tax consequence.¹⁷

Interpreting the Installment Sale

Interpreting an installment sale involves understanding its implications for both the seller and the buyer. For the seller, the primary benefit is the ability to defer income tax on the gain. Instead of paying taxes on the entire profit in the year of sale, which could push them into a higher tax bracket, they recognize the gain over time, potentially smoothing out their income for tax purposes. This can be a key component of effective financial planning.

For the buyer, an installment sale can provide a flexible financing option, especially if traditional lending is difficult to obtain or undesirable. It effectively transforms the seller into a lender, allowing the buyer to make payments over time directly to the seller. However, buyers should be aware of the terms, including any interest charged and the consequences of default. From an accounting perspective, the seller records a receivable on their balance sheet representing the future payments. The portion of each payment that is a return of basis is tax-free, while the portion representing gross profit is taxable.¹⁶

Hypothetical Example

Consider Sarah, who sold a piece of investment land in 2024 for $200,000. Her adjusted basis in the land was $80,000, and she incurred $5,000 in selling expenses. The buyer made a $50,000 down payment in 2024 and agreed to pay the remaining $150,000 in three annual installments of $50,000 each, plus 5% interest, starting in 2025.

1. Calculate Gross Profit:
   Selling Price: $200,000
   Adjusted Basis: $80,000
   Selling Expenses: $5,000
   Gross Profit = $200,000 - $80,000 - $5,000 = $115,000

2. Calculate Contract Price: In this case, there's no debt assumed by the buyer that exceeds the basis, so the contract price is the selling price.
   Contract Price = $200,000

3. Calculate Gross Profit Percentage:
   Gross Profit Percentage = $\frac{$115,000}{$200,000} = 0.575 \text{ or } 57.5% $

4. Calculate Installment Sale Income for 2024:
   Payment Received (Down Payment): $50,000
   Installment Sale Income = $50,000 \times 0.575 = $28,750$
   Sarah reports $28,750 as gain in 2024. The remaining $21,250 is a tax-free return of her basis.

5. Calculate Installment Sale Income for 2025 (and subsequent years, excluding interest):
   Annual Payment (Principal): $50,000
   Installment Sale Income = $50,000 \times 0.575 = $28,750$
   Sarah will report $28,750 as gain for each of the next three years, in addition to any deferred income from interest payments.

Practical Applications

Installment sales are widely applied in several financial contexts. They are frequently used in the sale of real estate, especially when the seller wishes to provide financing to the buyer, often due to the buyer's inability to secure traditional mortgage financing or to simplify the transaction. This method allows for greater flexibility in terms and conditions compared to conventional lending.¹⁵

Beyond real estate, installment sales can be employed for the disposition of significant asset disposition, such as a privately held business or large equipment. For business owners, it can facilitate the transfer of ownership by structuring payments over time, making the acquisition more affordable for the buyer and potentially providing the seller with a steady stream of income. The rise of "Buy Now, Pay Later" (BNPL) services in e-commerce represents a modern iteration of installment financing, allowing consumers to split purchases into smaller, interest-free payments. The Consumer Financial Protection Bureau (CFPB) has been actively monitoring the rapid growth of this industry, noting that the number of BNPL loans in the U.S. market grew by 970% between 2019 and 2021.¹⁴,¹³ These contemporary applications demonstrate the continued relevance of installment-based financing in facilitating transactions. Regulatory bodies like the Federal Trade Commission (FTC) also provide guidance on consumer protection related to various forms of credit and loans, including those structured as installment plans.¹²

Limitations and Criticisms

While installment sales offer significant advantages, they also come with limitations and potential criticisms. For the seller, the main drawback is the ongoing credit risk associated with the buyer. If the buyer defaults on payments, the seller may face legal costs and the complexities of repossessing the property, which can be a lengthy and expensive process. Furthermore, the seller must manage the deferred payments and potential changes in tax laws over the years the payments are received. The installment method cannot be used to report losses.¹¹

From a broader economic perspective, excessive reliance on installment credit without proper underwriting can lead to consumer overextension and contribute to financial instability. Historically, high default rates associated with installment buying in the 1920s are sometimes cited as a contributing factor to the Great Depression.¹⁰ In the modern context, while "Buy Now, Pay Later" (BNPL) schemes offer convenience, concerns have been raised by the CFPB regarding unclear disclosures, difficulty in dispute resolution, potential for "loan stacking" (where borrowers take out multiple loans quickly from different lenders), and the lack of comprehensive reporting to major credit bureaus, creating a "shadow debit" issue.⁹,⁸ These criticisms underscore the importance of clear terms, responsible lending, and robust consumer protections within installment sale arrangements. The CFPB has noted that installment loans are the most cited type of personal lending in consumer complaints.⁷

Installment Sale vs. Revolving Credit

An installment sale differs fundamentally from revolving credit in how credit is extended and repaid.

The key distinction lies in the nature of the credit. An installment sale is a closed-end transaction with a defined end, where the full amount is disbursed upfront and repaid in fixed installments. Revolving credit, conversely, is an open-ended arrangement, providing continuous access to funds that can be borrowed, repaid, and re-borrowed as needed.

FAQs

What types of property qualify for an installment sale?

Generally, most types of property that result in a gain when sold can qualify, including real estate, personal property, and business assets. However, certain assets, like inventory or stock traded on an established securities market, typically do not qualify.⁶,⁵

Do I have to use the installment method if my sale qualifies?

No, using the installment method is generally an election you can make. You can choose to report all of your gain in the year of the sale if you prefer, even if the sale qualifies as an installment sale.⁴,³

What happens if the buyer defaults on an installment sale?

If a buyer defaults, the seller may have the right to repossess the property, depending on the terms of the sale agreement. There are specific IRS rules regarding repossessions and how to account for any gain or loss in such situations.²

Is interest charged on an installment sale?

Yes, typically interest is charged on the outstanding balance of an installment sale, similar to other loans. This interest income is taxable to the seller as it is received. The IRS has rules regarding imputed interest if the stated interest rate is too low.¹

How does an installment sale affect my credit?

For the buyer, making timely payments on an installment sale can positively impact their credit report, especially if the seller reports payment activity to credit bureaus. For the seller, it primarily affects their income and cash flow over time rather than directly impacting their credit score in the same way.