When you sell an asset on installment, you may be able to avoid paying tax in the year of sale and instead pay tax on your gain as you receive payments over future years. Under the tax law, an installment sale is any sale of property where at least one payment is received after the tax year in which the sale occurs.
Each payment is allocated between a tax-free return-of-cost, taxable gain, and interest. The allocation between return-of-cost and gain is based on a gross profit percentage calculated as the gain divided by the contract price multiplied by the principal payments. Interest accrues normally on the unpaid balance.
Things to be mindful of:
- Depreciation recapture: When property is sold at a gain, the gain will usually be taxed at capital gain rates. However, when depreciable property is sold at a gain, part of that gain will be recharacterized as ordinary income (and taxed at higher rates) to the extent of prior depreciation. Any depreciation recapture income must be included in income in the year of sale (i.e., it cannot be deferred into future years as payments are received).
- Section 1250 gain: Section 1250 gain applies to certain depreciation recapture on real estate. It is taxed at a 25% capital gain rate. If the installment sale gain includes both 25% and 15% capital gain, all 25% capital gain is recognized before any 15% capital gain is recognized
- Sales of property between a taxpayer and a business they control cannot qualify for installment sale treatment if the property is depreciable by the purchaser. The IRS is concerned that the seller recognizes capital gain over a number of years, but the business they control takes an immediate depreciation deduction for the cost of the property.
- Deferred gain on installment sales between related parties must be recognized immediately if the property is resold within 2 years of the sale between related parties.
Also, keep in mind that when the total balance of certain installment receivables exceed $5 million, the IRS requires interest to be paid on deferred gains. If you have any questions regarding installment sales, please do not hesitate to contact us .