What Is an Installment Sale?
An installment sale is one of several possible approaches to revenue recognition under the rules of Generally Accepted Accounting Principles (GAAP). More specifically, this method accounts for when revenue and expense are recognized at the time of cash collection rather than at the time of sale. Based on GAAP, this is the principal method of revenue recognition when the recognition occurs subsequently to a sale.
- An installment sale is a form of revenue recognition where revenue and expenses are recognized at the time of cash exchange.
- Installment sales require the buyer to make regular payments—i.e. installments.
- This method is useful for taxpayers looking to defer capital gains to future years.
- These types of sales are common with real estate.
How an Installment Sale Works
An installment method allows for the partial deferral of any capital gain to future taxation years. Installment sales require the buyer to make regular payments, or installments, on an annual basis, plus interest if installment payments are to be made in subsequent taxation years.
Benefits of an Installment Sale
An installment sale can help keep sellers keep their income within a desired tax bracket by spreading out their income. These sales can also keep capital gains in a lower tax bracket. Installment sales can also help individuals either lower or avoid higher Medicare Part B premium, net investment income taxes, or alternative minimum taxes.
These types of sales can also help prevent Social Security benefits from being taxed by keeping income lower. The benefits of not recognizing the entire sale can also help ensure an individual can still take the full amount of student loan interest deduction, itemize deductions, or take other deductions that are limited by income.
Requirements for an Installments Sale
Installment sales are useful for lowering capital gains taxes, where the income can be delayed until they are taxed at lower rates. However, there are two requirements for an installment sale. The first is that if an asset is sold and payments will be made over time that at least one payment be received a year after the tax year of the sale. The second is that the installment sale is recorded on Form 6252.
An installment sale cannot be used when the property or asset is sold at a loss or if the personal property or real property is sold by dealers. Installment sales cannot be used for inventory that is sold during the normal course of business. As well, the sale of stocks or other investment securities cannot be used for an installment sale.
Example of Installment Sale
Installment sales are common in the real estate market but are restricted to individual buyers and sellers. Dealers are prohibited from using the installment method of income reporting. Payers on installment sales with a deferred aggregate sales total above $5 million (for the individual sale of homes, over $150,000) will be required to include interest on the installment sales.
When it comes to selling real estate, an installment sale is best used for properties with no mortgages and when the seller is willing to finance the buyer’s purchase. This creates a steady stream of income over a number of years for the seller and allows the sale to be taxed over years and not immediately upon sale. An installment sale is also useful in the case of selling major business assets or businesses.