Understanding installment sales and how to report them on a federal tax return

Installment sales offer taxpayers a practical way to report gains from the sale of certain property over time, aligning tax payments with the receipt of income. If your clients are selling real estate or business assets, understanding the rules outlined in IRS Publication 537 is essential to correctly reporting their income on their tax return.

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. This payment structure defers a portion of the taxable gain to future years, matching tax liability with the receipt of actual payments.

Installment sales are often used to sell real estate, closely held businesses or other high-value assets, especially when the buyer cannot pay the full purchase price upfront. The installment method spreads out the taxable gain over the period during which payments are received rather than recognizing the entire gain in the year of sale.

What qualifies and what doesn’t?

Not all sales qualify for installment reporting. Sales of inventory or dealer property, such as items held for sale in the ordinary course of business, are not eligible for sale. Similarly, if the property sold is publicly traded or the seller chooses not to use the installment method, the rules do not apply.

Additionally, depreciation recapture under §§1245 and 1250 must be reported as ordinary income in the year of sale, even if payments are made in later years. This rule applies to the portion of the gain attributed to depreciation previously claimed, and it cannot be deferred under the installment method.

Key terms to understand

Before diving into the mechanics of reporting, it’s essential to understand some terms:

• Selling price: Total amount the buyer agrees to pay, including any liabilities assumed
• Gross profit: Selling price minus the adjusted basis and selling expenses
• Contract price: Selling price, minus any qualifying indebtedness assumed by the buyer that doesn’t exceed the seller’s basis
• Gross profit percentage: Gross profit divided by contract price. This determines how much of each payment is taxable

How to report an installment sale

Installment sales are reported using Form 6252, Installment Sale Income, which must be filed for each year you receive a payment. The form calculates the gain to report based on the gross profit percentage.

Step-by-step:

1. Complete Form 6252:

• Part I asks for general information about the sale, including the property description, date of sale and buyer information
• Part II calculates the gross profit, contract price and gross profit percentage
• Part III computes the gain to be reported for the current year based on the payments received

2. Transfer to Schedule D or Form 4797:

• For personal or investment property, report the gain from Form 6252 on Schedule D (Form 1040)
• If the asset was used in trade or business, the gain is reported on Form 4797

3. Include interest income:

• Interest on installment obligations is not part of the gain; it must be reported separately as interest income on Schedule B (Form 1040) for individual taxpayers. Corporations and other entities will report interest on their respective business tax returns.
• If the contract doesn’t specify interest, the tax professional may need to impute interest under the original issue discount (OID) rules

4. Report in each year a payment is received:

• Every year a payment is received, the taxpayer must report that year’s portion of the gain using the gross profit percentage
• Keep copies of Form 6252 and the amortization schedule to track remaining basis and gain

Electing out of the installment method

Taxpayers may elect not to use the installment method. To do this, they must report the entire gain in the year of sale, even if payments are received in later years. This election is made by reporting the full gain on a timely filed return, without using Form 6252. The taxpayer might choose to elect out if they expect to be in a higher tax bracket in future years or if they want to avoid the complexity of tracking installment payments.

Special situations

• Contingent payment sales: Special rules apply if the number of future payments depends on uncertain factors. In rare cases, you may need to estimate the total contract price or use the open transaction method
• Related party sales: If the taxpayer sells property to a related party and disposes of it within two years, the taxpayer may have to recognize all the remaining gain
• Repossession: If the buyer defaults and the taxpayer/seller repossesses the property, Publication 537 provides guidance on how to compute the gain or loss from repossession and the basis of the reacquired property

Installment sales offer significant tax deferral benefits when structured and reported correctly. By understanding how to calculate and report gains, and when the installment method applies, you can help your clients reduce their audit risk and ensure compliance. When in doubt, refer to Publication 537.