Installment Sales: Defer Taxes, Attract Buyers

With escalating prices and the era of COVID-19, Installment sales may be a good way to attract buyers even if they don’t the ability to cover the full purchase price upfront.

In addition, installment sales can enable you to defer the tax on some or all of the gain on the sale of property or a business.

In general, if you receive payments from a buyer over time, you report the gain on the payments in the year you receive them, rather than reporting the entire gain in the year of the sale.

How Do Installment Sales Work?

Each time you receive a principal payment on the debt, a pro rata portion of the gain will be subject to tax. The installment sales method is used unless you elect out of it.

By using an installment sale, you, the seller, may benefit by:

• Partially deferring taxes while improving cash flow
• Keep income within a desired tax bracket (spreading out income over a longer time period)
• Restricting capital gains to a lower tax bracket
• Avoiding higher net investment income taxes or alternative minimum taxes
• Taking advantage of additional tax deductions that may only be available with lower income.

Exceptions that Impact Deferred Tax

Depreciation

The installment method is not available to the extent that the gain on the property sold is treated as the recapture of any depreciation that you have taken on real or personal property.

Thus, that portion of the gain is recognized at the time of the sale even if you do not receive any cash at that time.

Payment on Demand

For the gain to be deferred, the buyer’s debt cannot be payable on demand or readily tradeable on an established securities market.

In addition, the debt cannot be secured directly or indirectly by cash or a cash equivalent, such as a certificate of deposit or a treasury note.

However, the debt can be backed up by a third party guarantee or secured by a standby letter of credit.

Publicly Traded Property

The installment method cannot be used for sales of certain types of property, such as most sales of property by a dealer or sales of publicly traded property, such as stock or securities that are traded on an established securities market.

Thus, the installment method is not available to the extent the gain includes gain on your inventory or gain on publicly traded property.

When an installment sale is made—subject to certain exceptions such as a transfer to a spouse or a transfer at death—a transfer of the buyer’s debt will result in the recognition of the deferred gain.

The advantage of an installment sale is limited if you intend to transfer the note in the future.