Installment Sales Method

Installment Sales Method

Installment Sale Method

The installment sale method is an alternative to the cash method vs accrual method debate of accounting. The installment sale method allows the taxpayer to defer the inclusion of income until the payments is made in cash or a cash equivalent.

An installment sale occurs when the buyer pays the purchase price in installments rather than one single payment. The seller must include the gain realized from the sale in the entire purchase price. In the case of installment sales, the seller has not received all of the gain from the sale due. A harsh result would occur if sellers were required to include all of the gain upfront on amounts not yet received. [Section 453] of the United States Tax Code allows the seller to instead recognize the gain from the sale over the time period the payments will be received.

Under this method, the taxpayer will recognize gain equal to the amount of payments received during the taxable year multiplied by the ratio of the profit to the total contract price. The contract price does not include indebtedness assumed by the buyer on behalf of the seller.

Calculating the Installment Sale Method

First it is necessary to determine the seller’s adjusted basis in the property. This includes the seller’s basis in the property and the cost of selling the property, so long as the seller does not sell property as a trade or business. [Treas. Reg. §15A.453-1(b)(2)(v)] . The seller’s adjusted basis is then subtracted from the sale price of the property, which results in the seller’s gross profit.

The next step is to determine the contract price. This is done by subtracting any qualified indebtedness from the sale price. Indebtedness is any debt assumed by or taken subject to by the buyer that does not exceed the seller’s adjusted basis. Qualified indebtedness is debt secured by the property and any other debt incurred in the acquisition or operation of the property. [Treas. Reg. §15A.453-1(b)(2)(iv)] .

The next step is to determine the gross profit percentage. This is done by dividing the gross profit by the contract price. Finally, the resulting percentage is applied to all of the payments the taxpayer receives during the year. In the first year, it is important to remember that any debt that did not qualify as qualified indebtedness must be treated as a payment, as well as any qualified indebtedness that exceeded the taxpayer’s adjusted basis in the property. The amount that results from the final calculation is the amount that must be recognized as gain in the tax year. It will be treated as long term capital gain.

Comparison to the Cash and Accrual Methods

Cash Method – The cash method requires that an amount be included in gross income when it is actually or constructively received. The installment method allows greater deferral when the payment is received in the form of a negotiable note. The cash method does not allow for differing between cost recovery and gain.

Accrual Method – The accrual method requires income to be recognized as soon as the taxpayer has a right to the income regardless of when the payment is actually received. This means that the taxpayer would have to recognize the full amount of the sale despite the fact that the purchase price may not be paid in full for years.

References

1. Section 453 of U.S. Tax Code
2. Treas. Reg. §15A.453-1(b)(2)(v) of U.S. Tax Code
3. Treas. Reg. §15A.453-1(b)(2)(iv)

ee also

Tax

Cash Method v. Accrual Method

Doctrine of Cash Equivalence

Accounting methods

Installment sale (USA)

Revenue recognition

Tax accounting


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