Tax on Installment Sale

 How is Tax Calculated on Installment Sale


An installment sale is a sale of property where you receive at least one payment after the tax year in which the sale occurs.

When you receive payment in installment for sale of asset, you're required to report gain on an installment sale under the installment method unless you elect out from it on filing the return or before the due date for filing your tax return (including extensions) for the year of the sale. You can recognize full gain in the year of sale even if it is an installment sale on Form 4797, Sales of Business Property, or on Schedule D (Form 1040), Capital Gains and Losses and Form 8949, Sales and Other Dispositions of Capital Assets.

It is worthwhile to remember that installment sale method is not available for property sold on loss. Likewise, you cannot use the installment method to report gain from the sale of inventory or stocks and securities traded on an established securities market.

Even it is installment sale, you must report any portion of the gain from the sale of depreciable assets that's ordinary income under the depreciation recapture rules in the year of the sale.

Example

Asset Cost: $10,000

Depreciation taken: $8,000

Sold for: $3000

Installment: $1000 for 3 years

Total gain on sale = 3,000-2,000 = $1,000

Installment sale = 0

The basis of the asset sold was $2,000 ($10,000 - $8,000). Hence gain of $1,000 is recaptured depreciation and taxes as ordinary income and should be taxed in the year of sale. Therefore there is no gains in future years.

However, the capital gain portion can be recognized on installment basis. 

Let’s take an example of an asset without depreciation.

Land cost: $10,000

Sold for $17,500

Capital Gain:  $7,500

Below are the installment payments

Down Payment: $5,000                      Gain recognized = 7500x (5000/17500) =  $2,143

1st Installment:  $5,000                       Gain recognized = 7500x (5000/17500) =  $2,143

2nd Installment: $5,000                        Gain recognized = 7500x (5000/17500) =  $2,143

3rd Installment” $2,500                       Gain recognized = 7500x (5000/17500) =  $1,071

Total                 $17,500                                                                                           $7,500         

Interest will be taxed in the year it is charged/received as ordinary income as any other income you received. If the installment sales contract doesn't provide for adequate stated interest, part of the stated principal may be re-characterized as unstated interest or original issue discount for tax purposes, even if you have a loss. You must use the applicable federal rate (AFR) to figure the amount of stated principal re-characterized as unstated interest or original issue discount. (Index of Applicable Federal Rates (AFR) Rulings.)

 Please refer to IRS Publication 537 for more detail on Installment Sale

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