Installment Sales: Definition, Tax Implications & Examples

Instructor: Lee Davis

Lee has a BA in Political Science; and my MA is in Political Science with a concentration in International Relations.

This lesson will cover what an installment sale is, the tax implications of this type of transaction, and how to record it on taxes. We will also go over some examples of installment sales and why an installment sale can be risky for a business.

Doing Business with Installment Sales

Imagine that you have decided to go into real estate and are selling properties and land. You have many potential buyers who want to buy a home or property from you. But, many of them would like to do an installment sale. How would you go about this? Would an installment sale be in your best interest, or should you wait for someone who can buy the home or property with all of the money up front?

What Are Installment Sales?

An installment sale is one that allows for a partial deferral of any capital gain to be accounted for in future tax years. The buyer must make regular payments on an annual basis plus interest. An example of this would be a car, house, or any purchase that is done on credit.

Installment sales are common in real estate but are restricted to individual sellers and buyers. One condition for real estate is that if the value of the purchase is over $150,000, the buyer is required to pay interest on the installment payments. Basically put, an installment sale is when revenue and expenses are recognized at the time of each payment, rather than at the time of sale.

The reason why an installment sales method is used is because the risk of not being able to collect is reasonably high. Therefore, the revenue is deferred over time and the tax is paid on each installment payment made. Therefore, a business does not have to pay a tax on the full amount of the product if only half of the installments have been paid for.

Risks and Alternatives to Installment Sales

An installment sale is a way to reduce the risk to a business. The ability to defer the tax is a way to help businesses should the buyer neglect to pay on the sale. There is still risk to the business, as it will have to use its resources and judgement to determine the creditworthiness of the customer and whether or not they will be responsible.

Consider the American housing crisis in 2007 and 2008 that lead to a severe recession. Too many people financed houses without sufficiently considering how they were going to afford those houses. As a result, many people lost their homes and banks lost the money that they had lent to the buyers of the homes.

An alternative to the installment sale is a method called the structured sale. A structured sale is intended to protect the seller from the risk that is connected to the buyer's creditworthiness. An example of this would be a first time homebuyer getting a government grant or government backed loan that would guarantee the bank its money should the buyer fail to pay the installments on time.

The IRS & Tax Implications of Installment Sales

Topic 705 of the Internal Revenue Service (IRS) states that an installment is when you will receive at least one payment after the tax year in which the sale occurs. You are required to report gain on an installment sale under the installment method unless you choose not to before the filing date of the tax return which the sale would be reported on.

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