How to File Taxes for Installment Sales

Installment sales enable you to defer some portion of income.

Installment sales often have different definitions, depending on the context. For example, purchasing an auto using a bank or credit union loan is not an installment sale. Although you will repay your loan monthly, the seller or car dealer is receiving payment in full. For tax purposes, an installment sale typically relates to a sale or disposition of an asset in one tax year and one or more payments from the buyer are due in subsequent tax years. The benefit to the taxpayer is the ability to defer some portion of the income (interest and profit).

Difficulty:

Moderate

Instructions

1. Structure the sale of an asset to a buyer agreeable to make multiple payments to you. If you want the transaction to be treated as an installment sale, make sure the payment period will extend longer than one tax year.

2. Calculate your "adjusted cost basis" for the item. Add your cost to buy the property and any selling expenses you've incurred. Deduct any accumulated depreciation you've taken on prior year taxes. The resulting amount is your adjusted basis for the property you are selling. Don't forget to deduct any loan balance you might owe for the item.

3. Subtract your adjusted basis from your agreed-upon selling price to determine your gross profit (gain). This is the amount of your income deferred over the period of repayment on an annual basis.

4. Break down your scheduled payments into three categories: interest income, return of your adjusted cost for the item and your gain (profit) on the sale of the asset. You must report the interest portion as "ordinary income." The remaining amount of the payment will be split between a recovery of your cost (adjusted basis) and your profit on the sale.

5. Calculate the amount of your expected payments. Simply determine your "profit percentage" for the sale. For example, you sell your car for $12,000. Your adjusted basis for the auto is $9,600. Your profit, $2,400, represents 20 percent of the selling price or your profit percentage. Consequently, 80 percent of your scheduled payment should be allocated to repayment of your cost and 20 percent will represent income. Therefore, should your buyer agree to pay you $500 per month, $400 would be allocated to your cost (tax-free) and $100 per month would become income for you.

6. Record the amount of interest and profit you receive during the tax year as taxable income. The amount applied to the recovery of your cost (adjusted basis) will be tax-free.

7. Retain a qualified tax advisor to review all your data and provide valuable advice if you lack confidence in the accuracy of your calculations. Accounting for installment sales can certainly become complicated and confusing.

Tips & Warnings

• If you have spent money "improving" the property you are selling, add this amount to your purchase price to calculate an appropriate cost basis.

• Calculate a fair interest rate/amount into the scheduled payment or risk that the IRS will require you to estimate an amount.

• Use clear, simple English to construct your sales and installment agreement so anyone reading the document will understand the sale and repayment terms.

• Exercise caution when including one or more installment sales in your taxes because the IRS typically subjects this to close scrutiny.

• If selling similar items is a common feature of your regular business, you may not be allowed to treat these transactions as installment sales regardless of your documentation. The IRS may mandate taxation of these profits as ordinary income.

• Try to be sure you have correctly documented installment sales to avoid future tax problems. Consulting a tax advisor is always a wise consideration for these transactions.

Resources

• IRS: Publication 537