Installment sales are a popular method for selling property, particularly rental real estate, because the seller can help grease the deal by providing at least part of the necessary financing for the buyer. Rather than demanding the full price up front, with an installment sale you agree to have the buyer pay at least part of the price in the future. The IRS doesn't tax your profit on the sale until you actually receive the money.
If you will receive at least one payment in a year after the sale, you can use the installment method to report and pay tax on the profit as you receive it. Each year, the payments you receive will have three components:
The interest portion should be easy to identify and segregate. To determine how much of the rest of the payments is taxable, you must first figure the "gross profit percentage" on the sale (see the help in this form for gross profit percentage).
The law requires that you charge an adequate amount of interest on the installment sale. The rationale is to prevent the price from being set artificially high to make up for interest-free or below-market financing. The IRS cares about the price of the sale, of course, because it affects the seller's gain or loss and the buyer's basis for depreciation in the building.
The law requires that you charge a rate at least equal to the "applicable federal rate" (AFR) at the time of the sale. The AFR is set by the IRS and is basically what it costs the government to borrow money. Regardless of the AFR, however, you don't have to charge more than 9%, compounded semiannually. If the AFR at the time of the sale is less than 9%, it was about 5.21% in the fall of 2006, you can use the lower rate.
If the contract fails to provide for adequate stated interest, the IRS has ways for figuring what part of each payment is "imputed" interest. That's the part treated as interest no matter what you call it. This affects your gain or loss and the buyer's basis. You have to report the imputed interest as income, and the buyer gets to count it as interest paid, which may be deductible. It's much easier to check with the IRS before finalizing a deal to be sure you include an adequate interest rate. (You can find current AFR information at www.irs.gov.)
Depreciation recapture is a complication you need to be aware of. Because depreciation reduces your basis it translates into higher gain when you sell. The tax rules treat gain attributable to depreciation differently than gain due to appreciation of the property's value.
If you used an accelerated depreciation method (as most residential real estate investors who bought their property before 1987 did) you claimed more depreciation over the years than you would have been allowed under straight-line depreciation. the law allowed that, it also called for that extra depreciation to be "recaptured" when you sold. The part of the profit that resulted from that extra depreciation is taxed as ordinary income rather than as capital gain. That can be painful if it means you're taxed in the 25%, 28%, 33%, or 35% bracket instead of enjoying the 15% rate that applies to long-term gains.
Under rules passed in 1997, gain resulting from straight-line depreciation (which used to be taxed as a capital gain) is now taxed at a flat 25% rate, unless you're in the 10% or 15% bracket, in which case that rate applies.
The twist with installment sales is that when recapture of gain attributed to accelerated depreciation is involved, the full amount of tax on that gain must be paid in the year of sale — not spread over the years you'll be receiving payment. If you sell a building that's affected, you'll probably want to make sure the down payment is at least enough to cover the tax bill on any recaptured depreciation. The tax on unrecaptured gain from properties put in service after 1986 is not caught up in this rule. So it can be spread over the years of the installment sale.
If the sale doesn’t have depreciation recapture, the gross profit percentage is determined by dividing gain on the sale (proceeds minus basis ) by the contract price.
Assume that you sell for $150,000 a rental house that had a tax basis of $75,000 (ignore depreciation for illustration purposes). You receive a $25,000 down payment and the contract calls for $25,000 payments (plus interest) for each of the next five years. The gross profit percentage on this sale would be 50%: $75,000 profit divided by $150,000 contract price. That means 50% of the down payment and of each subsequent payment you receive is taxable gain. The other half is the nontaxable return of your basis.