How to Calculate Installments & Gross Profit

How to Calculate Installments & Gross Profit
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Buying something by making installment payments allows many taxpayers the benefit of making large purchases that they otherwise wouldn’t be able to obtain if they had to pay the total cost up front. But if you’re the seller behind an installment sale, your income tax liability for the sale could be quite substantial if you had to pay your total tax bill at the end of the year in which you made the sale.

Even though your purchaser may have 30 years, for example, to make installment payments to you, you’d be hit pretty hard if you had to pay income tax on your total 30-year profit in the year you made the sale. But the IRS cuts you a break by allowing you to defer paying income tax on eligible installment sales through what’s called “installment sale rules.”

What is an Installment Sale?

The IRS defines an installment sale as the sale of property for which at least one payment is received after the end of the tax year in which the sale was made. Eligible sales allow the seller to prorate her profit over the life of the transaction, as the purchaser makes his payments, which also prorates her income tax liability. Sellers do not have to choose the installment sale method of paying income taxes, and some sales do not even qualify for this method, eliminating it as an option.

Installment Sale Exclusions

The IRS gives these guidelines for transactions that do not meet the definition of installment sales for tax purposes:

  • Personal property that’s sold by someone who routinely sells or disposes of this same type of personal property, even if the property is sold on an installment plan. For example, agents or brokers who sell or broker real estate as part of their business do not qualify for the installment sale method, but an individual who owner-finances her own home is eligible.
  • Real property that’s held for sale to customers during the ordinary course of a person’s trade or business. One exception is installment sales of properties that are used or produced in farming. Another exception is certain sales of timeshares and residential lots sold by dealers, if dealers choose to pay a special interest charge. IRS Publication 537, Section 453(1) explains this exception.

  • Regular sales of personal property inventory are ineligible as installment sales even if a payment is received after the year of the sale.

  • Stocks and other securities that are traded on an established securities market. If you sell one of these securities, you’ll have to report your entire gain on the sale for the tax year in which the trade date occurred.

Installment Sales General Rules

The IRS outlines general rules that define installment sales, including three notable restrictions:

  • You cannot treat a sale as an installment sale if the sale results in a loss, even if your sale resulted from a transaction that was set up to receive installment payments. If you experienced a loss on the sale, you’ll have to deduct the loss in the tax year the sale was made.
  • If you have a transaction that qualifies as an installment sale for tax purposes, you’ll need an “installment obligation.” This can be a mortgage, note, deed of trust, land contract or other document that proves your buyer’s debt to you.
  • To qualify as an installment sale, your property must have fair market value (FMV), which is the price that’s agreed upon between a willing seller and willing buyer, both of whom have a reasonable knowledge of the transaction details and neither of whom have any compulsion to buy or sell the property.

Calculating Installment Sale Income

If your transaction qualifies as an installment sale, each payment you receive typically includes three parts: interest income, return of your adjusted basis in the property and your gain on the sale. For each year that you receive at least one payment for your installment sale, you’ll have to report your interest income as well as your gain on the sale, but you do not have to report as income the portion that is the return of your basis in the property. Your basis represents the amount you invested in the property for installment sale purposes.

IRS Form 6252 (Installment Sale Income) will help you calculate the reportable income from your installment sale.

Installment Sale Interest Income

When you calculate total installment sale income, all interest income you receive from the sale must be reported as ordinary income on your income tax return. Other than the down payment, which typically does not include interest, each installment payment you receive may have implied interest, even if it’s not expressly described as interest. The interest that’s noted in your sales agreement is called stated interest.

Installment Sale Adjusted Basis Components

After you’ve figured the portion of each installment payment that’s interest, the remainder of each payment is composed of two parts:

  • Tax-free return of the adjusted basis in your property
  • Gain on sale (Form 6252 refers to this as installment sale income)

Figuring Installment Sale Adjusted Basis

Figuring your basis in a property hinges on how you acquired the property. If you purchased the property, its basis is typically the cost you paid. If you built the property yourself, inherited it or received it as a gift, you’ll figure its basis a little differently. And after you figure your adjusted basis, you may need to make adjustments to this figure. In a nutshell, your adjusted cost basis is your basis plus any expenses you paid for improvements to the property, such as adding a room, or subtracting any losses, such as from casualties.

Using Publication 537 Worksheet A

IRS Publication 537 contains Worksheet A, which you can use to figure your installment sale property’s adjusted basis. After you complete this worksheet, you’ll also have calculated your annual installment sale gross profit percentage.

Worksheet A includes these steps to help you calculate both of these factors:

  • Enter your property’s sales price. This price represents the total cost you receive for the property, including any existing mortgage or other debt you pay, assume or take through any liability such as a lien, accrued interest or taxes. The sales price may also include any selling expenses that your buyer pays.
  • Enter your property’s adjusted basis. This figure represents the tax-free portion of your investment that is returned to you.
  • Enter your property's selling expenses. These expenses include things like broker commissions, attorney fees and advertising costs.

  • Enter your property's depreciation recapture. This figure considers any depreciation costs you may have previously claimed on a tax return, part of the gain of which you may have to recapture as ordinary income. Refer to Publication 537 for more information about what to include for depreciation recapture.

  • Calculate adjusted basis for installment sale purposes. Add your property's adjusted basis with any selling expenses and depreciation recapture to determine your adjusted basis for installment sale purposes.

Calculating Your Gross Profit

After performing the calculations in Worksheet A, subtract your adjusted basis for installment sale purposes from your property's sales price to figure your gross profit. If this amount is zero or less, you cannot use the installment sales method.

Installment Sale Gross Profit Percentage

Your property’s gross profit percentage is the percentage of each installment payment, minus interest, that you report as installment sale income. You’ll figure this amount by dividing your gross profit by your property’s contract price. Your contract price is the total of your property’s sales price minus any mortgages, debts or other liabilities assumed or taken by the purchaser plus the amount that these purchaser costs exceed your adjusted basis for installment sale purposes.

Tax on Installment Sales

To determine the amount of income you must report for your installment sales, multiply the sum of the payments you receive in a tax year, minus the interest, by the gross profit percentage you calculated with the information you entered in Worksheet A. This amount represents your installment sale income for that tax year. In some situations, such as a mortgage assumption for the property, you may be considered as having received a payment, even though you didn’t directly receive anything. Refer to Publication 537 for more details on this subject.

Reporting Installment Sale Income

Use IRS Form 6252 to report the income you receive from the installment sale method. But you only have to file Form 6252 if your property’s sale results in a gain. If the sale results in a loss, you’ll report the sale on IRS Form 4797 (Sales of Business Property).

Filling Out Form 6252

Form 6252 is subdivided in three parts:

  • Part I – Gross Profit and Contract Price. You’ll only complete this part for the year of your property’s sale.

                        Part II – Installment Sale Income. Complete this part for the property’s sale year as well as the year you received any payment.    Part III – Related Party Installment Sale Income. Complete this part if your property’s sale is a transaction between IRS-defined “related parties,” as defined in IRS Publication 550 (Investment Income and Expenses). Examples of related parties include members of your family and partnerships or corporations in which you directly or indirectly own more than 50 percent of the capital investment, profits interest or outstanding stock.

Following these three parts you’ll find the directions for this form, which define the terms and explain how to complete the form.

Form 6252 Considerations

New 2018 tax laws allow taxpayers the option of deferring all or part of their capital gains to a Qualified Opportunity Fund (QOF).

Requirements for this deferment include:

  • Funds must be invested within 180 days.
  • Deferred funds must be noted on Form 8949 and filed with your tax return.
  • Invested QOF funds cannot be a debt interest; they must be an equity interest.