What it means
Selling a business, a piece of land or a building often involves a large price that the buyer cannot pay in one go. The seller may therefore accept a deposit and a series of later payments, with interest on the unpaid balance.
Under the instalment method used in the United States, the seller works out what proportion of each payment is profit and pays tax only on that part as it is received. The rest of each payment is treated as a return of the seller's original investment, which is not taxed again.
This matters because it avoids a situation in which the seller owes tax on the whole gain in year one but has received only part of the cash. It can also keep the seller's income in a lower tax bracket from year to year.
There are limits. Sales of inventory and sales of publicly traded shares generally cannot use the method, and any depreciation recapture must usually be reported as income in the year of sale, even if no cash has arrived.
Sellers can also elect out of the method and pay tax on the whole gain immediately. Interest on the unpaid balance is taxed as ordinary income when received and is reported separately from the gain.
The seller also carries the risk that the buyer fails to pay, so security such as a mortgage or personal guarantee is common. Because the rules are detailed and change from time to time, sellers should agree on the structure with a tax adviser before signing.
The payment schedule, the interest rate and the security can all affect the tax outcome.
In practice
Real-world examples.
Example
A founder sells her small design agency for $1,000,000, taking $250,000 up front and the remaining $750,000 over three years. Her accountant spreads the taxable gain over the four years in which payments are received. She also asks the buyer to sign a promissory note that sets out the payment dates and interest.
Example
A farmer sells part of his land to a neighbour who pays over ten years. He avoids a large tax bill in one year, and he holds a mortgage over the land as security. If the neighbour stops paying, the farmer can take the land back and sell it again.
Example
A property developer sells a commercial building and finances the buyer with a five-year note. The sales contract states the interest rate, and the developer reports the interest separately each year as ordinary income.
Formula
Calculation
Gross profit percentage = Gross profit / Contract price
Gain reported each year = Principal payments received x Gross profit percentage
A landowner sells property with a tax basis of $200,000 for $500,000. The gross profit is 500,000 - 200,000 = $300,000, and the gross profit percentage is 300,000 / 500,000 = 60%. The buyer pays $100,000 now and $100,000 a year for four years, plus interest. Each $100,000 payment includes a gain of 100,000 x 60% = $60,000, so the seller reports $60,000 in each of five years, a total of $300,000, instead of $300,000 in year one. The interest the buyer pays on the unpaid balance is extra and is taxed separately as ordinary income.Case study
Seen in the real world.
Brookside Dental Group is an illustrative, fictional practice whose owner, Dr Amara, agreed to sell it for $2,000,000. Her basis in the business was $500,000, and the buyer could pay $400,000 in cash with the rest over four years.
Her tax adviser showed that the gross profit percentage was 1,500,000 / 2,000,000 = 75%. If she took the instalment method, she would report 75% of each payment as gain, or $300,000 of the first payment and $300,000 in each later year, rather than $1,500,000 at once.
The fictional seller chose the instalment method and kept a lien on the practice's equipment as security. The illustrative lesson is that the structure of the payments can shape the tax result as much as the price. Dr Amara also asked her adviser to review the sale agreement before signing, to make sure the payment dates and the security were clearly written down.
Watch out
Common mistakes.
- Assuming the whole gain is deferred, when depreciation recapture is generally taxed in the year of the sale.
- Forgetting that interest on the deferred payments is taxed separately as ordinary income.
- Taking a long payment schedule from an unreliable buyer without security, which risks a taxable gain on money never received.
Questions
People also ask.
Who can use the instalment method?
Sellers of eligible property, such as land, buildings and most business assets, can use it, but dealers in inventory and sellers of publicly traded securities generally cannot. The rules differ by country, so non-US sellers should look at their own tax law.
Can a seller choose not to use the instalment method?
Yes, a seller can elect out and report the entire gain in the year of sale, which may be wise if tax rates are expected to rise. The election is made on the tax return for the year of the sale and is generally hard to reverse.
What happens if the buyer defaults?
The seller may repossess the property and could have a gain or loss on the repossession, so a tax adviser should be consulted.
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