Key Takeaways
- An installment sale is any sale where at least one payment is received after the tax year of sale; the installment method under IRC Section 453 applies automatically unless the taxpayer elects out.
- Gross Profit Percentage = Gross Profit / Contract Price; multiply each payment received by this percentage to determine taxable gain for that year.
- Depreciation recapture under Sections 1245 and 1250 must be recognized as ordinary income in the year of sale, even if no payment is received that year.
- Installment sales to related parties trigger the 2-year disposition rule: if the related buyer resells within 2 years, the original seller must recognize gain as if they received the proceeds.
- Ineligible property for installment method includes: dealer property (inventory), publicly traded securities, and depreciable property sold to related parties.
Installment Sales (Form 6252)
An installment sale is a sale of property where you receive at least one payment after the tax year in which the sale occurs. Under IRC Section 453, the installment method allows you to spread gain recognition over the years you receive payments.
Key Formulas
Gross Profit
Gross Profit = Selling Price - Adjusted Basis
Contract Price
Contract Price = Selling Price - Mortgages Assumed by Buyer (but not exceeding basis)
If the buyer assumes a mortgage that exceeds your adjusted basis:
- The excess is treated as a payment received in the year of sale
- The excess is also added to the contract price
Gross Profit Percentage
Gross Profit Percentage = Gross Profit / Contract Price
Step-by-Step Calculation Example
Facts: Sarah sells rental property for $500,000. The buyer pays $100,000 down and $100,000 annually for 4 years. The buyer assumes Sarah's $150,000 mortgage. Sarah's adjusted basis is $200,000. Selling expenses are $30,000.
Step 1: Adjusted Basis for Installment Sale $200,000 + $30,000 = $230,000
Step 2: Gross Profit $500,000 - $230,000 = $270,000
Step 3: Contract Price $500,000 - $150,000 = $350,000
Step 4: Gross Profit Percentage $270,000 / $350,000 = 77.14%
Step 5: Annual Installment Income Each $100,000 payment × 77.14% = $77,140 taxable gain
Depreciation Recapture Rules
Critical rule: Depreciation recapture under Sections 1245 and 1250 must be recognized as ordinary income in the year of sale, regardless of whether any payment is received.
Related Party Installment Sales
The 2-Year Disposition Rule
If you sell to a related party using the installment method, and that related party disposes of the property within 2 years, you must recognize gain as if you received the proceeds from the second sale.
Depreciable Property to Related Parties
When selling depreciable property to a related party, the installment method is generally prohibited. All payments are deemed received in the year of sale.
Ineligible Property
| Property Type | Why Excluded |
|---|---|
| Inventory | Regular sales of stock-in-trade |
| Dealer property | Held for sale to customers |
| Publicly traded securities | Traded on established markets |
| Depreciable property to related parties | Special rule deems all payments received in year of sale |
EA Exam Tips
- Memorize the formulas: Gross Profit % = Gross Profit / Contract Price
- Depreciation recapture is NOT deferred: Always recognize recapture as ordinary income in the year of sale
- Related party sales are heavily tested: Know the 2-year rule
- Default is installment method: Taxpayers must actively elect OUT to report all gain in year of sale
- Watch for excess mortgage: When mortgage assumed exceeds basis, the excess is treated as a payment received
Marcus sells land for $200,000 with an adjusted basis of $80,000. The buyer pays $50,000 down and $50,000 per year for 3 years. What is the gross profit percentage?
Linda sells business equipment with $15,000 of Section 1245 depreciation recapture for $100,000, receiving $20,000 in the year of sale and the balance over 4 years. How much ordinary income must Linda report in the year of sale?
Robert sells rental property to his daughter using the installment method. Eighteen months later, his daughter sells the property to an unrelated third party. What is the tax consequence to Robert?
Jennifer sells property for $300,000. The buyer assumes her $180,000 mortgage and pays $120,000 over 6 years. Jennifer's adjusted basis is $150,000. What is her contract price?