Internal Revenue Service form 6252 records installment sales. An installment sale allows for a taxpayer to recognize income over a period of time as income is actually collected. Typically, this income will be long-term capital gain (property held for more than a year) and will yield the most favorable of tax rates, 5% or 15%. In addition to postponing the collection of income, the installment note will also have interest associated with the transaction giving the seller an additional financial benefit. Is the installment sale method always the best way to go? Of course not my friends. The one thing that we who practice tax have come to learn is never say always, and never say never.
If I were to sell a capital asset (normally a piece of real estate or a business interest), I might consider the installment method of accounting for income tax purposes under the following two scenarios. Number one, if I am selling a business interest, I might have no choice but to hold paper (take back of a note) as the buyer may not be able to get adequate financing (beware of selling business interests and consult some one who knows). In the other instance, I might be fine finacially and have access to other larger blocks of funds and can afford to receive installments over time. By entering into an installment agreement, I will want to make sure that my note is properly secured in case the buyer defaults and I will want to review the possible income tax attributes.
Suppose that our favorite taxpayer has a carryover of capital losses consisting of both long-term and short-term capital losses. In addition, this taxpayer has investment interest expenses that has been carried over for years because he has not had enough investment income to make use of the deduction. Our taxpayer friend wishes to sell a piece of land that will carry a significant long-term capital gain upon its sale. Upon studying the installment sale method, he decides to hold the note on the transaction and will charge the buyer 9% annual interest. If the note is for ten years, the taxpayer will report long-term capital gain income on the principal he receives from the note payments. The earlier years will be more in the form of interest income with smaller amounts going towards principal. This interest will provide investment interest income that will be offset by any carry-over of invetsment interest expense. This interest income provides an additional return on this transaction and will be further enhanced by offsetting it against invesment interest expense carryover. On the capital gains side, the long-term capital gain will be netted against the capital loss carry-forwards, first against the long-term losses and then against the short-term losses. The idea with capital gain and loss netting is to have any remaining gain leftover be long-term capital gain because of the more favorable tax consequences. If during the installment period, the taxpayer recognizes any short-term gains (subject to the taxpayer's top marginal income tax rate as high as 35%), there will be more opportunity to shelter the short-term gains first. If our taxpayer hadn't elected to use the installment method, he would have used his capital losses to offset income that would have been taxed at 5% and 15% rates as opposed to the higher marginal income tax rates. The installment method allows for the prolonging of capital losses to be carried over and thus, offsetting gains that would be taxed at much higher rates.
As always, carefully consider your strategy and know your tax returns as it may contain carryovers that you can use to your advantage.
Ron Piner, CPA Host of "Better Business" Saturday Mornings at 10ET ON WBIS AM 1190
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