Installment Sales Tax Primer

April 2011

I. Introduction

Deferred sale payments generally consist of interest and principal components. The installment sale rules determine the portions of each principal payment that are gain, on the one hand, and recovered basis, on the other. Basically, the seller is required to compute the percentage of the sum of the principal payments he or she will receive that will constitute gain on the sale and then multiply each principal payment he or she receives by that percentage to determine the portion of the payment that is gain.

II. The Basic Rules

Under Internal Revenue Code (“Code”) Section 453(a), except as otherwise provided in Section 453, income from an “installment sale” is reported using the “installment method.”

A. Installment sale. Code Section 453(b)(1) and Section 15A.453-1(b)(1) of the Income Tax Regulations (the “Regulations”) define an “installment sale” as any disposition of property where at least one payment is to be received in a year after the year of the disposition.

B. Installment method. Under the installment method, the gain from an installment sale is reported as “payments” are received.
1. Basic notion. Under Code Section 453(c) and Regulations 15A.453-1(b)(1), each “payment” is multiplied by the “gross profit ratio” (or “GPR”) determined for the sale. The product of the payment and the GPR is the gain portion of the payment. The balance of the payment is a non-taxable recovery of basis.
Thus: Payment times GPR equals Gain 2. GPR. GPR equals gross profit (“GP”) divided by contract price (“CP”)

a. GP. GP equals selling price (“SP”) minus adjusted basis (“AB”), with AB including any selling expenses paid by the seller. Regulations Section 15A.453-1(b)(2)(v).

b. CP. CP equals SP minus qualifying indebtedness (“QI”) to the extent not in excess of AB (which, again, includes any selling expenses paid by the seller). Regulations Section 15A.453-1(b)(2)(iii).

c. SP. SP equals gross selling price (i) including any mortgage or other encumbrance on the property and without reduction for any selling expenses paid by the seller, but (ii) excluding any interest or original issue discount (“OID”) payable to the seller. Regulations Section 15A.453-1(b)(2)(ii).

d. QI. Under Regulations Section 15A.453-1(b)(2)(iv), QI is (i) any mortgage or other indebtedness encumbering the property and (ii) any indebtedness not secured by the property but incurred or assumed by the purchaser incident to the purchaser’s acquisition, holding or operation of the property in the ordinary course of business or investment. QI does not include, however:

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