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In an economy still struggling on many fronts, installment sales offer a useful tool for many taxpayers to create liquidity to buy and sell property in an otherwise "creditsparse" environment. With correct planning, the installment method can also defer taxable gain on these sales and, therefore, provide an additional reason to commit to an installment sales strategy.
INSTALLMENT METHOD BASICS
For tax purposes, an installment sale is a sale of property for a gain, with at least one payment after the year of sale. An installment sale for tax purposes allows gain to be deferred under the installment method. The gain is deferred in direct proportion to die payments that are deferred. Ihe installment method is a method of accounting that can be used by both cash and accrual -basis taxpayers.
The buyer's obligation to make future payments generally takes the form of an installment note. Each installment payment under the note generally will include a portion of: return of adjusted basis, gain on the sale, and interest (stated, unstated or original issue discount). With the AFR rates historically low, sellers benefit from the interest calculation.
* Excluded property. Some installment sales are not allowed to use the installment method to defer income. Ihe installment sale method is not available for the regular sale of inventor)' of personal property. Dealer sales are excluded from the installment method, as are sales of stock or securities if traded on an established securities market.
A notable exception to the general rule on sales barred from the installment method is property used or produced in farming. Dealers in time-share properties and residential lots may also treat sales as installment sales, provided they pay a deemed interest charge.
SOME RISK REQUIRED
The objective in using an installment sale is to lock in a sale while deferring recognition of income. To defer income, however, the Tax Code not only requires that receipt of the proceeds must be contractually postponed, but also that receipt of the proceeds must not a "sure thing" until received. To defer gain under an installment sale, a seller must some risk that the purchaser will default on the installment obligation. In that respect, loan by the seller to the buyer to cover part of the purchase price...