IRS Publication 537: How to Report an Installment Sale

The Internal Revenue Service provides guidance on reporting gains from property sales through Publication 537, “Installment Sales.” An installment sale is a disposition of property where at least one payment is received after the tax year of the sale. This method allows a seller to recognize a portion of the gain as each payment is received, rather than reporting the entire gain in the year of the transaction, which aligns tax liability with cash flow.

The installment method is an automatic arrangement for qualifying sales, but it is not universally applicable. This framework covers which sales qualify, how to calculate the taxable portion of each payment, and various special circumstances.

What Qualifies as an Installment Sale

The installment method can be used for most sales of property where payments are spread out. This includes sales of real estate, such as a primary residence or rental property, and personal property that is not inventory, like a collectible car. The qualifying factor is that at least one payment is deferred to a tax year after the sale.

Certain sales are excluded. You cannot use the installment method to report a loss. Another exclusion involves the sale of inventory. If a business regularly sells personal property, such as a car dealership selling vehicles, those sales do not qualify even if payments are received in later years.

Furthermore, the installment method cannot be used for sales of stocks or securities traded on an established market, as these assets are considered readily convertible to cash.

Calculating and Reporting Your Gain Using Form 6252

Key Terms and Calculations

To report an installment sale, you must determine several key figures. The selling price is the total amount you will receive, including cash, the fair market value of other property, and any of the buyer’s debt you assume. From this, you subtract selling expenses and your adjusted basis in the property (original cost plus improvements, minus depreciation) to arrive at the gross profit.

The contract price is the selling price minus any mortgage the buyer assumes, up to the amount of your adjusted basis. The gross profit percentage is then calculated by dividing the gross profit by the contract price. This percentage represents the portion of each payment you must report as a taxable gain.

For example, if you sell land with a gross profit of $50,000 and a contract price of $200,000, your gross profit percentage is 25%. This means that for every dollar you receive from the buyer (excluding interest), 25 cents is a taxable gain.

Applying the Formula

Once you have the gross profit percentage, you apply it to the payments you receive each year. The amount of each payment, not including any stated interest, is multiplied by the gross profit percentage to determine the installment sale income for that tax year.

Any interest you receive must be reported as ordinary income and is not included in the installment sale calculation.

Reporting on Form 6252

These calculations are reported to the IRS on Form 6252, “Installment Sale Income,” filed with your tax return for each year you receive a payment. Part I of the form is used to calculate your gross profit and contract price, and Part II is for reporting income from payments received in the current year. This gain is then transferred to Schedule D of your Form 1040.

Special Rules and Considerations

Depreciation Recapture

A primary exception to the standard rules involves depreciation recapture. If you have claimed depreciation on the property you sold, any gain attributable to that depreciation must be reported as ordinary income in the year of the sale. The recaptured amount is not eligible for deferral under the installment method.

This portion of the gain is reported on Form 4797, “Sales of Business Property.” The remaining gain, if any, is then eligible for the installment method and reported on Form 6252.

Sale to a Related Party

Special rules apply when you sell property to a related party, such as a spouse, child, grandchild, parent, or a controlled corporation. If the related party sells the property again within two years of the original sale, the “second disposition rule” may be triggered. This rule can accelerate the recognition of your gain from the original sale.

You may be required to report the remaining gain in the year of the second disposition. This rule prevents related parties from using an installment sale to defer taxes on a gain realized within the family group.

Selling an Installment Obligation

If you hold an installment obligation from a buyer and sell it to a third party, this is a disposition of the obligation. You must generally report the remaining gain from the installment sale at the time you sell the note. The gain is calculated as the difference between the amount you receive for the obligation and your basis in it.

Your basis in the obligation is the remaining unpaid principal multiplied by the gross profit percentage.

Repossession of Property

If the buyer defaults and you repossess the property, the repossession is treated as a disposition of the installment obligation, which can result in a taxable gain or a deductible loss. The gain or loss is the difference between the fair market value of the repossessed property and your basis in the installment obligation.

The character of the gain or loss will be the same as from the original sale.

Electing Out of the Installment Method

Taxpayers can elect out of the installment method. If you choose to do so, you must report the entire gain from the sale in the year it occurs, using Schedule D (Form 1040) and Form 8949, “Sales and Other Dispositions of Capital Assets.”

A taxpayer might elect out if they have capital losses in the current year that can offset the gain. The decision to elect out is irrevocable and must be made by the due date, including extensions, for filing your tax return for the year of the sale.

Unstated Interest and Original Issue Discount

When a contract for the sale of property with deferred payments does not specify an adequate interest rate, the IRS may impute interest. This is known as “unstated interest.” The purpose is to prevent sellers from disguising interest income as part of the selling price to achieve a lower capital gains tax rate.

The IRS uses the Applicable Federal Rates (AFRs) to determine if the interest rate is sufficient. The AFRs are published monthly and vary based on the loan’s term. If the contract’s rate is lower than the relevant AFR, a portion of the principal payments will be recharacterized as interest.

This amount is treated as ordinary income for the seller and reduces the property’s selling price, which affects the gain reported on Form 6252.

Original Issue Discount (OID) rules may also apply to installment sales. OID is a form of interest that accrues over the life of the debt instrument. If an installment obligation has OID, the seller must include a portion of it in their income each year, even if no cash is received.