Installment sales are a common tax management and tax reduction feature in taxpayer sales of major property assets. Yet, too often, taxpayers do not understand the hazards and risks inherent in installment sales that can result from improper or misunderstood tax planning. An installment sale is simply the sale of property where you receive at least one payment after the year of the sale. Form 6252 is applied to installment sales to calculate things like gross profit and percentages of installment sale income per year.

Three parts exist to an installment sale: a) interest income, b) return of your adjusted basis in the property, c) gain on the sale. Each year you receive payment, you must include in income both the interest income and the segment that is your gain on the sale. The gain simply your adjusted basis subtracted from the sale price. Interest is the accrued for the time value of the note. If you’re unfamiliar with installments sales, here is how they work. Let’s say you sell a tract of land for $500,000. If your basis 20 years ago was $100,000, the gain is $400,000. If the installment sale is for a period of five years, then equal payments will be made of $100,000 per year. The gain of $400,000 would also be taxable over 5 years, or $80,000 per year. The benefit of the installment sale is that depending on tax attributes, a larger portion of the sales capital gains can result in lower tax, given the income is in a lower bracket (or say maybe exempt from capital gains tax), e.g. in this example $80,000 of capital gain per year vs. $400,000 in one tax year.

Hazards with installment sales occur in the following property instances: sale of inventory, dealer sales, sales of securities, property with depreciation recapture, sales to related parties, sales of depreciable property. Too often taxpayers think an installment sale will work with most any type of property they wish to sell.

Let’s consider the possible tax hazards with installment sales on depreciation recapture property (property purchased with accrued accumulated depreciation). With these assets, the gain must be reported in the year of sale; it is simply a tax code requirement. So for instance, if you sell equipment that cost $100,000 for $50,000 during the tax year, and you expensed the purchase with Section 179, the entire $50,000 is taxable in the year of sale; same tax rules with depreciable equipment, securities and say inventory.

These specific small print tax code restrictions, i.e. hazards, can easily be overlooked, especially for a business owner who personally prepares a business tax filing. This is the benefit of a CPA preparing your business taxes – the confidence of lower tax audit risks.

Consider Farmer Elliot who sold his business on the installment sale. In the second year of the installment sale, the tax auditor discovers that $800,000 of the depreciable equipment has recapture gains on a 20 year sales agreement. Soon the year’s tax planning become increasingly interesting. What was planned as $40,000 of gain for the year is now likely taxed at 100% on the remaining balance. A $10,000 tax liability could then be a $250,000 snowman for Elliot’s bank account for the year. Proper tax planning prevents these problems, and when appropriate can provide tax assurance that minimizes tax audit surprises. Talk with your CPA before preparing your own tax installment sales on business property.