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Lump-Sum Sale with Installment Payments

An installment sale occurs whenever property is sold and at least one payment is received in a tax year subsequent to the year of the sale. If you elect not have the installment sale rules apply the entire gain is included in gross income for the year of the sale. Tax on the entire gain will be due, even though all of the payments have not been received.

Note: The following discussion applies if you sold standing timber (stumpage) and will receive payments for the timber after the tax year in which the timber was disposed of.

Electing to not have the installment sale rules apply is done by reporting the sale on Form 1040 Schedule D, or Form 4797 if the timber is used in a business. A pay-as-cut contract would ordinarily be considered an installment sale unless it qualifies under Section 631(b), in which case the rules for Section 631(b) must be applied. The installment sale method does not apply to dispositions of real property held for sale to customers in the course of an ordinary trade or business.

Taxpayers who are not dealers in the particular type of property but who make casual sales of property must recognize income from the sale by using the installment method, unless they elect to recognize the entire gain in the year of the sale. The installment method is based on the wherewithal-to-pay concept and recognizes income proportionally as the selling price is receives. For further information see IRS Pub. 537, Installment Sales.

These rules apply to sales of real estate and casual sales of personal property. Any outstanding debt on the sale (deferred payments) must be owed to the seller, not a third party such as a bank. Guaranteeing the deferred payments with an escrow account will result in the gain being fully taxable in the year of the sale unless there is a substantial restriction on the escrow account.

Tax Liability - In order to determine your tax liability each year in which an installment payment is received it is necessary to calculate the "gross profit percentage". The gross profit percentage is the gross profit to be realized from the sale expressed as a percentage of the total contract price. Unless the contract price has changed the "gross profit percentage" that was calculated in the year of the sale will remain the same for each of the installment payments. Taxable gain each year is determined by multiplying the total payments received during the year by the "gross profit percentage."

Gross Profit Percentage - The "gross profit percentage" is calculated by subtracting your "allowable basis" and "selling expenses" from the "contract price". The result is your gross profit, which is divided by the contract price.

gross profit = contract price - allowable basis - selling expenses

gross profit percentage = gross profit / contract price

Unstated interest rules - The unstated interest rules penalize sellers who accept deferred payments without requiring the buyer to pay reasonable interest for the privilege of deferring the payments. These provisions were enacted under the assumption that a buyer is willing to pay more for an asset if they don't have to pay for it all at once. Therefore, if a contract doesn't provide for the payment of interest on deferred payments the higher selling price results in the receipt by the seller of income qualifying for capital gains treatment that actually represents disguised interest. Interest of course must be reported as ordinary income. The penalty is to require the seller to report a portion of each payment otherwise qualifying for capital gains as interest payments taxed as ordinary income. This requirement remains in effect, even though there is no longer a significant differential tax rate for capital gains.

For more information on when "unstated interest rules" apply and how to calculate it click here.

Reporting a Lump-sum Sale with Installment Payments

The installment sale provisions are used by filing Form 6252, "Installment Sales" in the year of the sale and each year a payment is received.

Note: The gain from an installment sale of an asset qualifying for long-term capital gain treatment in the year of the sale continues to be long-term in later tax years. If it is short-term in the year of sale, it continues to be short-term when payments are received in later tax years.

Personal use or as an investment:

Capital Gain -

Income received from the lump-sum sale of standing timber under an installment sale, held for personal use or as an investment, that qualifies as as capital gain is carried forward from Form 6252 and reported on Schedule D of Form 1040. A long-term capital gain is reported in Part II. A short-term capital gain is reported in Part I.

Ordinary Income-

If the timber did not qualify as a capital asset the income from the sale of standing timber is reported as ordinary income. This is done by completing Line 21 of Form 1040 (Other Income), and writing in a description of the income.

Use in a trade or business:

Capital Gain -

Partnership: Capital gains from an installment sale are carried forward from Form 6252 Part II and reported on Form 1065 Schedule D. Short-term capital gains are reported in Part I. A long-term capital gain is reported in Part II. The net short- and long-term capital gains or losses are carried forward to Form 1065 Schedule K.

S-Corporation: Capital gains from an installment sale are carried forward from Form 6252 and reported of Form 1120S, Schedule D. Short-term capital gains are reported in Part I. Long-term capital gains are reported in Part II. The net short- and long-term capital gains or losses are carried forward to Form 1120S, Schdeule K.

C-Corporations: Capital gains from an installment sale are carried forward from Form 6252 and reported on Form 1120, Schedule D. Short-term capital gains are reported in Part I. Long-term capital gains are reported in Part II. The net short- and long-term capital gains and losses are carried forward to Form 1120.

Ordinary Income-

Partnership, S-Corporation, and C-Corporation - Ordinary gain from the sale of standing timber under an installment agreement is reported by completing Form 6252, the amount from Line 25 or 36 is then reported on Form 4797 Line 15. The amount from Form 4797 is then carried forward to the appropriate business form; 1065, 1120S or 1120.