Selling property as an installment sale can be a creative way to sale property and can also be a good way to defer the payment of taxes. An installment sale is a sale where a part of or the entire sales price is paid in later years. If you finance the buyer’s purchase of the property instead of the buyer paying with cash or getting a mortgage, you probably have entered into an installment sale.
In an installment sale, you report your gain on the sale of property only as it is received. You are taxed on the part of the payment that is attributable to your profit. So, when you sale property on an installment sale you do not pay the taxes in the year you sale the property because you have not fully received payment. Instead, you pay taxes only as you receive payment. To correctly report the taxes, you need to determine what portion of each installment payment is going to be taxable gain.
To do this, you divide your gross profit (selling price minus basis) by the contract price. For example, say you purchase a property for $200,000 and later sell it for $400,000 under seller financed terms. Since you purchased the property for $200,000, you have a basis of $200,000 (you would also adjust the basis for improvements, depreciation, and other factors) and a contract sale price is $400,000. This gives you a gross profit of $200,000 (contract price minus basis). You then divide your gross profit of $200,000 by the $400,000 contract sale price, which equals 50%. You then take this 50% and apply it to each payment to determine which portion of the payment is taxable. This makes sense because each payment you receive, in this example, equally consists of a return of your basis which is not taxable and a payment towards the gross profit which is taxable. Other factors should be considered in an installment sale but hopefully this helps illustrate the point.
The benefit of the installment sale is that you take a portion of the gain into income each year. This gives the advantage of deferring taxes over time and can also keep you in a lower tax bracket. The major disadvantage is that you do not obtain the sale proceeds immediately and as result you cannot invest them elsewhere.