Publication 537 (2007), Installment Sales

IRS Resources

Publication 537 - Main Contents

Table of Contents

What Is an Installment Sale?

An installment sale is a sale of property where you receive at least one payment after the tax year of the sale.

Sale of inventory. The regular sale of inventory is not an installment sale even if you receive a payment after the year of sale. See Sale of a Business under Other Rules, later.

Dealer sales. Sales of personal property by a person who regularly sells or otherwise disposes of the same type of personal property on the installment plan are not installment sales. This rule also applies to real property held for sale to customers in the ordinary course of a trade or business. However, the rule does not apply to an installment sale of property used or produced in farming.

Special rule. Dealers of time-shares and residential lots can treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge. For more information, see section 453(l) of the Internal Revenue Code.

Stock or securities. You cannot use the installment method to report gain from the sale of stock or securities traded on an established securities market. You must report the entire gain on the sale in the year in which the trade date falls.

Installment obligation. The buyer's obligation to make future payments to you can be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer's debt to you.

General Rules

If a sale qualifies as an installment sale, the gain must be reported under the installment method unless you elect out of using the installment method.

See Electing Out of the Installment Method under Other Rules, later, for information on recognizing the entire gain in the year of sale.

Sale at a loss. If your sale results in a loss, you cannot use the installment method. If the loss is on an installment sale of business or investment property, you can deduct it only in the tax year of sale.

Unstated interest. If your sale calls for payments in a later year and the sales contract provides for little or no interest, you may have to figure unstated interest, even if you have a loss. See Unstated Interest and Original Issue Discount (OID), under Other Rules, later.

Figuring Installment Sale Income

You can use the following discussions or Form 6252 to help you determine gross profit, contract price, gross profit percentage, and installment sale income.

Each payment on an installment sale usually consists of the following three parts.

Interest income.
Return of your adjusted basis in the property.
Gain on the sale.

In each year you receive a payment, you must include in income both the interest part and the part that is your gain on the sale. You do not include in income the part that is the return of your basis in the property. Basis is the amount of your investment in the property for installment sale purposes.

Interest Income

You must report interest as ordinary income. Interest is generally not included in a down payment. However, you may have to treat part of each later payment as interest, even if it is not called interest in your agreement with the buyer. Interest provided in the agreement is called stated interest. If the agreement does not provide for enough stated interest, there may be unstated interest or original issue discount. See Unstated Interest and Original Issue Discount (OID), under Other Rules, later.

Adjusted Basis and Installment Sale Income (Gain on Sale)

After you have determined how much of each payment to treat as interest, you treat the rest of each payment as if it were made up of two parts.

A tax-free return of your adjusted basis in the property, and
Your gain (referred to as installment sale income on Form 6252).

Figuring adjusted basis for installment sale purposes. You can use Worksheet A to figure your adjusted basis in the property for installment sale purposes. When you have completed the worksheet, you will also have determined the gross profit percentage necessary to figure your installment sale income (gain) for this year.

Worksheet A. Figuring Adjusted Basis and Gross Profit Percentage

1.	Enter the selling price for the property
2.	Enter your adjusted basis for the property
3.	Enter your selling expenses
4.	Enter any depreciation recapture
5.	Add lines 2, 3, and 4. This is your adjusted basis for installment sale purposes
6.	Subtract line 5 from line 1. If zero or less, enter -0-. This is your gross profit
	If the amount entered on line 6 is zero, Stop here. You cannot use the installment method.
7.	Enter the contract price for the property
8.	Divide line 6 by line 7. This is your gross profit percentage

Selling price. The selling price is the total cost of the property to the buyer. It includes:

Any money you are to receive,
The fair market value (FMV) of any property you are to receive (FMV is discussed at Property Used As a Payment under Other Rules, later),
Any existing mortgage or other debt the buyer pays, assumes, or takes (a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes you owe on the property), and
Any of your selling expenses the buyer pays.

Do not include stated interest, unstated interest, any amount recomputed or recharacterized as interest, or original issue discount.

Adjusted basis for installment sale purposes. Your adjusted basis is the total of the following three items.

Adjusted basis.
Selling expenses.
Depreciation recapture.

Adjusted basis. Basis is the amount of your investment in the property for installment sale purposes. The way you figure basis depends on how you acquire the property. The basis of property you buy is generally its cost. The basis of property you inherit, receive as a gift, build yourself, or receive in a tax-free exchange is figured differently.

While you own property, various events may change your original basis. Some events, such as adding rooms or making permanent improvements, increase basis. Others, such as deductible casualty losses or depreciation previously allowed or allowable, decrease basis. The result is adjusted basis.

For more information on how to figure basis and adjusted basis, see Publication 551.

Selling expenses. Selling expenses are any expenses that relate to the sale of the property. They include commissions, attorney fees, and any other expenses paid on the sale. Selling expenses are added to the basis of the sold property.

Depreciation recapture. If the property you sold was depreciable property, you may need to recapture part of the gain on the sale as ordinary income. See Depreciation Recapture Income, under Other Rules, later.

Gross profit. Gross profit is the total gain you report on the installment method.

To figure your gross profit, subtract your adjusted basis for installment sale purposes from the selling price. If the property you sold was your home, subtract from the gross profit any gain you can exclude. See Sale of Your Home, later, under Reporting Installment Sale Income.

Contract price. Contract price equals:

The selling price, minus
The mortgages, debts, and other liabilities assumed or taken by the buyer, plus
The amount by which the mortgages, debts, and other liabilities assumed or taken by the buyer exceed your adjusted basis for installment sale purposes.

Gross profit percentage. A certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing your gross profit from the sale by the contract price.

The gross profit percentage generally remains the same for each payment you receive. However, see the Example under Selling Price Reduced, later, for a situation where the gross profit percentage changes.

Amount to report as installment sale income. Multiply the payments you receive each year (less interest) by the gross profit percentage. The result is your installment sale income for the tax year. In certain circumstances, you may be treated as having received a payment, even though you received nothing directly. A receipt of property or the assumption of a mortgage on the property sold may be treated as a payment. For a detailed discussion, see Payments Received or Considered Received, under Other Rules, later.

Example.

You sell property at a contract price of $6,000 and your gross profit is $1,500. Your gross profit percentage is 25% ($1,500 ÷ $6,000). After subtracting interest, you report 25% of each payment, including the down payment, as installment sale income from the sale for the tax year you receive the payment. The remainder (balance) of each payment is the tax-free return of your adjusted basis.

Selling Price Reduced

If the selling price is reduced at a later date, the gross profit on the sale also will change. You then must refigure the gross profit percentage for the remaining payments. Refigure your gross profit using Worksheet B, New Gross Profit Percentage — Selling Price Reduced. You will spread any remaining gain over future installments.

Worksheet B. New Gross Profit Percentage — Selling Price Reduced

1.	Enter the reduced selling price for the property
2.	Enter your adjusted basis for the property
3.	Enter your selling expenses
4.	Enter any depreciation recapture
5.	Add lines 2, 3, and 4.
6.	Subtract line 5 from line 1. This is your adjusted gross profit
7.	Enter any installment sale income reported in prior year(s)
8.	Subtract line 7 from line 6
9.	Future installments
10.	Divide line 8 by line 9. This is your new gross profit percentage ^*.

* Apply this percentage to all future payments to determine how much of each of those payments is installment sale income.

Example.

In 2005, you sold land with a basis of $40,000 for $100,000. Your gross profit was $60,000. You received a $20,000 down payment and the buyer's note for $80,000. The note provides for four annual payments of $20,000 each, plus 12% interest, beginning in 2006. Your gross profit percentage is 60%. You reported a gain of $12,000 on each payment received in 2005 and 2006.

In 2007, you and the buyer agreed to reduce the purchase price to $85,000 and payments during 2007, 2008, and 2009 are reduced to $15,000 for each year.

The new gross profit percentage, 46.67%, is figured in Worksheet B.

You will report a gain of $7,000 (46.67% of $15,000) on each of the $15,000 installments due in 2007, 2008, and 2009.

Example — Worksheet B. New Gross Profit Percentage — Selling Price Reduced

1.	Enter the reduced selling price for the property		85,000
2.	Enter your adjusted basis for the property	40,000
3.	Enter your selling expenses	-0-
4.	Enter any depreciation recapture	-0-
5.	Add lines 2, 3, and 4.		40,000
6.	Subtract line 5 from line 1. This is your adjusted gross profit		45,000
7.	Enter any installment sale income reported in prior year(s)		24,000
8.	Subtract line 7 from line 6		21,000
9.	Future installments		45,000
10.	Divide line 8 by line 9. This is your new gross profit percentage ^*.		46.67%

* Apply this percentage to all future payments to determine how much of each of those payments is installment sale income.

Reporting Installment Sale Income

Generally, you will use Form 6252 to report installment sale income from casual sales of real or personal property during the tax year. You also will have to report the installment sale income on Schedule D (Form 1040) or Form 4797, or both. See Schedule D (Form 1040) and Form 4797, later. If the property was your main home, you may be able to exclude part or all of the gain. See Sale of Your Home, later.

Form 6252

Use Form 6252 to report an installment sale in the year it takes place and to report payments received, or considered received because of related party resales, in later years. Attach it to your tax return for each year.

Form 6252 will help you determine the gross profit, contract price, gross profit percentage, and installment sale income.

Which parts to complete. Which part to complete depends on whether you are filing the form for the year of sale or a later year.

Year of sale. Complete lines 1 through 4, Part I, and Part II. If you sold property to a related party during the year, complete Part III.

Later years. Complete lines 1 through 4 and Part II for any year in which you receive a payment from an installment sale.

If you sold a marketable security to a related party after May 14, 1980, and before January 1, 1987, complete Form 6252 for each year of the installment agreement, even if you did not receive a payment. (After December 31, 1986, the installment method is not available for the sale of marketable securities.) Complete lines 1 through 4. Complete Part II for any year in which you receive a payment from the sale. Complete Part III unless you received the final payment during the tax year.

If you sold property other than a marketable security to a related party after May 14, 1980, complete Form 6252 for the year of sale and for 2 years after the year of sale, even if you did not receive a payment. Complete lines 1 through 4. Complete Part II for any year during this 2-year period in which you receive a payment from the sale. Complete Part III for the 2 years after the year of sale unless you received the final payment during the tax year.

Schedule D (Form 1040)

Enter the gain figured on Form 6252 (line 26) for personal-use property (capital assets) on Schedule D (Form 1040), Capital Gains and Losses, as a short-term gain (line 4) or long-term gain (line 11). If your gain from the installment sale qualifies for long-term capital gain treatment in the year of sale, it will continue to qualify in later tax years. Your gain is long-term if you owned the property for more than 1 year when you sold it.

Form 4797

An installment sale of property used in your business or that earns rent or royalty income may result in a capital gain, an ordinary gain, or both. All or part of any gain from the disposition of the property may be ordinary gain from depreciation recapture. For trade or business property held for more than 1 year, enter the amount from line 26 of Form 6252 on Form 4797, line 4. If the property was held 1 year or less or you have an ordinary gain from the sale of a noncapital asset (even if the holding period is more than 1 year), enter this amount on Form 4797, line 10, and write “From Form 6252.”

Sale of Your Home

If you sell your home, you may be able to exclude all or part of the gain on the sale. See Publication 523, for information about excluding the gain. If the sale is an installment sale, any gain you exclude is not included in gross profit when figuring your gross profit percentage.

Seller-financed mortgage. If you finance the sale of your home to an individual, both you and the buyer may have to follow special reporting procedures.

When you report interest income received from a buyer who uses the property as a personal residence, write the buyer's name, address, and social security number (SSN) on line 1 of Schedule B (Form 1040) or Schedule 1 (Form 1040A).

When deducting the mortgage interest, the buyer must write your name, address, and SSN on line 11 of Schedule A (Form 1040).

If either person fails to include the other person's SSN, a $50 penalty will be assessed.

Other Rules

The rules discussed in this part of the publication apply only in certain circumstances or to certain types of property. The following topics are discussed.

Electing out of the installment method.
Payments received or considered received.
Escrow account.
Depreciation recapture income.
Sale to a related person.
Like-kind exchange.
Contingent payment sale.
Single sale of several assets.
Sale of a business.
Unstated interest and original issue discount.
Disposition of an installment obligation.
Repossession.
Interest on deferred tax.

Electing Out of the Installment Method

If you elect not to use the installment method, you generally report the entire gain in the year of sale, even though you do not receive all the sale proceeds in that year.

To figure the amount of gain to report, use the fair market value (FMV) of the buyer's installment obligation that represents the buyer's debt to you. Notes, mortgages, and land contracts are examples of obligations that are included at FMV.

You must figure the FMV of the buyer's installment obligation, whether or not you would actually be able to sell it. If you use the cash method of accounting, the FMV of the obligation will never be considered to be less than the FMV of the property sold (minus any other consideration received).

Example.

You sold a parcel of land for $50,000. You received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8% interest. The buyer gave you a note for $40,000. The note had an FMV of $40,000. You paid a commission of 6%, or $3,000, to a broker for negotiating the sale. The land cost $25,000 and you owned it for more than one year. You decide to elect out of the installment method and report the entire gain in the year of sale.

Gain realized:
Selling price			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain realized			$22,000
Gain recognized in year of sale:
Cash			$10,000
Market value of note			40,000
Total realized in year of sale			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain recognized			$22,000

The recognized gain of $22,000 is long-term capital gain. You include the entire gain in income in the year of sale, so you do not include in income any principal payments you receive in later tax years. The interest on the note is ordinary income and is reported as interest income each year.

How to elect out. To make this election, do not report your sale on Form 6252. Instead, report it on Schedule D (Form 1040) or Form 4797, whichever applies.

When to elect out. Make this election by the due date, including extensions, for filing your tax return for the year the sale takes place.

Automatic six-month extension. If you timely file your tax return without making the election, you still can make the election by filing an amended return within 6 months of the due date of your return (excluding extensions). Write “Filed pursuant to section 301.9100-2” at the top of the amended return and file it where the original return was filed.

Revoking the election. Once made, the election can be revoked only with IRS approval. A revocation is retroactive. You will not be allowed to revoke the election if either of the following applies.

One of the purposes is to avoid federal income tax.
The tax year in which any payment was received has closed.

Payments Received or Considered Received

You must figure your gain each year on the payments you receive, or are treated as receiving, from an installment sale.

In certain situations, you are considered to have received a payment, even though the buyer does not pay you directly. These situations occur when the buyer assumes or pays any of your debts, such as a loan, or pays any of your expenses, such as a sales commission. However, as discussed later, the buyer's assumption of your debt is treated as a recovery of your basis rather than as a payment in many cases.

Buyer Pays Seller's Expenses

If the buyer pays any of your expenses related to the sale of your property, it is considered a payment to you in the year of sale. Include these expenses in the selling and contract prices when figuring the gross profit percentage.

Buyer Assumes Mortgage

If the buyer assumes or pays off your mortgage, or otherwise takes the property subject to the mortgage, the following rules apply.

Mortgage less than basis. If the buyer assumes a mortgage that is not more than your installment sale basis in the property, it is not considered a payment to you. It is considered a recovery of your basis. The contract price is the selling price minus the mortgage.

Example.

You sell property with an adjusted basis of $19,000. You have selling expenses of $1,000. The buyer assumes your existing mortgage of $15,000 and agrees to pay you $10,000 (a cash down payment of $2,000 and $2,000 (plus 12% interest) in each of the next 4 years).

The selling price is $25,000 ($15,000 + $10,000). Your gross profit is $5,000 ($25,000 - $20,000 installment sale basis). The contract price is $10,000 ($25,000 - $15,000 mortgage). Your gross profit percentage is 50% ($5,000 ÷ $10,000). You report half of each $2,000 payment received as gain from the sale. You also report all interest you receive as ordinary income.

Mortgage more than basis. If the buyer assumes a mortgage that is more than your installment sale basis in the property, you recover your entire basis. The part of the mortgage greater than your basis is treated as a payment received in the year of sale.

To figure the contract price, subtract the mortgage from the selling price. This is the total amount you will receive directly from the buyer. Add to this amount the payment you are considered to have received (the difference between the mortgage and your installment sale basis). The contract price is then the same as your gross profit from the sale.

If the mortgage the buyer assumes is equal to or more than your installment sale basis, the gross profit percentage always will be 100%.

Example.

The selling price for your property is $9,000. The buyer will pay you $1,000 annually (plus 8% interest) over the next 3 years and assume an existing mortgage of $6,000. Your adjusted basis in the property is $4,400. You have selling expenses of $600, for a total installment sale basis of $5,000. The part of the mortgage that is more than your installment sale basis is $1,000 ($6,000 - $5,000). This amount is included in the contract price and treated as a payment received in the year of sale. The contract price is $4,000:

Selling price		$9,000
Minus: Mortgage		(6,000)
Amount actually received		$3,000
Add difference:
Mortgage	$6,000
Minus: Installment sale basis	5,000	1,000
Contract price		$4,000

Your gross profit on the sale is also $4,000:

Selling price	$9,000
Minus: Installment sale basis	(5,000)
Gross profit	$4,000

Your gross profit percentage is 100%. Report 100% of each payment (less interest) as gain from the sale. Treat the $1,000 difference between the mortgage and your installment sale basis as a payment and report 100% of it as gain in the year of sale.

Mortgage Canceled

If the buyer of your property is the person who holds the mortgage on it, your debt is canceled, not assumed. You are considered to receive a payment equal to the outstanding canceled debt.

Example.

Mary Jones loaned you $45,000 in 2003 in exchange for a note mortgaging a tract of land you owned. On April 4, 2007, she bought the land for $70,000. At that time, $30,000 of her loan to you was outstanding. She agreed to forgive this $30,000 debt and to pay you $20,000 (plus interest) on August 1, 2007, and $20,000 on August 1, 2008. She did not assume an existing mortgage. She canceled the $30,000 debt you owed her. You are considered to have received a $30,000 payment at the time of the sale.

Buyer Assumes Other Debts

If the buyer assumes any other debts, such as a loan or back taxes, it may be considered a payment to you in the year of sale.

If the buyer assumes the debt instead of paying it off, only part of it may have to be treated as a payment. Compare the debt to your installment sale basis in the property being sold. If the debt is less than your installment sale basis, none of it is treated as a payment. If it is more, only the difference is treated as a payment. If the buyer assumes more than one debt, any part of the total that is more than your installment sale basis is considered a payment. These rules are the same as the rules discussed earlier under Buyer Assumes Mortgage. However, they apply only to the following types of debt the buyer assumes.

Those acquired from ownership of the property you are selling, such as a mortgage, lien, overdue interest, or back taxes.
Those acquired in the ordinary course of your business, such as a balance due for inventory you purchased.

If the buyer assumes any other type of debt, such as a personal loan or your legal fees relating to the sale, it is treated as if the buyer had paid off the debt at the time of the sale. The value of the assumed debt is then considered a payment to you in the year of sale.

Property Used As a Payment

If you receive property rather than money from the buyer, it is still considered a payment in the year received. However, see Like-Kind Exchange, later.

Generally, the amount of the payment is the property's FMV on the date you receive it.

Exception. If the property the buyer gives you is payable on demand or readily tradable, the amount you should consider as payment in the year received is:

The FMV of the property on the date you receive it if you use the cash receipts and disbursements method of accounting,
The face amount of the obligation on the date you receive it if you use the accrual method of accounting, or
The stated redemption price at maturity less any original issue discount (OID) or, if there is no OID, the stated redemption price at maturity appropriately discounted to reflect total unstated interest. See Unstated Interest and Original Issue Discount (OID), later.

Debt not payable on demand. Any evidence of debt you receive from the buyer that is not payable on demand is not considered a payment. This is true even if the debt is guaranteed by a third party, including a government agency.

Fair market value (FMV). This is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of all the necessary facts.

Third-party note. If the property the buyer gives you is a third-party note (or other obligation of a third party), you are considered to have received a payment equal to the note's FMV. Because the FMV of the note is itself a payment on your installment sale, any payments you later receive from the third party are not considered payments on the sale. The excess of the note's face value over its FMV is interest. Exclude this interest in determining the selling price of the property. However, see Exception under Property Used As a Payment, earlier.

Example.

You sold real estate in an installment sale. As part of the down payment, the buyer assigned to you a $50,000, 8% interest third-party note. The FMV of the third-party note at the time of the sale was $30,000. This amount, not $50,000, is a payment to you in the year of sale. The third-party note had an FMV equal to 60% of its face value ($30,000 ÷ $50,000), so 60% of each principal payment you receive on this note is a nontaxable return of capital. The remaining 40% is interest taxed as ordinary income.

Bond. A bond or other evidence of debt you receive from the buyer that is payable on demand or readily tradable in an established securities market is treated as a payment in the year you receive it. For more information on the amount you should treat as a payment, see Exception under Property Used As a Payment, earlier.

If you receive a government or corporate bond for a sale before October 22, 2004, and the bond has interest coupons attached or can be readily traded in an established securities market, you are considered to have received payment equal to the bond's FMV. However, see Exception, earlier.

Buyer's note. The buyer's note (unless payable on demand) is not considered payment on the sale. However, its full face value is included when figuring the selling price and the contract price. Payments you receive on the note are used to figure your gain in the year received.

Installment Obligation Used as Security (Pledge Rule)

If you use an installment obligation to secure any debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is known as the pledge rule and it applies if the selling price of the property is over $150,000. It does not apply to the following dispositions.

Sales of property used or produced in farming.
Sales of personal-use property.
Qualifying sales of time-shares and residential lots.

The net debt proceeds are the gross debt minus the direct expenses of getting the debt. The amount treated as a payment is considered received on the later of the following dates.

The date the debt becomes secured.
The date you receive the debt proceeds.

A debt is secured by an installment obligation to the extent that payment of principal or interest on the debt is directly secured (under the terms of the loan or any underlying arrangement) by any interest in the installment obligation. For sales after December 16, 1999, payment on a debt is treated as directly secured by an interest in an installment obligation to the extent an arrangement allows you to satisfy all or part of the debt with the installment obligation.

Limit. The net debt proceeds treated as a payment on the pledged installment obligation cannot be more than the excess of item (1) over item (2), below.

The total contract price on the installment sale.
Any payments received on the installment obligation before the date the net debt proceeds are treated as a payment.

Installment payments. The pledge rule accelerates the reporting of the installment obligation payments. Do not report payments received on the obligation after it has been pledged until the payments received exceed the amount reported under the pledge rule.

Exception. The pledge rule does not apply to pledges made after December 17, 1987, to refinance a debt under the following circumstances.

The debt was outstanding on December 17, 1987.
The debt was secured by that installment sale obligation on that date and at all times thereafter until the refinancing occurred.

A refinancing as a result of the creditor's calling of the debt is treated as a continuation of the original debt so long as a person other than the creditor or a person related to the creditor provides the refinancing.

This exception applies only to refinancing that does not exceed the principal of the original debt immediately before the refinancing. Any excess is treated as a payment on the installment obligation.

Escrow Account

In some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These sales cannot be reported on the installment method. The buyer's obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, you no longer rely on the buyer for the rest of the payments, but on the escrow arrangement.

Example.

You sell property for $100,000. The sales agreement calls for a down payment of $10,000 and payment of $15,000 in each of the next 6 years to be made from an irrevocable escrow account containing the balance of the purchase price plus interest. You cannot report the sale on the installment method because the full purchase price is considered received in the year of sale. You report the entire gain in the year of sale.

Escrow established in a later year. If you make an installment sale and in a later year an irrevocable escrow account is established to pay the remaining installments plus interest,