The 2023 federal tax deadline is April 18 for most of the United States and U.S. territories. Some states (most of California and parts of Alabama and Georgia) have a longer deadline, due to natural disasters impacting those areas.
Whether you must file taxes in mid-April or have until mid-October, if you participated in an installment sale in 2022, it’s important to know what will—or will not—be taxed.
Defining an Installment Sale
Let’s say you sell a property. But rather than accepting the full sales price in one lump sum, you agree that the buyer can pay what is owed, over a period of time. The IRS classifies this as an installment sale if you receive at least one payment after the tax year during which that property sale occurs.
But you and the buyer just can’t suddenly decide that a transaction will become an installment sale. An installment sale agreement must be signed by both. Also keep in mind certain property types aren’t eligible for installment sales. These include publicly traded securities.
How an Installment Sale is Taxed
One advantage of an installment sale is that you only report the gain you receive. Not the whole price. Let’s say you sell a duplex for $5 million in a tax year. You and the buyer agree you’ll receive $3 million during the following year (and $2 million the year after that). In most cases, you pay taxes only on that $3 million received.
You need to file Form 6252—Installment Sale Income—to report what you earn from an installment sale. Form 6252 must be filed for each year when you are paid.
Now comes the question about how an installment sale must be taxed. Both the capital gains and ordinary income rates come into play with this type of sale.
First you need to determine whether you held the property over the short-term (less than a year) or long-term (one year or longer). Any gain earned on a short-term hold will be taxed as ordinary income. If you held that property for a year or longer, you’d pay a capital gain tax.
Second, any interest income you receive from the buyer from an installment sale is taxed at the ordinary income tax rate.
And finally, if you are selling a depreciable asset (like residential or commercial real estate), you’ll also need to pay depreciation recapture in the year of the sale.
Ensuring the Right Paperwork
Installment sales can be useful as a potential deferred tax strategy. But it’s important to understand what needs to be filed with your Form 1040 to properly report that sale. You also need to know what you owe to the IRS. Because of the tax intricacies involved with an installment sale, be sure to consult with your tax professional before filing.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.