The default runs the other way
Where property is sold and at least one payment is received after the close of the year of sale, the installment method applies automatically. Gain is reported as payments are received, in proportion to the gross profit on the sale.
A seller who wants the whole gain in the year of sale must elect out, on a timely filed return for that year. The election is generally irrevocable, and permission to revoke is not readily given.
Why a seller would decline deferral
Deferral is not free and is not always advantageous.
- 01Rates. Recognizing into a year in which rates are expected to rise, or into several years in which the seller's other income will be higher, can cost more than the deferral is worth.
- 02Losses about to expire. A seller with capital loss carryforwards, or a large current-year loss, may want the gain now while there is something to absorb it.
- 03A one-year window. Where the seller has an unusually low-income year, taking the gain into it may run through lower brackets that will not be available later.
- 04Collection risk. Deferral assumes the buyer pays. If the buyer defaults, the seller has a repossession and a mess, and may have deferred tax on money never received.
- 05Simplicity. An installment obligation is an asset to be administered, valued, and dealt with on death or divorce for as long as it runs.
What does not defer
Three features of the rules regularly produce a tax bill larger than the cash received in the year of sale.
| Item | Treatment |
|---|---|
| Depreciation recapture | Recognized in full in the year of sale, regardless of payments received. On a heavily depreciated asset this can exceed the entire first-year payment |
| Inventory and dealer property | Ineligible for the method entirely |
| The interest charge | Where the sale price exceeds a statutory threshold and the seller holds installment obligations above a further threshold at year end, an interest charge is imposed on the deferred tax. Deferral stops being free |
Pledging, and other ways to accelerate by accident
An installment obligation used as security for a borrowing can cause the proceeds of that borrowing to be treated as a payment on the obligation, accelerating gain. A seller who defers tax and then borrows against the note has, in substance, received the money, and the rules say so.
Disposition of the obligation itself, including by gift, generally accelerates the remaining gain. Transferring the note as part of an estate plan is therefore a transaction with an income tax consequence attached, and it is one of the more common ways a well-intentioned gift produces an unexpected bill.
Where the decision belongs in the sequence
The election is made on the return for the year of sale, which makes it feel like a filing decision. It is not. The deal terms determine what the election is worth, and the deal terms are set months earlier.
Payment schedule, allocation of purchase price among asset classes, whether an escrow or earn-out is contingent, and whether the seller will need to borrow against the note are all negotiated before signing and all change the answer. Modeling them afterwards is an exercise in describing a decision that has already been made.
General information only. This article describes law and practice as we understand them at the time of writing. It is not tax, legal, accounting, or investment advice, it does not consider your circumstances, and it does not create an advisor-client or attorney-client relationship. Odyssey Strategic Advisors LLC is not a law firm and is not a CPA firm. Confirm any position with your own tax professional before acting on it. See our disclosures.