What Is an Installment Sale?
An installment sale is one of several possible approaches to revenue recognition under the rules of Generally Accepted Accounting Principles (GAAP). More specifically, this method accounts for when revenue and expense are recognized at the time of cash collection rather than at the time of sale. Based on GAAP, this is the principal method of revenue recognition when the recognition occurs subsequently to a sale.
Key Takeaways
- An installment sale is a form of revenue recognition where revenue and expenses are recognized at the time of cash exchange.
- Installment sales require the buyer to make regular payments—i.e. installments.
- This method is useful for taxpayers looking to defer capital gains to future years.
- These types of sales are common with real estate.
How an Installment Sale Works
An installment method allows for the partial deferral of any capital gain to future taxation years. Installment sales require the buyer to make regular payments, or installments, on an annual basis, plus interest if installment payments are to be made in subsequent taxation years.
Benefits of an Installment Sale
An installment sale can help keep sellers keep their income within a desired tax bracket by spreading out their income. These sales can also keep capital gains in a lower tax bracket. Installment sales can also help individuals either lower or avoid higher Medicare Part B premium, net investment income taxes, or alternative minimum taxes.
These types of sales can also help prevent Social Security benefits from being taxed by keeping income lower. The benefits of not recognizing the entire sale can also help ensure an individual can still take the full amount of student loan interest deduction, itemize deductions, or take other deductions that are limited by income.
Requirements for an Installments Sale
Installment sales are useful for lowering capital gains taxes, where the income can be delayed until they are taxed at lower rates. However, there are two requirements for an installment sale. The first is that if an asset is sold and payments will be made over time that at least one payment be received a year after the tax year of the sale. The second is that the installment sale is recorded on Form 6252.
An installment sale cannot be used when the property or asset is sold at a loss or if the personal property or real property is sold by dealers. Installment sales cannot be used for inventory that is sold during the normal course of business. As well, the sale of stocks or other investment securities cannot be used for an installment sale.
Example of Installment Sale
Installment sales are common in the real estate market but are restricted to individual buyers and sellers. Dealers are prohibited from using the installment method of income reporting. Payers on installment sales with a deferred aggregate sales total above $5 million (for the individual sale of homes, over $150,000) will be required to include interest on the installment sales.
When it comes to selling real estate, an installment sale is best used for properties with no mortgages and when the seller is willing to finance the buyer’s purchase. This creates a steady stream of income over a number of years for the seller and allows the sale to be taxed over years and not immediately upon sale. An installment sale is also useful in the case of selling major business assets or businesses.
If you are looking to improve your cash flow and are searching for a method to defer capital gains to the future tax years, then adopting the installment sale method can do the trick for you. Moreover, the capacity to recognize income effectively is critical to a company's financial success. When you let your customer make
the payment over a pre-agreed period of time, instead of receiving the full payment at the time of the purchase, the sale is termed installment sale. In this post, we shall be closely looking at the different aspects associated with the installment sale, which are as follows: An installment sale is a kind of revenue recognition adopted by the sellers in which they permit the buyer to make payments in installments over a stipulated period of time without transferring the full benefits at the time of the sale. This method enables
the seller or supplier to recognize the revenue and expense while collecting cash rather than at the time of sale. A partial postponement of any capital gain to future taxation years is done using the installment approach. The installment sale method necessitates the purchasers to
make payments as agreed upon and pay the interests if the payments are paid in consecutive taxation years. Installment sales can help you save money on capital gains taxes by deferring the income until it is taxed at a reduced rate. However, it is important to note the two conditions while using it. When a product or asset is sold at a loss, an installment sale cannot be employed. In addition, the sale of stocks or other financial assets also cannot be used applying the installment sale method. Although the use of the installment sale method is quite usual, it is still restricted to a select few individual buyers and dealers. The real estate industry is a field where the buyer may not have to pay entire amount upfront and therefore, the installment sale works well here. In real estate, an installment sale works best for properties that don't have any mortgages and where the
seller is ready to fund the buyer's purchase. This provides the seller with a consistent stream of income over time and permits the sale to be taxed over time rather than immediately upon sale. Following are the benefits of using the Installment sale method: The disadvantages of the installment sale method are: Here are the steps you can follow to complete accounting for an installation sale: Separate records for installment sales You can start by keeping a track of installment sales separately from other types of sales. The receivables associated with an installment sale should be recorded, sorted by the year that they were created. Keep track of
cash receipts Every time you receive cash in connection with an installment sale, you should keep track of that deal against which you received it. Shift Sales Revenue Each Year Every year, you should move the revenue from installment sales and the cost of sales into the deferred gross profit account. Estimate Gross Profit For all installment sales that occur during that fiscal year, calculate the gross profit rate. Apply
the Gross Profit RateWhat is an Installment Sale?
Prerequisites to Installment Sale
Installment Method Use in Real Estate Sector
Advantages of Installment Sale Method
Disadvantages of Installment Sale Method
How to Account for an Installment Sale Transaction?
All cash receipts that relate to installment sales from previous periods should be applied to your gross profit rate from previous years. Add the result to your gross profit.
Deferred Gross Profit Carryforward
At the end of the year, carry forward any deferred gross profit. Once you receive payment for it from the buyer, you'll need to recognize and record it.
Installment Sale Example
Let’s assume a company ABC, a manufacturer of wooden art work, sells a product at the price of $10,000 in the month of January. The cost to the company for the furniture is $4,000. The gross margin, therefore, comes out to be 60%. In the deal, the customer is required to pay a monthly installment payment of $2,500. They must pay the installments until the amount has been covered entirely.
Sale | Payment | Payment | Payment | Payment |
Cash owed $10,000 | Cash paid $2,500 | Cash paid $2,500 | Cash paid $2,500 | Cash paid $2,500 |
Deferred GP $6,000 | GP $1,500 | GP $1,500 | GP $1,500 | GP $1,500 |
Inventory $4,000 | COGS $1,000 | COGS $1,000 | COGS $1,000 | COGS $1,000 |
The journal entries for the above deal are:
Date | Debit | Credit | |
January 31 | Accounts Receivables (installments) | $10,000 | |
Inventory | $4,000 | ||
Deferred Gross Profit | $6,000 |
Journal entries for the initial payments are as above. The gross profit will be 60% of $10,000, and the remnant 40% will be the COGS (Cost Of Goods Sold).
Date | Debit | Credit | |
February 29 | Cash | $2,500 | |
Accounts Receivables (installments) | $2,500 | ||
February 29 | Deferred Gross Profit (60% x $2500) | $1,500 | |
COGS (40% x $2,500) | $1,000 | ||
Sales Revenue | $2,500 |
These are the journal entries for the installments paid, and revenue recognized. The journal entries for the months of March, April, and May will be similar to the ones shown in the above table.
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Key Takeaways
Revenue recognition is essential and integral to estimating the financial progress of any business. Let us also look at the other points discussed in the post:
- Installment sale is a type of revenue recognition method in which the buyer is allowed to make the payment for an extended period of stipulate time
- Revenue and expense are recognized at the time of cash collection rather than at the time of sale in the installment sale method
- An installment sale is used when the control or ownership is not entirely transferred at the time of sale
- An installment sale is used when the control or ownership is not entirely transferred at the time of sale and there is a lot of ambiguity in the collection of cash
- The installment sale method is very commonly applied in the real estate sector but only a few individual dealers and buyers are allowed to use it
- This strategy is beneficial for taxpayers who want to postpone capital gains to later years
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