Selling an asset can be taxing and sometime you run into problems when you sell an asset and you don’t collect all of the money at once. Let’s look at an extreme example. You have a building that’s worth $1 million but you’ve owned it for so long that it’s fully depreciated so if you sell if for $1 million, you’re going to have quite the gain. Since it’s a long term capital asset and you sell it by the end of this year, your gain would be 15%, or $150,000. You had a hard time finding a buyer and the one you finally found is cash strapped and they put 10% down and you seller-finance the rest. The problem here is, your tax ($150,000) is actually more then the cash you received ($100,000) so you’re left with a shortfall.
That’s where the installment sale rules come in. You can elect to report your gain on an installment basis if you expect payments in a tax year after the year of sale. This is done on Form 6252 and the first thing you need to do is compute the gross profit percentage. In our example, since there’s no longer any depreciable basis, the gross profit percentage is easy because it’s 100%. That means whenever you collect principal payments, you pay tax on 100% of the amount received. In our example, the down payment would result in a $100,000 or $15,000 in tax (assuming this year). If you collected $50,000 in principal next year, that would be your gain in that year and so on until the note is paid off.
One interesting quirk this year is capital gains are expected to go up in 2013 so you might want to actually pay the tax on the entire amount rather than wait and potentially pay a higher tax rate in the future. The good news is, you elect the installment method when you file your return so you could potentially put off the decision until you have a better handle on what tax rates will be.