If you've put up a big property up for sale, the chances are quite high that you're not going to receive one giant lump-sum for it. So why pay tax on money which you do not receive when you put your property for sale?
Accounting by Installment Sales
Most common instances of installment sales can be seen where large sums of money are involved. Real estate deals generally follow the method as it happens to be a win-win situation for both parties involved in this transaction. The buyer gets the keys to the property and has his expenditure broken up into easy annual installments, while the seller gets his total tax liability deferred to the number of years over which the sale is carried out.
There is one basic requirement for a sale to qualify under the method. Basically, for a sale to be an installment sale, it needs to have at least one installment to be paid in the next tax year. So if you have an agreement where your buyer pays a fixed installment each year for say, the next 5 years, only then does it count as an installment sale. The method cannot be applied if all the installments are paid within a year.
The installment sales method starts with the agreement of sale. First, the seller and buyer agree to transfer the property and also that the seller will be compensated in equal installments. Of course, for the seller's magnanimity of letting the buyer pay in installments, he will also charge an interest to the total amount payable. With that deal done, the buyer will possess the property and continue to make the yearly payments to the seller.
In the sellers books of accounting, instead of recording the complete sale, he will account for each individual installment. Thus, the amount received as income, as can be seen in his books, is a lot lesser than it would be, had he recorded the entire sale amount. Hence since his income is lesser, so is his tax liability. In this way, the seller by using the method, ensures that he doesn't have to pay tax for the money he hasn't yet received.
Benefits of Installment Sales
The benefit of installment sale to the buyer is sufficiently clear. Instead of having to break the bank to pay for the property all at once, the buyer can pay in easy, annual installments. This financial agreement ensures that he doesn't have to resort to debt financing and loans, and gets him out of that whole muddle.
By recording the transaction as under the method, the seller defers the tax liability and spreads it out over the years. Let me explain this with the help of an example.Suppose that the buyer and seller agree on $100,000 to be paid over 5 years for the property. The amount also includes the interest which the seller demands. Now if the seller recorded the transaction as a lump-sum of $100,000, his tax would swell by that much amount, and hence he would have to pay a higher rate of tax. But why should the seller pay the higher rate of tax when each year, he only receives $100,000/5 = $20,000? This is where recording this transaction with the installment sales comes in pretty handy. This way, the seller can only record an annual income of $20,000 and pay the required tax on it.
The installment sales ensures that the seller receives the money for his property in equal installments including the interest component, while the buyer can pay lesser in the form of installments than what he would have to otherwise. Hence it is a popular part of the sales agreement especially when it comes to property deals.