The installment sale method offers a beneficial way to defer income tax on gains from the sale of property by spreading tax payments over the period during which sales proceeds are received. However, not all gains or types of sales qualify for this deferral. Specific exclusions apply, requiring immediate recognition of certain income regardless of the payment schedule.
The items and transactions that cannot be deferred using the installment sale method primarily include:
Key Exclusions from the Installment Sale Method
The ability to defer income tax on a gain by spreading it over the period payments are received is not universally applicable. Several types of gains and sales are explicitly excluded from using this method, meaning the entire gain must be recognized in the year of the sale, regardless of when cash payments are received.
Gains on Certain Ordinary Income Items
- Inventory Gains: Any gain derived from the sale of inventory—property held primarily for sale to customers in the ordinary course of a trade or business—cannot be deferred using the installment method. These gains are treated as ordinary business income and are recognized in the year of the sale.
- Depreciation Recapture: When depreciable property is sold, the portion of the gain that represents previously deducted depreciation (often referred to as Section 1245 or Section 1250 recapture) must be recognized in the year of the sale. This specific part of the gain cannot be spread out over the installment period, even if other portions of the gain qualify for deferral.
- Amortization Recapture: Similar to depreciation, gains related to previously amortized amounts on certain assets are also subject to immediate recognition and are not eligible for installment method deferral.
- Other Ordinary Income Items: Beyond depreciation and amortization, any other gain classified as ordinary income, as opposed to capital gain, generally does not qualify for installment sale deferral and must be recognized in the year of the sale.
Sales by Dealers
- Dealers of Real or Personal Property: Businesses that are considered dealers—meaning their ordinary course of trade involves selling real or personal property (e.g., a real estate developer selling homes, or a car dealership)—are generally prohibited from using the installment method for their sales. Their gains are recognized when the sale occurs, reflecting the regular nature of their business operations.
Sales at a Loss
- No Deferral for Losses: The installment sale method is exclusively designed to defer the recognition of gains. If a sale results in a loss rather than a gain, the installment method does not apply. Losses are typically recognized in full in the year they are incurred, subject to other tax rules regarding loss deductibility.
Summary of Non-Deferrable Items
To provide a clear overview, here’s a table summarizing the types of income or sales that are not eligible for deferral under the installment sale method:
| Item Not Eligible for Installment Sale Deferral | Reason for Exclusion |
|---|---|
| Gains on Inventory | Considered ordinary business income; must be recognized immediately |
| Depreciation Recapture | Immediate recognition required for prior tax benefits |
| Amortization Recapture | Immediate recognition required for prior tax benefits |
| Other Ordinary Income Items | Generally treated as current income, not deferrable |
| Sales by Real/Personal Property Dealers | Part of ordinary business operations; not eligible |
| Sales at a Loss | Method applies only to gains, not losses |
Practical Implications of These Exclusions
For sellers considering an installment sale, it is critical to understand these exclusions. For example, if a business sells a piece of machinery for an installment note, the portion of the gain attributable to depreciation recapture must be recognized immediately in the year of sale, even if no cash payment has been received for that portion. Only the remaining capital gain, if any, can be deferred. Understanding these specific rules is essential for accurate tax planning and avoiding unexpected tax liabilities in the year of the sale.
