Starczewski (2004) posits that: “an installment sale is a disposition of property in which one or more payments are received by the seller after the close of the taxable year in which the sale occurs”. The gain from an installment sale is reported (at least in substantial part) in a year other than the year in which the sale took place. This is done because at least one payment by the customer will be received after the tax year in which the sale occurs, and it would be harsh to tax the seller on revenue not received.
Two methods of recognizing the gain from an installment sale are Installment (Sales) Method and Cost Recovery Method. In the installment sales method, income on an installment sale is recognized when each payment is received from the customer. A portion of the gross profit on the sale and the gain is recognized, based on the gross profit percentage in the year of the sale. The reason for this procedure is simple. It is done so that by the time the customer makes the final payment, the entire gross profit is recorded.
The second and more conservative approach is the Cost Recovery Method. In this method of revenue recognition, no gross profit is recorded until the complete cost of the goods has been recovered. This means that the initial payments by customers are classified as a recovery of the cost of the goods sold to the customers. One the complete cost of the goods have been recovered, the remaining payments by the customer are recorded as gross profit. This method is used because of the uncertainty of complete collection of the price of the goods.
In calculating gain from an installment sale, the seller’s adjusted basis is subtracted from the sale price of the goods. This results in the seller’s gross profit. Under the installment sale method, the taxpayer’s gain is seen as equal to the amount of payments received during the taxable year multiplied by the ratio of the profit to the total contract price.
- Starczewski, L. 2004. Installment Sales. Volume 565 of Tax Management Portfolios.