Installment Sale

It is an approach seller in different markets take to minimize taxes on capital gains made from sales transactions in a specific year. 

Author: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Reviewed By: Christopher Haynes
Christopher Haynes
Christopher Haynes
Asset Management | Investment Banking

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds asset management firm with $20 billion under management, and as an investment banking analyst in SunTrust Robinson Humphrey's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Last Updated:October 10, 2023

What Is An Installment Sale?

An installment sale is a method where sellers spread revenue and expenses over multiple years, minimizing taxes on capital gains and offering flexibility, faster sales, and security to buyers.

For many of us, this term could mean the repayment of what we bought via an installment plan. How about its meaning from a business point of view? What value do businesses gain from selling their products or assets through an installment plan or model? Is the value merely gained from attracting more customers?

Selling or offering products and services through installment plans benefits buyers and sellers. For the buyers, it is the ease of acquiring products and services, and it also makes them less pressured to pay for high-priced products through their installment plan.

On the other hand, we have the sellers, who have many factors to consider when they offer their assets, products, or services through installment plans.

For instance, they need to worry about the value of the money returned at a different period, the possibility of defaults, and many other factors that could severely threaten their businesses.

The installment sale we will cover in this article will explore the term from the seller's point of view and the possible value to be gained. In addition, we will explore its meaning, correlation with capital, taxation, and future income taxation. All these factors exist at the core of the installment sale approach.

Key Takeaways

  • An installment sale is a method where sellers spread revenue and expenses over years, minimizing capital gains taxes and offering flexibility, faster sales, and security to buyers.
  • Installment sale plans offer ease of acquisition, reducing pressure on buyers to pay high prices upfront.
  • Sellers must navigate various factors like delayed revenue, defaults, and market fluctuations, requiring strategic planning for successful installment sales.
  • Installment sales provide flexibility, faster transactions, lower tax brackets, secure investments, and facilitate easier sales at desired prices.
  • Businesses, including startups, can benefit from this approach amid market fluctuations.

Understanding an installment sale

Simply, it is an approach taken by sellers in different markets to minimize taxes on capital gains made from sales transactions in a specific year.

The gains will be realized through an installment plan, where expenses and revenue will only be recognized in the year of repayment rather than the year of the sale.

This approach will allow buyers to purchase assets like real estate on a structured installment plan, allowing more buyers to enter the real estate market while directly benefiting sellers,  as they will now pay fewer taxes on capital gains from selling property, for instance.

This structure of selling products or assets is a form of "revenue recognition." Therefore, it also lies under the Generally accepted accounting principles (G.A.A.P) rules.

As we briefly stated, this approach allows revenue and expenses to be recognized at the time of cash collection rather than at the time of sale.

This approach has many benefits for sellers. For instance, it provides their products with a flexibility element for the buyers to acquire them and enables them to obtain a faster sale rate, lower tax bracket, high-interest income, and an easy sale for a top price.

These valuable elements will all reflect positively on the seller's financial statements

An installment sale sells assets or products to buyers through a structured payment plan. This will provide market entry value to buyers, and low taxation on capital gains value to sellers.

How an Installment Sale Works

Your taxable gains, which you have made during a specific operational year of your business, are divided over a couple of years, falling under the installment sale approach.

These gains are calculated once (gross sales without cost of goods sold minus cost basis minus selling expenses) and translated as a gross profit percentage.

The percentage resulting from this equation is then applied to each repayment as it is collected. Gains are added to income yearly at which the product or asset seller contains a payment from the buyer. 

Moreover, the buyer pays interest to compensate the seller for the installment service or waiting period. Later, taxes applied to the seller would not be high or related to high bracket taxation. 

Gains, on the other hand, will be taxed at either short-term or long-term rates, depending on a variety of criteria, such as whether the asset was held for one year or less (short-term) or more than one year (long-term) (long-term).

This selling and tax reduction on capital gains approach has extra steps that require completion when a deal is conducted. The seller must ensure that the transaction will be within the installment guidelines and make a decision regarding the payment of taxes.

The taxation options will be whether you desire to pay the taxes on the payments once they are received or pay the total amount of taxes once the whole sum of cash is collected. This is called "electing out" of the installment sale.

Benefits of an Installment Sale

Some of the benefits are:

1. Flexibility

Usually, this sale approach is initiated between a traditional loaning entity and a buyer, but this approach can be formed between the seller and the buyer directly. 
The terms of this transaction can be arranged directly by the seller and the buyer, maximizing benefits for both sides of this sale approach.

Lawyers of both parties (seller/buyer) will assist them in conducting this transaction. However, it will still have to be more flexible than when shown through a traditional financial or a lending entity like a bank, which will need to find its interest in this deal.

For example, a bank might not be allowed to provide a loan to a buyer if a property inspector discovers a specific fault in the property to be bought or if their analysts determine that the property will not be a sound investment decision.

However, by using this strategy, both parties, the seller and buyer, may set up this transaction within the guidelines of the installment sale approach and assess the transaction based on their interests and expertise rather than an intermediary party.

2. Faster sale

Buyers would not need to undergo a thorough credit analysis to secure a mortgage (real estate market example), usually if they conducted this sale with a bank or a lending institution. So the process of securing a mortgage will be shortened and less complex.

In other cases, a bank might spend weeks studying a possible deal and still deliver a rejection decision to the mortgage applicant. 
With this approach, the possibility of creating a purchase on an installment, agreeing on specific repayment terms, and many other conditions can all be done in one day.

They have enabled eager purchasers to compete with other potential buyers who can secure funds through a traditional lending institution faster, resulting in a level playing field for all potential buyers.

3. Lower tax bracket

One significant benefit of this approach is that it allows buyers to acquire a lower tax bracket. Buying a property of a sizable value can impose a tax bracket on buyers they would rather avoid. This approach will allow the minimization of this tax bracket.

The exact value will fall on sellers, who may spread their capital gain and costs over numerous years, allowing them to fall into lower tax categories rather than higher tax brackets from a single complete payment from purchasers.

This technique may cause you to consider it from an ethical standpoint since it appears to be a loophole for tax evasion and fraudulent income reporting. But this is not the case, as the sellers and buyers will have different business scenarios each year. 

For instance, most investors or buyers will have significant annual changes in their income when considering the current global financial changes and the impacts of major financial markets on different segments and fields. 

This indicates that it is not rational for sellers or buyers with volatile income rates to pay the same amount of taxes or have a high tax bracket on a good investment at the time of the transaction, which might turn into a bad one because of external factors. 

An installment sale, for example, helps real estate investors deal with market fluctuations and fluctuating revenue to cover the capital spent on these investments; this approach is also beneficial for the whole real estate market to keep it viable for more potential investors.

4. Safety of investment

This selling technique is a seller finance approach in which the original owner sells a property but doesn't receive the payment in a lump sum. This is analogous to a buyer obtaining a mortgage and paying for the property with one payment.

This will create a reasonably secure income stream for the seller because the asset will be considered collateral. If the buyer breaches their terms and decides not to pay the rest of the installments, the seller can retrieve their asset or property just like the bank. 

There is also a greater sense of security for the consumer. For instance, if they fail to pay a bank-backed mortgage, their property will go into foreclosure, and in many cases, there is little to no recourse to negotiate better terms to enable them to keep the property. 

Even in the worst scenario, the buyer may still have room to negotiate better terms and reach an agreement allowing them to continue making installment payments while keeping the home.

5. Easy sale for top price

Both parties will make recognizable gains through sellers' providing this option for buyers. In addition, sellers may now sell at or near the desired price since buyers will find it much easier to purchase these items because no substantial upfront outlay is required.

This will help both parties close the deal faster as they can agree on terms that will allow them to achieve their objectives from this transaction and keep their interests in check. 

Finding a buyer to purchase their given assets or products at the desired price may be difficult for many sellers. Still, this strategy makes market access for buyers much more manageable, even at high prices.

This method is precious in real estate-related enterprises. It will allow them to secure more buyers for their properties and enable more buyers to acquire the property they desire with the reasonable terms that both parties agree upon.

The bottom line

Businesses of any size can adopt installment sales; if you are trying to sustain your business during unstable times locally or globally, or maybe the market you operate within is witnessing significant changes, you can apply this approach to deliver value to your customers as well as value to you.

Many businesses in many industries are adopting this strategy now since the global economy is experiencing difficult times that demand enterprises to be astute to sustain themselves, their assets, and the well-being of their people.

Apart from businesses following this approach exclusively during hard times, many start-ups use the "buy now & pay later" model to provide a wide range of products and services to their client base, who prefer this approach over having a credit card.

This approach is being refined and tested.

The new approach of these models today is being offered without the need to pay interest. This has enabled this model to acquire popularity and affect customers' purchasing habits. 
However, it might carry even more significant risks for the buyer, which we will cover in another topic.

You can gain a deeper understanding of your revenue and expenses in a way that can benefit your business or start-up. You can find more about these topics in our courses list, providing valuable information and examples for enrollers.

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Researched and authored by Ahmed Fagiry | LinkedIn

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