 Hello, and welcome to this session in which we will discuss installment sales for tax purposes. Installment sales is one of these transactions that you might have the gained, deferred, to future period. Just like qualified like kind exchange, like involuntary conversion, installment sales, we will have this deferred component of the gain. Now we need to understand how does it occur from an installment sales perspective. We already covered 1031 as well as involuntary conversion. So what is installment sales? Installment sales represent the sale of a property where at least one payment is made by the buyer and attacks year after the year which the property was disposed of. Simply put, let's assume we are looking at year one and there was a sale in year one, but here's what's gonna happen. The sale happened in year one, but a payment for the sale will happen in year two. Sometime in year two, it doesn't matter. It doesn't have to be at the end. And sometime another payment would happen in year three and sometime you might have a series of payment. Simply put, when the sale takes place in one period and the payment takes place in another period, simply put, the buyer bought the asset and will be making payments. This is what installment is. We should all be familiar as accounting student with the term installment. Now as usual, the realized gain would have to be computed. It's the same as the regular realized gain that we compute, which is what? Which is the selling price minus the adjusted basis. So we look at the selling price of the asset minus the adjusted basis will come up with the realized gain. That does not change, whether it's an installment sales or simply regular sales. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Now under the installment sales method, the taxpayers are taxed when the cash is received rather than when the gain is actually realized. So what's gonna happen now, we computed our realized gain. When do we pay taxes on this gain? We pay taxes in proportion of the cash received based on the gross profit. Don't worry, I'll explain this. So what's gonna happen is this. In subsequent years, we will receive a portion of the payment. The taxpayer is required to recognize a portion of the gain. Now, how do we recognize this portion of the gain based on something we called the gross profit percentage? In this manner, by the time the taxpayer received all installment payment, he or she would recognize the total amount realized. Now, the taxpayer may still elect to report all the gain in the year of disposition of the property. You might be saying, why would you wanna do that? Well, maybe this year, your tax rate is, let's assume for the sake of illustration, 25%. In subsequent year, maybe your tax rate is 35%. What you do, you will take all the gain and you pay the 25% based on that. You think it's, you will save money because in future year, your tax rate is higher. You do have this option. And believe me, the IRS is not gonna say no to that because they want their money now. Installment sales will defer the payment. Now, how do we, when we defer the payment, how much do we account for from the payments? How much of it is gained? Well, the amount of gain is recognized computed using the gross profit percentage. And I hope as an accounting student, you know how the gross profit percentage work. If not, don't worry, we're gonna work with it now. How do you compute the gross profit percentage? Selling price minus the adjusted basis. Sale minus cost, which is adjusted basis for the property. We'll give us the gross profit. Now we need to figure out the gross profit percentage. So how does it work? If we sold something for $100, the adjusted basis is 60, the gross profit is 40. Well, if we take gross profit 40 divided by 100, we see that the gross profit percentage 60. It means we are earning 60% on these sales. This is what the gross profit percentage. So gain to be recognized in the future is the payment that we're gonna be receiving times 40%. For this example, whatever that payment happens to be times 40% will be the gain recognized in those years. And don't worry, I'll always work an example. The character of the gain recognized is dictated by the character of the asset sold. Don't worry about this now, we'll talk about the character of the assets later on in future chapters and future lessons. So the best way to illustrate the concept is to work an example. On March 15, Carly sold the residential property to Jane for $100,000. Carly's basis is 70. Good. Now on the date of the sale, Jane immediately paid Carly $7,000 in cash. Additionally, the two parties agreed that the balance will be paid in three equal installment on March 15, year two, year three, and year four. That's the deal. Determine the amount of gain that Carly should recognize in year one, two, three, and four under the installment sales. So this is an installment sales. We made a payment now and we're gonna be making future payments. Okay, under this method, the taxpayer report revenue over the period in which the cash payment are received using the gross profit percentage. First is we need to find out what is our gross profit percentage? Well, what is our gross profit? It is 100,000 selling price minus the adjusted basis of 70 will give us a gross profit of 30,000. Now we're gonna take the gross profit divided by 100,000. So the gross profit divided by the selling price will give us a gross profit percentage for this deal of 30%. Now what's gonna happen is this, every time we receive a cash payment, 30% of the cash payment is considered gain. So in year one, in year one Carly received $7,000. Well, we'll take $7,000 times 30%. We're gonna come up with 2,100. This is the reported gain. In future year, what's gonna happen is we're gonna have a remaining balance of 93,000, which is 100,000 minus 7,000 paid upfront, which is basically a yearly payment of 31,000. Now every time we receive a payment of 31,000, we'll take 31,000 times 30% and that's gonna give us a gain of 39,300. And the 31,000 is the remaining balance divided by three payments. And now we recognize each year, year one, year two, I'm sorry, year three, and year four, this is the gain that's recognized in the subsequent years. More about the installment method, you need to know the following. Ineligibility of gains and losses for the installment method. Now if you sold inventory, marketable securities, you cannot use the installment method for those type of assets. Also, when there is a depreciation recapture, now if you don't know what depreciation recapture, don't worry about this, we're gonna work on depreciation recapture later, but just need to know they are not eligible for installment methods. So depreciation recapture, that will be recognized in the year of sale. You don't defer those. On the other hand, the installment sales rules out the applicability to losses. So you cannot use, if you incur losses, you cannot defer your losses. That will be, you don't wanna do that anyway, but the point is installment sales are not applicable to losses. Interest on installment sales, remember every time we make a payment into the future, part of it is interest. The seller of the property should impose interest on installment sales because when you receive the payment, part of it is interest. If the seller does not impose an interest or imposes interest at inadequate rate, each installment payment is considered to include imputed interest and would have to be separated. So this 31,000 part of it is gained and part of it should be considered part of it is interest. Why? Because it's a loan and loan would involve interest. We'll talk about imputed interest shortly. So this is what you need to know about the installment method. What should you do now? Whether you are a CPA, EA or an accounting student, you wanna know this topic inside out. It's important because installment sales is also covered in financial accounting and it's covered in, you need to know it and auditing as well. So it's an important topic that applies in many different fields. CPA accounting is an important rewarding career. Take it seriously, good luck, stay safe. I'm always here to help you.