Installment Method Accounting: Book vs Tax and Journal Entries
Installment method accounting recognizes the gain on a sale as the cash comes in, instead of all at the date of sale. For taxes, IRC §453 requires it by default whenever at least one payment is received after the year of sale. For financial statements under GAAP, it is the exception: current standards generally book the whole gain at closing if collection is probable, which creates a gap between book income and taxable income that has to be tracked with deferred gross profit or a deferred tax liability.
This page is for owners and their bookkeepers: the tax rule, the GAAP rule, sample journal entries, and how to reconcile the two. For the tax formula itself see gross profit percentage.
Tax vs book: the short version
| Tax (IRC §453) | GAAP (ASC 606 / ASC 610-20) | |
|---|---|---|
| When gain is recognized | As principal is received, at the gross profit percentage | At transfer of control, if collection is probable |
| Default or elective | Default; you may elect out (§453(d)) | Not an option in normal cases |
| What is excluded | Inventory, dealer sales, publicly traded securities, §1245 and additional §1250 recapture (taxed in year of sale) | n/a |
| Interest on the note | Ordinary income as earned; imputed if the rate is below the applicable federal rate | Interest income under the effective interest method; significant financing component considered |
| If the buyer is shaky | Still installment method | No contract until collection is probable; cash received is a liability |
Before the current revenue standard, older GAAP permitted the installment method for some real estate and other sales when collection was not reasonably assured. That guidance was superseded. Today, for most companies following GAAP, "installment method" means a tax-return method, and the books carry a timing difference.
Private companies that prepare statements on the income tax basis of accounting (a special purpose framework, often called OCBOA) can mirror the tax treatment and use deferred gross profit on the balance sheet. The journal entries for both approaches are below.
Key terms
- Gross profit: selling price minus adjusted basis (and selling expenses).
- Contract price: the selling price minus qualifying debt the buyer assumes, but not below the gross profit.
- Gross profit percentage (GPP): gross profit divided by contract price. Each dollar of principal collected carries that percentage of gain.
- Deferred gross profit: the gain not yet recognized. It shrinks as payments come in.
- Installment receivable (note receivable): the balance the buyer still owes.
Reporting on the tax return is covered in Form 6252 instructions.
Simple example: the numbers
Simple example. A company sells a parcel of land (not inventory, no depreciation) with a carrying amount and tax basis of $400,000 for $1,000,000 on January 1. The buyer pays $200,000 down and signs an $800,000 note payable in four annual principal payments of $200,000 plus interest at a market rate. Selling expenses are ignored.
| Item | Amount |
|---|---|
| Gross profit | $600,000 |
| Contract price | $1,000,000 |
| Gross profit percentage | 60% |
| Gain recognized in year one (tax) | $120,000 ($200,000 x 60%) |
| Gain recognized each later year (tax) | $120,000 |
| Gain recognized in year one (GAAP, collection probable) | $600,000 |
Journal entries under the installment method
Use these for income-tax-basis books or to keep a memo ledger for the tax return.
At the sale:
| Account | Debit | Credit |
|---|---|---|
| Cash | $200,000 | |
| Installment note receivable | $800,000 | |
| Land | $400,000 | |
| Deferred gross profit | $600,000 |
Recognize the gain in the down payment:
| Account | Debit | Credit |
|---|---|---|
| Deferred gross profit | $120,000 | |
| Realized gain on installment sale | $120,000 |
Each annual collection (principal plus interest):
| Account | Debit | Credit |
|---|---|---|
| Cash | $200,000 + interest | |
| Installment note receivable | $200,000 | |
| Interest income | interest | |
| Deferred gross profit | $120,000 | |
| Realized gain on installment sale | $120,000 |
On the balance sheet, show deferred gross profit as a contra account against the note receivable, so the net figure equals the unrecovered basis. After the down payment: $800,000 note minus $480,000 deferred gross profit equals $320,000, which is exactly the basis still to be recovered (four payments x $80,000 of basis each).
Journal entries under GAAP
At the sale (collection probable, control transferred):
| Account | Debit | Credit |
|---|---|---|
| Cash | $200,000 | |
| Note receivable | $800,000 | |
| Land | $400,000 | |
| Gain on sale of land | $600,000 |
Each collection: debit cash, credit the note receivable for principal and credit interest income. No further gain.
If the stated interest rate is below market, GAAP discounts the note to present value and the discount becomes interest income over the term, which lowers the gain at the sale. Taxes have their own version of this under §483 and §1274; see imputed interest. If the note becomes doubtful later, the receivable is evaluated for credit losses under the current expected credit loss rules rather than by switching methods.
The deferred tax liability (ASC 740)
When the books recognize $600,000 of gain in year one and the tax return recognizes $120,000, the $480,000 of gain not yet taxed is a taxable temporary difference. An entity that pays income tax records a deferred tax liability for it.
Simple example, continued. Assume the entity is a C corporation with a 21% federal rate and ignore state tax.
| Point in time | Untaxed gain (temporary difference) | Deferred tax liability at 21% |
|---|---|---|
| After the down payment | $480,000 | $100,800 |
| After year-two payment | $360,000 | $75,600 |
| After year-three payment | $240,000 | $50,400 |
| After year-four payment | $120,000 | $25,200 |
| After final payment | $0 | $0 |
Year-one entry for the deferred portion:
| Account | Debit | Credit |
|---|---|---|
| Deferred income tax expense | $100,800 | |
| Deferred tax liability | $100,800 |
Each year the liability is reduced as the gain moves onto the tax return and current tax is paid. Total tax expense on the income statement in year one reflects the full $600,000 gain; the cash tax follows the installment schedule.
Pass-through entities. Partnerships and S corporations generally do not pay federal income tax, so they usually do not record deferred taxes for this; the installment gain flows to the owners' returns as it is recognized. Watch for state entity-level taxes (including pass-through entity tax elections) and S corporation built-in gains tax, which can change that answer.
Traps bookkeepers run into
- Recapture comes first. If the asset was depreciated, §1245 and additional §1250 recapture are taxed in the year of sale (§453(i)) and are added to basis before the GPP is figured. The installment ledger must reflect that, or every later year's gain will be wrong.
- Mortgage over basis. If the buyer takes over debt that exceeds the seller's basis, the excess is treated as a payment in the year of sale.
- Note interest. Record interest separately from principal every year. It is ordinary income on both books and return.
- Selling or pledging the note. Disposing of the note triggers the remaining deferred gross profit for tax (§453B), and pledging a large note can be treated as a payment (§453A(d)).
- Electing out. If the owner elects out on the tax return, book and tax line up and there is no temporary difference. Installment sale vs lump sum covers when that is worth it.
- Holding the note in the books. A note receivable is an asset, current for the portion due within a year and noncurrent for the rest; see notes receivable.
To see the year-by-year gain on your own deal, run the installment sale calculator. For the overall mechanics of the tax rule, start with the installment sale guide.
Bottom line
For tax, the installment method is the default and spreads gain over the collections at the gross profit percentage. For GAAP books, the gain is usually recognized at closing, and the difference is tracked as a deferred tax liability for taxable entities or as deferred gross profit on income-tax-basis statements. Keep one ledger that shows principal, interest, recognized gain and remaining deferred gross profit, and the tax return, the financial statements and the reconciliation all fall out of it.
Questions to ask your CPA
- Do our financial statements follow GAAP or the income tax basis, and how should the sale be recorded?
- What is the gross profit percentage after recapture and selling expenses?
- Does our entity record a deferred tax liability, and at what rate?
- How should the note be classified between current and noncurrent?
- Would electing out of the installment method on the tax return make sense for us?
Run your own numbers. Compare a cash sale, seller financing and a structured installment sale side by side, free.
Educational only, not tax, legal or investment advice. Examples are illustrative. Have your CPA or tax attorney review your facts before you act. Hans Goldstein is a licensed insurance agent (CA Insurance License #4273294) and is not a CPA or attorney. He is paid a commission only if a structured installment sale is funded; seller financing pays him nothing. Disclosures.