The installment method is an accounting practice that makes it possible to recognize the revenue generated from the sale of an asset when it is actually received. This process is particularly helpful when the payment for the asset is arranged to take place in a series of consecutive payments, rather than one lump sum. Doing so makes it easier to only account for the revenue as it is received, a factor that can have an impact on the overall capital gains for a given tax period. This in turn helps to ensure no tax liability is incurred on any portion of the sale prices that has yet to be delivered to the seller.
In order to perceive the value of installment method accounting, it is helpful to consider what the process does as far as the entry into accounting records. Assuming that an asset that has recorded in the accounting records as being worth $20,000 in US Dollars (USD) is sold for $25,000 USD, that would show a profit of $5,000 USD if the asset is paid for in one lump sum. That entire profit is recorded in one calendar year and is subject to capital gains tax liability for that period.
However, if the asset is paid for in a series of five annual payments of $5,000 USD, the installment method allows the seller to only report capital gains on the portion of the sale that was received in that calendar year, adjusted to allow for the book value of the asset. This means that in order to determine the amount of tax liability on the annual installment, the difference between the sales price and the book value is divided by five. Using the example cited, that leaves the seller paying capital gains taxes on the $1,000 received in each of the five years in the form of annual installment payments.
Even in situations where payments are made monthly but stretched out over two or three calendar years, the same general benefit is received. The process of the installment method makes it possible to still honor the tax liability that applies to the overall profit generated, but spreads it out over the same period of time that it takes to eventually receive full payment for the asset. Thus, the seller does not have to pay taxes on profits he or she has yet to receive. Instead, the installment method makes it possible to track the progress, record the received payments accurately, and calculate taxes due when and as each installment payment is received.
