When you buy something under a conditional sales contract, you receive possession of the item and the right to use it, but ownership remains in the hands of the seller until the specified conditions in the contract have been met. The most common conditional sales contract involves installment payments, wherein the sale is not final until the payments have been finished.

If you have a mortgage (although mortgages are a bit different) or entered into a car sale contract with payments, you probably understand the basis of a conditional contract.

To put it more simply: If the buyer breaks the conditions in the contract, the seller can take back the property.

Understanding Conditional Sales Contracts

A conditional sales contract doesn't necessarily have to involve installment payments.

A neighbor, for example, could sell you his lawnmower for $5 with the condition that you mow his grass for the rest of the summer. A distant relative could sell you a haunted house for $1,000 with the condition that you spend one night without leaving before sunrise. But in the majority of cases, a conditional sales contract involves a down payment and installment payments with a specified rate of interest.

For business owners, conditional sales contracts give you all the benefits of owning items, like vehicles or machinery, without having to pay all of the money upfront.

This can be particularly useful to reduce costs if you're just starting out or plan to resell the item later. The payments are often similar to leasing the items, except that when you lease, you don't actually own them at the end unless you opt to buy the item once the lease has terminated.

The tax implications are quite different as well.

How to Identify a Conditional Sales Contract

The IRS has seven rules to determine whether or not a buyer has entered into a conditional sales contract. If any one of these rules applies to an agreement, it's a conditional sales contract:

  1. The contract designates a portion of each payment towards an equity interest in the property. 
  2. The buyer gets title to the property after a specified number of payments. 
  3. The amount the buyer pays to use the property for a short time period is a large portion of the amount she would pay to get title to that property.
  4. The buyer pays substantially more than the current fair rental value for that property.
  5. The contract gives the buyer an option to buy the property at a much lower price compared to the value of the property.
  6. The buyer has the option to purchase the property for a smaller amount compared to the amount they had already paid under the contract.
  7. The contract specifies or suggests that a part of each payment represents interest. 

Conditional Sales Agreements and Taxes

If your business purchases equipment or other items in a conditional sales agreement, you can usually deduct the cost of the purchase through depreciation deductions on your business income taxes.

This is significantly different than a lease. In a lease of property you can usually deduct the monthly payments as rent.

There is one caveat to this rule, which involves the issue of ownership.

As far as the IRS is concerned, the owner of an item is the person or company that has both the benefits and burdens of the property, rather than the person with legal title. This is the case with most conditional sales contracts.

For example, if you purchase a forklift for your warehouse, you would have both the benefit of using the forklift and the burden of maintaining and insuring it, regardless of who still owns the title. However, if you are not deemed the owner, then you cannot use the depreciation deduction.