Installment Sales 1

Installment Sales

Ordinarily recognize gain or loss when property is sold under section 1001

Amount realized less adjusted basis

Typically, the entire amount of the sale or exchange will be recognized

Taxable income is computed under the

taxpayer’s regular method of accounting

Cash or accrual method

Or other permissible method

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Installment Sales

Installment Method under Section 453

Allows for a gain on sale as well as the accompanying tax liability to be deferred Gain is spread over the period during which the payments are

received Pro rata share of each principal payment is treated as recovery of

capital/basis

The remaining share of each principal payments is gain

Does not apply to sales at a loss

Changes the timing of income, not the total amount of income

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Installment Sales

Installment Sale: “…a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.

No requirement that any payment be made in year of disposition

No prohibition on using the installment method even if a substantial percentage of the total payments is received in the year of disposition

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Installment Sales

Cannot be used for:

Sales of publicly traded stock or securities

Personal property included in inventory

Sales pursuant to a revolving credit plan

Dealer dispositions, generally

Includes real property held for sale to customers in the ordinary course of

business

But, not to property used or produced in farming, or

Certain sales of residential lots or time shares

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Installment Sales

Three Parts to an Installment Payment Interest Income is reported as ordinary income Adjusted Basis is comprised of:

Adjusted Basis, Selling Expenses, and Depreciation recapture.

Character of Gain: What was the holding period and is it a capital asset?

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Interest Income

Return of Adjusted

Basis

Gain on Sale

Installment Payment

Installment Sales

Stated Interest Adequate Stated Interest: when the contract’s stated principal amount is at

least equal to the sum of the present value of all principal and interest payments.

The present value is based on the Test Rate of Interest Test Rate of Interest: The lowest AFR over a 3-month period based either on

the date of the date the contract becomes binding or when the sale or exchange has taken place.

Unstated Interest When the installment sale contract does not provide for adequate stated

interest. Part of the stated principal amount will be recharacterized as interest. Unstated interest is reported as income.

Either Section 1274 or 483 will apply

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Installment Sales

Amount of Gain to be Recognized When Payment Received

Gross Profit Ratio:

Ratio percentage stays consistent even if the payment amounts vary to determine the taxable amount

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Gross Profit Ratio Payment Received X

Gross Profit Total Contract Price ÷

Installment Sales

What Is Gross Profit? Gross Profit = Selling Price less Adjusted Basis

Selling Price = Gross Selling Price plus any mortgage or debt liability assumed by buyer Does not include stated or unstated interest

May also include selling expenses assumed by the buyer

What Is Contract Price? Contract Price = Selling Price less Qualifying Indebtedness

Installment sale recognized in any year is “that proportion of the payments received in that year which the gross profit (realized or to be realized when payment is completed) bears to the total contract price.” 453(c); Reg. 15A.453-1(b)(2)

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Installment Sales

Qualifying Indebtedness A mortgage or other indebtedness encumbering the property

Debt relief is generally not treated as payment but as “qualifying indebtedness” per Treas. Reg. 15A.453-1(b)(2)(iv) Mortgage relief is treated as a tax-free return of basis

Gross profit amount will remain the same but the amount of the payments and the contract price will be decreased by the amount of the mortgage relief

Excess liability: the amount by which qualifying indebtedness exceeds the basis Entire basis is recovered and excess is treated as a payment

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Installment Sales

Example: Buyer Assumes Mortgage Cash Payment ($2,000 now, and $2,000 in each of the next 4 years) $10,000 Plus: Mortgage Assumed by Buyer 15,000 Selling Price $25,000

Selling Price $25,000 Minus: Mortgage Assumed by Buyer 15,000 Contract Price $10,000

Adjusted Basis $19,000 Plus: Selling Expenses 1,000 Installment Sale Basis $20,000

Selling Price $25,000 Less: Installment Sale Basis 20,000 Gross Profit $5,000

Gross Profit Ratio = Gross Profit Contract Price = $5,000 $10,000 = 50% Example from IRS Publication 537: Installment Sales

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÷ ÷

Installment Sales

Transactions with Related Persons Second Dispositions by Related Persons

Related persons as defined by Sections 318(a) and 267(b) Acceleration of the recognition by the initial seller of the installment gain Limitation: Only applies to second dispositions occurring within 2 years of

the initial installment sale Does not apply to an involuntary conversion of the property Does not apply if the principal purpose was not for the avoidance of

taxes Sales of Depreciable Property to Related Persons

Installment method generally not available Related persons per 1239(b) – controlled entity, trust with the taxpayer or

spouse as beneficiary, or executor of an estate and the beneficiary of the estate deferral under 453 ends when the taxpayer disposes of an installment obligation

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Installment Sales

Contingent Payment Sales Property’s selling price is made contingent on future events No ascertainable fair market value Burnet v. Logan (1931): “Open Transaction” treatment - first fully

recover basis in the property; once basis is recovered remaining payments would constitute taxable gain.

Section 453(j)(2): prescribed regulations providing for ratable basis

recovery in a situation where gross profit or total contract price is not readily ascertainable

Treas. Reg. 15a.453-1(c) Methods: 1. Stated Maximum Selling Price 2. Fixed Period 3. Neither Stated Maximum Selling Price or Fixed Period

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Installment Sales

Electing Out of the Installment Method under 453(d) Elect out and report the gain on the sale in accordance with the

taxpayer’s normal method of accounting Must be made in a timely manner May be revoked only with the consent of the Service

Cash Method: taxpayer is directed to treat the fair market value of the obligation as having been realized in the year of sale and to treat that value as not less than the fair market value of the property sold (less other consideration received)

Accrual Method: taxpayer is directed to treat the total amount payable on the obligation as realized in the year of sale.

Election-out cannot be used as a deferral of income technique; acts as acceleration of income

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Installment Sales

Recapture Income Section 453(i) Exception: recognition in the year of sale of any

recapture income due to depreciation under Sections 1245 or 1250 Recognized currently regardless of when payments are made

Recaptured amount is added to seller’s basis

Also includes Section 179 and 179A deduction recapture

Reported as ordinary income

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Installment Sales

Dispositions of Installment Obligations 453B Tax deferral under 453 ends when the taxpayer disposes of an

installment obligation To determine gain or loss, the taxpayer must subtract the basis of the

obligation from either the fair market value of the obligation or the amount realized on its disposition.

The character of the gain or loss will depend on the underlying property

Sale or Exchange of Note Gift of Note Cancellation of Note Transfers between spouses or incident to divorce: rules of 453B do

not apply Transferee steps into the shoes of the transferor

Special rules apply to installment agreements transferred at death.

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Installment Sales

Installment Obligations and Like-Kind Exchanges

Receipt of an installment obligation issued by the other party as boot

453(f)(6) treatment:

1. The like-kind property is not treated as a payment

2. The gross profit ratio is specially determined, with the contract price reduced by the amount of the like kind property received and the total gross profit reduced by the amount of gain not recognized under 1031.

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Installment Sales

Other Interest on Deferred Tax

Property with sales price over $150,000 and total balance of all non-dealer installment obligations is more than $5,000,000.

Interest on deferred tax must be paid on the obligation that arises during the tax year

Exceptions: Rule does not apply to dispositions of: Farm property,

Personal use property by an individual,

Personal property before 1989, or

Real property before 1988.

Repossession Use of an Escrow Account Reporting an Installment Sale

Use Form 6252

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M. Robinson & Company, P.C. Tax Law Specialists

160 Federal St. Boston, MA 02110

(617) 428-6900

(c) Copyright M. Robinson & Company February 2016. All Rights Reserved. 19