What is an installment sale? How is it taxed?
JGTRRA 2003 reduced capital gain rates for sales or exchanges occurring on or after May 6, 2003 and before January 1, 2009. IRC Sec. 1(h), as amended by JGTRRA 2003.
An installment sale is a disposition of property (other than marketable securities, certain real property, and “inventory”) where at least one payment is to be received by the seller after the close of the taxable year in which the disposition occurs. IRC Sec. 453(b). It is not necessary that there be more than one payment.
Unless the taxpayer elects out on or before the due date, including extensions, for filing his federal income tax return for the taxable year in which the disposition occurred, any gain must be reported under this method. IRC Secs. 453(a), 453(d); Bolton v. Comm., 92 TC 303 (1989). An election out is made by reporting all of the gain on the transaction in the year of the sale. A decision by the taxpayer not to elect out is generally irrevocable unless the IRS finds that the taxpayer had good cause for failure to make a timely election. Temp. Treas. Reg. §15A.453-1(d); Rev. Rul. 90-46, 1990-1 CB 107. Good cause will not be found if the purpose of a late election out is tax avoidance. Let. Rul. 9230003. However, where a taxpayer intended to use the installment method but failed to do so through his accountant’s error, the IRS permitted the taxpayer to revoke his election out of the installment method. Let. Rul. 9218012. See also Let. Rul. 200226039. Similarly, the IRS has granted permission to revoke an election out where the election was not the result of a conscious choice by the taxpayer. Let. Ruls. 9419012, 9345027. But see Krause v. Comm., TC Memo 2000-343 (holding that an election out will not be revoked when one of the purposes for the revocation is the avoidance of federal income taxes).
Loss cannot be reported on the installment method. See IRC Sec. 453. Dealers generally are not permitted to use the installment method (with exceptions for farm property and certain timeshares and residential lots). IRC Secs. 453(b)(2)(A), 453(l)(2).
Under the installment method, the total payment is divided into (a) return of the seller’s investment, (b) profit, and (c) interest income. Generally, where the sale price is over $3,000 and any payment is deferred more than one year, interest must be charged on payments due more than six months after the sale at least at 100% of the “applicable federal rate,” compounded semiannually, or it will be imputed at that rate. IRC Sec. 483. However, the following are exceptions to this general rule: (1) if less than 100% of the AFR, a rate of no greater than 9%, compounded semiannually, will be imputed in the case of sales of property (other than new IRC Section 38 property) if the stated principal amount of the debt instrument does not exceed $4,483,000 in 2005 (Rev. Rul. 2004-107, 2004-47 IRB 852; $4,381,300 in 2004 (IRC Sec, 1274A; Rev. Rul. 2003-119, 2003-2 CB 1094); (2) if less than 100% of the AFR, a rate of no greater than 6%, compounded semiannually, is imputed on aggregate sales of land during a calendar year between an individual and a member of his family (i.e., brothers, sisters, spouse, ancestors, and lineal descendants) to the extent the aggregate sales do not exceed $500,000 (the general rule of 100% of the AFR, compounded semiannually, applies to the excess) (IRC Sec. 483(e)(3)); and (3) a rate of 110% of the AFR, compounded semiannually, applies to sales or exchanges of property if, pursuant to a plan, the transferor or any related person leases a portion of the property after the sale or exchange (“sale-leaseback” transactions) (IRC Sec. 1274(e)).
The applicable federal rate will be the lowest of the AFRs in effect for any month in the 3-month period ending with the first calendar month in which there is a binding contract in writing. IRC Sec. 1274(d)(2)(B).
All interest received by the taxpayer is ordinary income. Treas. Reg. §1.483-1. In some cases, depending on the property and amount involved, the interest (or imputed interest) to be paid over the period of the loan must be reported as “original issue discount” that accrues in daily portions; in other cases the interest is allocated among the payments and that much of each payment is treated as interest includable and deductible according to the accounting method of the buyer and seller.
Once interest is segregated, any depreciation is recaptured and recognized as ordinary income in the year of sale to the extent of gain on the sale. IRC Sec. 453(i). In the case of an installment sale of IRC Section 1250 property (i.e., generally, most real estate subject to the allowance for depreciation under IRC Section 167–see IRC Sec. 1250(c)), regulations state that unrecaptured IRC Section 1250 gain (which is generally taxed at a maximum marginal rate of 25%) must be taken into account before any adjusted net capital gain (taxed at a maximum of 15%/5%). Treas. Reg. §1.453-12(a). This means that the allocation of unrecaptured IRC Section 1250 gain is front-loaded, not prorated over the life of the installment transaction.
For installment sales of IRC Section 1250 property occurring before May 7, 1997, the amount of unrecaptured IRC Section 1250 gain that is taken into account on payments received after May 6, 1997 under the regulations is determined as follows: amounts received after the sale date but before May 7, 1997 are treated as if unrecaptured IRC Section 1250 gain on payments received before May 7, 1997 had been taken into account before adjusted net capital gain. Treas. Reg. §1.453-12(b). In other words, the taxpayer is permitted to treat payments after May 6, 1997 as though the regulations had already been applied to earlier payments. Also, if the amount of unrecaptured IRC Section 1250 gain on payments received after May 6, 1997 and before August 24, 1999 would have been less under the Internal Revenue Code than the amount as determined under the regulations, the lesser amount may be used to determine the amount of unrecaptured IRC Section 1250 gain that remains to be taken into account. Treas. Reg. §1.453-12(c).
Once depreciation has been recaptured, any adjusted net capital gain is allocated to each payment by determining a profit percentage (ratio of total profit to be realized to total selling price, exclusive of interest and any recaptured depreciation) that is applied to the noninterest portion of each installment. See IRC Sec. 453(c). Thus, if the selling price (the principal amount or imputed principal amount) was $10,000 and the total profit to be realized after depreciation has been recaptured is $2,000, 20% ($2,000/$10,000) of each dollar collected (after segregating interest) is gain that must be reported as income for that taxable year. Whether the gain is adjusted net capital gain or ordinary income is determined by the type of asset sold and the length of the holding period.
In determining the ratio, selling price may have to be adjusted for outstanding indebtedness on the property. Temp. Treas. Reg. §15A.453-1. See, however, Professional Equities, Inc. v. Comm., 89 TC 165 (1987).
Sales Between Related Parties
There are strict rules governing installment reporting of sales between “related” parties. Except as noted below, “related” persons include the following: (1) members of the same family (i.e., brothers, sisters, spouses, ancestors and lineal descendants); (2) an individual and a corporation of which the individual actually or constructively owns more than 50% of the stock; (3) a grantor and a fiduciary of a trust; (4) fiduciaries of two trusts if the same person is the grantor of both; (5) a fiduciary and a beneficiary of the same trust; (6) a fiduciary of a trust and a beneficiary of another trust set up by the same grantor; (7) a fiduciary of a trust and a corporation of which the grantor of the trust actually or constructively owns more than 50% of the stock; (8) a person and an IRC Section 501 tax-exempt organization controlled by the person or members of his family (as described in (1) above); (9) a corporation and a partnership if the same person actually or constructively owns more than 50% of the stock of the corporation, and has more than a 50% interest in the partnership; (10) two S corporations if the same persons actually or constructively own more than 50% of the stock of each; (11) an S corporation and a C corporation, if the same persons actually or constructively own more than 50% of the stock of each; or (12) generally, an executor and a beneficiary of an estate. IRC Secs. 453(f)(1), 318(a), 267(b).
For purposes of determining the ownership of stock, an individual is considered to own stock owned by family members (brothers and sisters, spouse, ancestors and lineal descendants), and stock owned by a corporation, partnership, estate, or trust in proportion to the interest in the entity owned by the individual or a family member, or a partner owning stock in the same corporation in which the individual owns stock. IRC Secs. 453(f)(1), 318(a), 267(c). A different definition of “related” generally applies to sales made before October 24, 1986. A different definition of “related” also applies in the case of sales of depreciable property, as explained below. See IRC Sec. 453(g).
If a related purchaser disposes of the property before the related seller has received the entire selling price, a special “second disposition” rule applies. This rule provides that the amount realized on the second disposition, (to the extent it exceeds payments already received by the related seller) will be treated as though it had been received by the related seller on the date of the second disposition. However, this rule generally does not apply if: the second disposition occurs more than two years after the first disposition; the second disposition is an involuntary conversion, the threat of which did not exist at the time of the first disposition; the second disposition occurs after the death of either of the related parties; or neither disposition had as one of its principal purposes the avoidance of income tax. IRC Sec. 453(e). If an installment sale between related parties is canceled or payment is forgiven, the seller must recognize gain in an amount equal to the difference between the fair market value of the obligation on the date of cancellation (but in no event less than the face amount of the obligation) and the seller’s basis in the obligation. IRC Sec. 453B(f). The Service ruled that no disposition occurred on the substitution of new installment notes, without any other changes, because there was no evidence that the rights accruing to the sellers under the installment sale had either disappeared or been materially altered. FSA 200125073.
A sale of depreciable property between related parties may not be reported on the installment method, unless it is shown that avoidance of income tax was not a principal purpose. For purposes of this rule only, “related persons” refers generally to controlled business entities, not natural persons related by family. IRC Sec. 453(g).
Generally, an interest surcharge is applied to installment obligations in which deferred payments for sales during the taxable year exceed $5,000,000. Exceptions to this rule are provided for: (1) property used or produced in the trade or business of farming, (2) timeshares and residential lots, and (3) personal use property. IRC Sec. 453A(b).
The amount of the interest surcharge is determined by multiplying the “applicable percentage” of the deferred tax liability by the underpayment rate in effect at the end of the taxable year. The “applicable percentage” is determined by dividing the portion of the aggregate obligations for the year that exceeds $5,000,000 by the aggregate face amount of such obligations that are outstanding at the end of the taxable year. If an obligation remains outstanding in subsequent taxable years, interest must be paid using the same percentage rate as in the year of the sale. IRC Sec. 453A(c). In addition, if the installment obligation is pledged as security for a loan, the net proceeds of the loan will be treated as a payment received on the installment obligation (up to the total contract price); however, no additional gain is recognized on subsequent payments of such amounts already treated as received. The date of such constructive payment will be (a) the date the proceeds are received or (b) the date the indebtedness is secured, whichever is later. IRC Sec. 453A(d)(1). See Revenue Act of 1987 Conf. Rept., at pages 22-23.
Planning Point: This interest surcharge on installment sales with deferred payments can be minimized in some cases by splitting the sale between a husband and wife, and in two taxable years.
For example, a $20 million business owned by a couple could be split into two $10 million sales, and the transaction could be completed in two stages: $5 million per spouse in December, followed by $5 million per spouse in January. Structured this way, the sale would not trigger the interest surcharge. Robert S. Keebler, CPA, MST, Virchow, Krause & Company, LLP, Green Bay, Wisconsin.