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Installment Method/Sales

§10.01 GENERALLY An “installment sale” is a sale in which one or more payments are received after the close of the tax year.1 In a typical installment sale, the seller finances all or part of the sale price by receiving payment in the form of a promissory note. Most sales of property are through the installment method. Every installment payment received by a seller under an installment sale has three parts:

(1) A partial return of the seller’s basis in the property sold (2) A portion of the gain on the sale (3) Interest

In general, taxpayers are required to recognize gain or loss at the time they sell property. This is not the case with respect to sellers to whom the installment method of reporting gain applies. Instead, they recognize gain in proportion to the installment payments received. Interest, however, must be reported under the taxpayer’s regular method of accounting. Since 1980 there have been a number of changes to installment reporting. At present, in addition to Section 453 of the Code, there is Section 453A, which contains special rules for non-dealer sales2 of property, and Section 453B, which covers dispositions of installment obligations.3 Section 453C was enacted in 1986. It dealt with the proportional disallowance rule and was repealed in 1987. Because of the many changes, exceptions, and special rules made to installment sales reporting, the rules can be a “trap for the unwary.” Not having a good working knowledge of these rules can cause a transaction to be reported in full currently even when the taxpayer has received little or no cash.4

§10.02 BENEFITS/DETRIMENTS

Benefits and detriments of the installment method include: • The deferral of gain recognition; • An increase in cash flow; • Flexibility in determining the year of recognition of gain; • Lower or higher taxes if the tax rate is reduced or the taxpayer is in a higher margin rate at the time

of recognition; • The risk of loss since the buyer may default; and • The purchase or sale of property with little or no cash.

1 Section 453(b). 2 See §10.10 et seq., below. 3 See §10.12, below. 4 A good example is found in Champy v. Commissioner, Tax Ct. Memo. 1994-355.

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§10.03 APPLICATION OF METHOD §10.03(a) Generally In general, the installment method applies to

• Sales of real property not held for sale to customers in the ordinary course of trade or business, and • Nondealer sales of personal property not required to be kept in inventory. Although the installment method is ordinarily used for sales, it is also available for like-kind exchanges when the cash equivalent could be paid on the installment method.5 The installment method can also be used for a dealer’s disposition of non-inventory personal property of a type the dealer does not regularly sell on the installment plan. On the other hand, dealers are forbidden from using the installment method for sales to customers in the ordinary course of business.6 The installment method applies to sales at a gain; it does not apply to loss transactions. The installment method must be used to report gain on a sale when at least one payment is due after the tax year7 in which the sale occurs, unless the seller elects not to use the method.8 Example

On April 1, 2008, Bob sells his motorboat and trailer to Alan. The sale price is $3,000. Bob paid $2,500 for them in the prior year. Al agrees to pay Bob on February 1, 2009.

Since at least one payment is in the taxable year following the sale, the installment method applies. Bob will report gain of $500 when he receives payment in February 2009.

§10.03(b) Exceptions Not all gains or transactions are covered by the installment method. Excluded from coverage are:

• The sale of personal property under a revolving credit plan;9 • Sales by dealers;10 • Sales of publicly traded property;11 • The portion of any gain attributable to depreciation recapture;12 and • The gain on the sale of depreciable property to related parties.13

5 Section 453(f)(6). 6 Section 453(b)(2). See §10.08 et seq., below, for a discussion of dealer rules. 7 Consider Champy v. Commissioner, Tax Ct. Memo. 1994-355, in which the court held that a demand note given as part of the purchase price did not meet the requirements of the statute and was instead considered payment in the year of sale. 8 Before 1980, taxpayers were required to file an affirmative election. 9 Section 453(k)(1). 10 Section 453(b)(2). 11 Section 453(k)(2). 12 Section 453(i).

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§10.04 TAXPAYERS NOT APPLYING METHOD

§10.04(a) Generally If a sale is ineligible for installment reporting, or if the taxpayer elects not to use installment method reporting, gain will be recognized under the taxpayer’s regular method of accounting. §10.04(b) Cash Basis Taxpayers A cash basis taxpayer reports gain upon actual or constructive receipt. The amount reported is the sum of money and the fair market value of the property received. When a cash basis taxpayer receives an installment obligation, it is treated as the receipt of property in an amount equal to its fair market value, whether or not the obligation is the equivalent of cash. This means that the cash equivalency doctrine is inapplicable14 and the taxpayer must report the fair market value of the promissory note.15 §10.04(c) Accrual Basis Taxpayers Under the accrual method, income is recognized when all events have occurred to establish the right to receive income and the amount of income can be determined with reasonable accuracy. When an accrual basis taxpayer receives a note as payment of the purchase price, ordinarily, the face amount of the note is included in income.16 When a fixed obligation is received, the accrual basis taxpayer reports the face amount of the obligation.17

§10.05 COMPUTATION OF GAIN §10.05(a) Generally The seller includes in taxable income all interest received on payments as well as the portion of the gain on the sale. The portion of an installment sale that represents the return of basis is excluded from income. Gain on the sale is computed by multiplying the gross profit percentage times the total installment payments received during the year.18 “Gross profit percentage” is a fraction in which the numerator is the gross profit and the denominator is the contract price.19 The use of “contract price,” rather than the selling price, to determine the gross profit percentage is a rule of administrative convenience. It was designed to deal with the problem of recognizing gain when some payments might be made to a mortgage holder rather than to the seller.20 To apply the installment sales gains rules correctly, one needs to have a working knowledge of the terms used in the text of the Temporary Regulations. The current definitions found in Temp.

13 Section 453(g). 14 See Chapter 5. 15 Temp. Reg. §15A.453-1(d)(2). 16 Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1934). 17 Rev. Rul. 79-292, 1979-2 C.B. 287. 18 Section 453(c). 19 Temp. Reg. §15.453a-1(b)(2). 20 See Burnet v. S.& L. Building Corp., 288 U.S. 406 (1933).

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Reg. §15A.453-1(b) are provided in the subsections below. §10.05(b) Gross Profit “Gross profit” means the selling price less the adjusted basis of the property. For sales of real property after October 19, 1980, other than sales by a dealer or casual sales of personal property, commissions and other selling expenses are added to the basis for determining the proportion of payments that is gross profit attributable to the disposition.21 §10.05(c) Selling Price “Selling price” means the gross selling price without reduction to reflect any existing mortgage or other encumbrance on the property (whether assumed or taken “subject to” by the buyer) and, for installment sales after October 19, 1980, the gross selling price without reduction to reflect any selling expenses. Interest, whether stated or unstated, or otherwise, is not considered to be part of the selling price.22 §10.05(d) Contract Price “Contract price” means the total contract price equal to the selling price reduced by that portion of any qualifying indebtedness assumed or taken “subject to” by the buyer that does not exceed the seller’s basis in the property (adjusted for installment sales after October 19, 1980, to reflect commissions and other selling expenses).23 §10.05(e) Qualifying Indebtedness “Qualifying indebtedness” means a mortgage or other indebtedness encumbering the property and indebtedness not secured by the property but incurred or assumed by the purchaser incident to the acquisition, holding, or operation of the property in the ordinary course of business or investment, etc. Qualifying indebtedness does not include an obligation that has been incurred incident to the disposition of the property (e.g., legal fees relating to the sale of the property), or an obligation functionally unrelated to the acquisition, etc., of the property (e.g., taxpayer’s medical bills). Moreover, any obligation created after the acquisition of the property is not qualifying indebtedness if the arrangement results in accelerating the recovery of the taxpayer’s basis in the installment sale.24 §10.05(f) Payment “Payment” includes amounts actually or constructively received in a taxable year under an installment obligation. The term “payment” does not include the receipt of the installment obligation of the person acquiring the property, whether the payment of the indebtedness is guaranteed by a third party or not.25 Payment may be received in cash or other property, such as in foreign currency, marketable 21 Temp. Reg. §15A.453-1(b)(2)(v). 22 Temp. Reg. §15A.453-1(b)(2)(ii). 23 Temp. Reg. §15A.453-1(b)(2)(iii). 24 Temp. Reg. §15A.453-1(b)(2)(iv). 25 Temp. Reg. §15A.453-1(b)(3).

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securities, or evidences of indebtedness that are payable on demand or are readily tradeable.26 Receipt of indebtedness will be treated as receipt of payment when the indebtedness is secured directly or indirectly by cash or a cash equivalent, such as a bank certificate of deposit or treasury note.27 The amount of qualifying indebtedness assumed or taken “subject to” by the party acquiring the property shall be included as payment, but only to the extent that it exceeds the basis of the property (after adjustments to reflect selling expenses).28 If a taxpayer sells property to a creditor and the debt is canceled in consideration of the sale, the cancellation is treated as payment. §10.05(g) Selling Expenses Selling expenses, such as commissions, are added to basis for the purposes of determining gross profit and the extent to which qualifying indebtedness exceeds basis. The addition of selling expenses does not affect the holding period.29 Example

Able, a calendar year taxpayer, sells Blackacre in 2008 to Ben for $100,000; $10,000 down and the remainder payable in nine equal annual installments along with stated interest. Able’s basis in Blackacre is $38,000. Selling expenses paid by Able are $2,000. The gross profit is $60,000 ($100,000 selling price less $40,000 basis inclusive of selling expenses). The gross profit ratio is 3/5ths (gross profit of $60,000) of the $100,000 contract price. Accordingly, $6,000 (3/5ths of each $10,000 annual payment received) is gain attributable to the sale. $4,000 is return of basis. The interest received is ordinary income to Able.

§10.06 RECAPTURE INCOME

“Recapture income” is the amount of gain that will be treated as ordinary income under Section 1245 or Section 1250 of the Code.30

26 Temp. Reg. §15A.453-1(b)(3). 27 Temp. Reg. §15A.453-1(b)(3). 28 Temp. Reg. §15A.453-1(b)(3). 29 Temp. Reg. §§15A.453-1(b)(2)(v), 15A.453-1(b)(3)(i). 30 A partner who sells the partner’s partnership interest must include as income the share of the partnership’s recapture

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