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ContentsIntroduction ........................................ 1

What Is an Installment Sale? ............ 2

General Rules ..................................... 2Figuring Installment Income ........... 2Reporting Installment Income ......... 3

Other Rules ......................................... 3Electing Out of Installment Method 3Payments Received ........................ 4Escrow Account .............................. 5Depreciation Recapture Income ..... 5Sale to Related Person .................. 5Like-Kind Exchange ........................ 6Contingent Sale .............................. 6Single Sale of Several Assets ........ 6Sale of a Business .......................... 7Unstated Interest ............................ 8Disposition of Installment Obligation 9Repossession ................................. 10

Reporting an Installment Sale .......... 12

How To Get More Information .......... 14

Index .................................................... 18

IntroductionAn installment sale is a sale of property whereyou receive at least one payment after theclose of the tax year of the sale. If you dis-pose of property in an installment sale, youreport part of your gain or profit when youreceive each installment payment. You can-not use the installment method to report aloss.

This publication discusses the generalrules that apply to all installment sales. It alsodiscusses more complex rules that apply onlywhen certain conditions exist or certain types

of property are sold. There are several ex-amples of reporting installment sales on Form6252 at the end of the publication.

If you sold your home or other nonbusi-ness property under an installment plan, youwill need to read only the General Rules. Ifyou sold business or rental property or had alike-kind exchange or other complex situation,see the appropriate discussion under OtherRules.

If you sold your entire interest in a passiveactivity, special rules apply to the treatmentof passive activity losses. Generally, you arein a passive activity if you have a trade orbusiness activity in which you do not mate-rially participate or have a rental activity. SeePublication 925 for information on this topic.

Useful ItemsYou may want to see:

Publication

523 Selling Your Home

541 Partnerships

544 Sales and Other Dispositions ofAssets

550 Investment Income and Expenses

551 Basis of Assets

925 Passive Activity and At-Risk Rules

Departmentof theTreasury

InternalRevenueService

Publication 537Cat. No. 15067V

Installment

Sales

For use in preparing

1997 Returns

Get f orms and other informat ion faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.

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Form (and Instructions)

6252 Installment Sale Income

See How To Get More Information nearthe end of this publication for informationabout getting these publications and the form.

What Is an

Installment Sale?An installment sale is a sale of property whereyou receive at least one payment after theclose of the tax year of the sale. The install-ment sale rules do not apply to the sale ofinventory. See Sale of a Business underOther Rules.

If a sale qualifies as an installment sale,you must report the gain on the sale under theinstallment method unless you elect to rec-ognize gain under your regular method ofaccounting. Under the installment method,you report prorated gain on the sale only aspayments are received. It does not matterwhether you use the cash or accrual methodof accounting. For information on recognizingthe entire gain in the year of sale, see Elect-ing Out of Installment Method under OtherRules, later.

TIP

If you finance the purchase of yourproperty, instead of having the buyerget a loan or mortgage from a third

party, you probably have an installment sale.It is not an installment sale if the buyer bor-rows the money from a third party and thenpays you the total selling price.

General RulesThe buyer's installment obligation to makefuture payments to you can be in the form ofa deed of trust, note, land contract, mortgage,

or other evidence of the buyer's debt to you.The rules discussed in this publication applyregardless of the form of the installment obli-gation.

Stock or securities. If you use the cashmethod of accounting, you cannot use theinstallment method to report the year-end saleof stock or securities traded on an establishedsecurities market. You must report the sale inthe year in which the trade date falls.

Dealer sales. Sales of personal property bya person who regularly sells or otherwisedisposes of the same type of property on theinstallment plan cannot be reported under theinstallment method. This also applies to real

property held for sale to customers in the or-dinary course of a trade or business. How-ever, this does not apply to an installmentsale of property used or produced in farming.

Special rule. Dealers of timeshares andresidential lots can report sales on the in-stallment method if they elect to pay a specialinterest charge. For more information, seesection 453(l) of the Internal Revenue Code.

Sale at a loss. If your sale results in a loss,you cannot use the installment method. If theloss is on an installment sale of business as-sets, you can deduct it only in the tax yearof sale. You cannot deduct a loss on the saleof property owned for personal use.

Unstated interest. If your sale calls forpayments in a later year and the sales con-tract provides for little or no interest, you mayhave to figure unstated interest, even if youhave a loss. See Unstated Interest, later.

FiguringInstallment IncomeEach payment on an installment sale usuallyconsists of three parts:

1) Interest income.2) Return of your adjusted basis in the

property.

3) Gain on the sale.

Each year you receive a payment, you mustinclude the interest part in income, as well asthe part that is your gain on the sale. You donot include in income the part that is the re-turn of your basis in the property.

Interest income. You must report interest asordinary income. Interest is generally not in-cluded in a down payment. However, youmay have to treat part of each later paymentas interest, even if it is not called interest inyour agreement with the buyer. See Unstated

Interest, later.

Return of basis and gain on sale. The restof each payment is treated as if it were madeup of two parts. One part is a tax-free returnof your adjusted basis in the property. Theother part is your gain.

Figuring gain part of payment. Tofigure what part of any payment isgain, multiply the payment (less in-

terest) by the gross profit percentage. Use thefollowing worksheet to figure the gross profitpercentage.

Selling price. The selling price is the totalcost of the property to the buyer. It includesany money and the fair market value of anyproperty you are to receive. It also includesany debt the buyer pays, assumes, or takesthe property subject to. The debt could be anote, mortgage, or any other liability, such asa lien, accrued interest, or taxes you owe onthe property. If the buyer pays any of yourselling expenses for you, that amount is alsoincluded in the selling price. The selling pricedoes not include interest, whether stated orunstated.

Installment sale basis. The adjusted ba-sis plus selling expenses and depreciationrecapture income (see Other Rules) is re-ferred to in this publication as the installmentsale basis.

Adjusted basis. Basis is a way of meas-uring your investment in the property you areselling. The way you figure basis depends onhow you first acquired the property. The basisof property you bought is generally its cost.The basis of property you inherited, receivedas a gift, built yourself, or received in a tax-free exchange is figured differently.

While you own personal-use property,various events may change your original ba-sis in the property. Some events, such asadding rooms or making permanent improve-ments, increase basis. Others, such as dam-age from deductible casualty losses or de-preciation allowed or allowable, decreasebasis. The result is adjusted basis.

For more information on how to figurebasis and adjusted basis, see Publication551.

Selling expenses. Selling expenses areany expenses that relate to the sale of theproperty. They include commissions, attorneyfees, and any other expenses paid on thesale. Selling expenses are added to the basisof the sold property.

Depreciation recapture. If you took de-preciation deductions on the asset, part of thegain on the sale of the asset may be recap-tured as ordinary income. See the discussionof depreciation recapture under Other Rules,later.

Gross profit. For an installment sale,gross profit is the total gain you report on theinstallment method.

To figure your gross profit, subtract yourinstallment sale basis from the selling price.If the property you sold was your home, sub-tract from the gross profit any gain you can

postpone or exclude. See Sale of your home,later, under Reporting Installment Income.

Contract price. The contract price is thetotal of all principal payments you are to re-ceive on the installment sale. It includes pay-ments you are considered to receive, eventhough you are not paid anything directly. SeePayments Received, later.

If part of the selling price is paid in cashand you hold a mortgage payable from thebuyer to you for the remainder, then the con-tract price equals the selling price.

Gross profit percentage. A certain per-centage of each payment (after subtractinginterest) is reported as gain from the sale. Itis called the gross profit percentage and isfigured by dividing your gross profit from the

sale by the contract price.The gross profit percentage generally re-mains the same for each payment you re-ceive. However, see the example under Sell-ing price reduced, later, for a situation wherethe gross profit percentage changes.

Example. You sell property at a contractprice of $2,000 and your gross profit is $500.Your gross profit percentage is 25% ($500 $2,000). After subtracting interest, 25% ofeach payment, including the down payment,is reported as gain from the sale for the taxyear the payment is received.

Amount to include in income. Each yearyou receive a payment on the installmentsale, multiply the payment (less interest) bythe gross profit percentage to determine theamount you must include in income for the taxyear. In certain circumstances, you may beconsidered to have received a payment, eventhough you received nothing directly. In addi-tion to cash, a receipt of property or the as-sumption of your mortgage on the propertysold may be considered a payment. For adetailed discussion, see Payments Receivedunder Other Rules, later.

Selling price reduced. If the selling price isreduced at a later date, the gross profit on thesale will also change. You must then refigureyour gross profit percentage for the remainingpayments. Refigure your gross profit using

1) Selling price ...........................................2) Installment sale basis:

Adjusted basis of property ...

Selling expenses ..................Depreciation recapture .........3) Gross profit (line 1 line 2) ...................4) Contract price .........................................5) Gross profit percentage (line 3 line 4) .

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the reduced sale price and then subtract gainalready reported. Spread the remaining gainevenly over the remaining installments. Youcannot go back and refigure the gain you re-ported in earlier years.

Example. In 1995, you sold land with abasis of $40,000 for $100,000. Your grossprofit was $60,000. You received a $20,000down payment and the buyer's note for$80,000. The note provides for four annualpayments of $20,000 each, plus 12% interest,

beginning in 1996. Your gross profit percent-age is 60%. You reported a gain of $12,000on each payment received in 1995 and 1996.In 1997, you and the buyer agreed to reducethe purchase price to $85,000 and paymentsduring 1997, 1998, and 1999 are reduced to$15,000 for each year.

The new gross profit percentage, 46.67%,is figured as follows. You will report a gain of$7,000 on each of the $15,000 installmentsdue in 1997, 1998, and 1999.

ReportingInstallment Income

Form 6252. You must use Form 6252 to re-port a sale of property as an installment sale.Use the form to report the sale in the year ittakes place and to report payments receivedin later years. Attach it to your tax return foreach year.

Form 6252 will help you determine thegross profit, contract price, gross profit per-centage, and how much of each payment re-ceived during the tax year to include in in-come.

Form 6252 is divided into three parts:

1) Part I, Gross Profit and Contract Price,is completed for the year of sale.

2) Part II , Installment Sale Income, is com-pleted for the year of sale and for anyyear you receive a payment or are con-sidered to have received a payment.

3) Part III, Related Party Installment SaleIncome, is completed if you sold the

property to a related person, as dis-cussed later under Sale to Related Per-son.

Year of sale. Answer the questions at thebeginning of the form and complete Part I andPart II. Question 3 asks whether you sold theproperty to a related party. If you answerYes, answer question 4 and complete PartIII.

Later years. Answer the questions at thebeginning of the form and complete Part II foreach year in which you receive a payment onthe sale. If you sold the property to a relatedperson, you may have to complete Part IIIalso.

Schedule D (Form 1040). Enter the gain fig-ured on Form 6252 for personal-use property(capital assets) on Schedule D (Form 1040),Capital Gains and Losses. If your gain fromthe installment sale qualifies for long-termcapital gain treatment in the year of sale, itwill continue to qualify in later tax years. Yourgain is long-term if you owned the property formore than one year when you sold it.

Form 4797. An installment sale of propertyused in your business or that earns rent or

royalty income may result in a capital gain,an ordinary gain, or both. All or part of anygain from its disposition may be ordinary gainfrom depreciation recapture. Use Form 4797to report these transactions and to determinethe ordinary or capital gain or loss.

Sale of your home. If you sold your homebefore May 7, 1997, you may be able topostpone or exclude all or part of the gain onthe sale. However, different rules apply if yousold it after May 6, 1997. See Publication 523for more information. If the sale is an install-ment sale, any gain you postpone or excludeis not included in gross profit when figuringyour gross profit percentage.

Seller-financed mortgage. Special re-porting procedures apply if you finance thesale of your home to an individual.

When you report interest income receivedfrom a buyer who uses the property as apersonal residence, write the buyer's name,address, and social security number (SSN)on line 1 of Schedule B (Form 1040) orSchedule 1 (Form 1040A).

When deducting the mortgage interest,the buyer must write your name, address, andSSN on line 11 of Schedule A (Form 1040).

If either person fails to include the otherperson's SSN, a $50 penalty may apply.

Other RulesThe rules discussed in this part of the publi-cation apply only in certain circumstances orto certain types of property. The rules cover:

1) Electing out of the installment method.

2) Payments received, including thoseconsidered received.

3) An escrow account.

4) Depreciation recapture income.

5) A sale to a related person.

6) A like-kind exchange.

7) A contingent sale.

8) A single sale of several assets.

9) The sale of a business.

10) Unstated interest.

11) Disposition of an installment obligation.

12) A repossession.

Electing Out ofInstallment MethodYou are required to use the installmentmethod to report an installment sale unlessyou elect not to use that method. If you makethe election, you will generally report the en-tire gain in the year of sale, even though you

will not be paid all of the selling price in thatyear.

To figure the gain to report, use the fairmarket value of the buyer's installment obli-gation. Notes, mortgages, and land contractsare examples of obligations that are includedat fair market value.

You must figure the fair market value ofthe buyer's installment obligation, whether ornot you would actually be able to sell it. If youuse the cash method of accounting, the fairmarket value of the obligation will never beconsidered less than the fair market value ofthe property sold (minus any other consider-ation received). If you use an accrual methodof accounting, you must always use the fullface value of the installment obligation as itsfair market value.

Example. You sold a parcel of land for$50,000. You received a $10,000 down pay-ment and will receive the balance over thenext 10 years at $4,000 a year, plus 8% in-terest. The buyer gave you a note for$40,000. The note had a fair market value of$40,000. You paid a commission of 6%, or$3,000, to a broker for negotiating the sale.The land cost $25,000 and you owned it formore than one year. You decide to elect outof the installment method and report the en-

tire gain in the year of sale.

The recognized gain of $22,000 is long-term capital gain. Since you include the entiregain in income in the year of sale, you do notinclude in income any principal payments youreceive in later tax years. The interest on thenote is ordinary income and is reported asinterest income each year.

How to elect out. To make this election, donot report your sale on Form 6252. Instead,report it on Schedule D (Form 1040) or Form4797, whichever applies.

When to elect out. Make this election by thedue date, including extensions, for filing yourtax return for the year the sale takes place.Once made, the election generally cannot berevoked. However, you can apply to the IRSto revoke the election not to use the install-

ment method. You will not be allowed to re-voke the election if:

1) One of the purposes is to avoid federalincome tax, or

2) The tax year in which any payment wasreceived has closed.

You may qualify for an automatic exten-sion of six months from the due date of thereturn, excluding extensions, to make thiselection. See Revenue Procedure 9285 formore information. You can read the full textof this revenue procedure at some IRS officesand public libraries.

1) Reduced selling price ........................... $85,0002) Minus: Basis .......................................... 40,0003) Adjusted gross profit ............................. $45,0004) Minus: Gain reported in 1995 & 1996 .. 24,0005) Gain to be reported ............................... $21,0006) Selling price to be received:

Reduced selling price ......... $85,000Minus: Payments receivedin 1995 and 1996 ............... 40,000 $45,000

Gain realized:7) New gross profit percentage(line 5 line 6) ...................................... 46.67% Selling price ............................................... $50,000

Minus: Property's adj. basis ........ $25,000Commission ..................... 3,000 28,000

Gain realized .............................................. $22,000

Gain recognized in year of sale:

Cash ........................................................... $10,000Market value of note .................................. 40,000Total realized in year of sale ..................... $50,000Minus: Property's adj. basis ........ $25,000

Commission ..................... 3,000 28,000Gain recognized ......................................... $22,000

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Payments ReceivedIncluding Payments ConsideredReceived

You must figure your gain each year on thepayments you receive, or are treated as re-ceiving, from an installment sale. These pay-ments include the down payment and eachlater payment of principal on the buyer's debtto you.

In certain situations, you are consideredto have received a payment, even though the

buyer does not pay you directly. These situ-ations arise if the buyer assumes or pays anyof your debts, such as a loan, or pays any ofyour expenses, such as a sales commission.

Buyer pays seller's expenses. If the buyerpays any of your expenses related to the saleof your property, it is considered a paymentto you in the year of sale. Include these ex-penses in the selling and contract priceswhen figuring the gross profit percentage.

Buyer assumes mortgage. If the buyer as-sumes or pays off your mortgage, or other-wise takes the property subject to the mort-gage, the following rules apply.

Mortgage less than basis. If the buyer

assumes a mortgage that is less than yourinstallment sale basis in the property, it is notconsidered a payment to you. The contractprice equals the selling price minus the mort-gage. This difference is all that you will di-rectly collect from the buyer.

Example. You sell property with an ad-justed basis of $19,000. You have selling ex-penses of $1,000. The buyer assumes yourexisting mortgage of $15,000 and agrees topay you $10,000 (a cash down payment of$2,000 and $2,000 (plus 8% interest) in eachof the next 4 years).

The selling price is $25,000 ($15,000 +$10,000). Your gross profit is $5,000 ($25,000 $20,000 installment sale basis). The con-tract price is $10,000 ($25,000 $15,000

mortgage). Your gross profit percentage is50% ($5,000 $10,000). You report half ofeach $2,000 payment received as gain fromthe sale. You also report all interest you re-ceive as ordinary income.

Mortgage more than basis. If the buyerassumes a mortgage that is more than yourinstallment sale basis in the property, you re-cover your entire basis. You are also relievedof the obligation to repay the amount bor-rowed. The part of the mortgage greater thanyour basis is treated as a payment receivedin the year of sale. This is in addition to thebuyer's other payments.

To figure the contract price, subtract themortgage from the selling price. This is the

total you will actually receive from the buyer.Add to this amount the payment you areconsidered to receive (the difference betweenthe mortgage and your installment sale ba-sis). The contract price is then the same asyour gross profit from the sale.

If the mortgage the buyer assumes isequal to or more than your installment salebasis in the property, the gross profit per-centage will always be 100%.

Example. The selling price for yourproperty is $9,000. The buyer will pay you$1,000 annually (plus 8% interest) over thenext 3 years and assume an existing mort-gage of $6,000. Your adjusted basis in theproperty is $4,400. You have selling ex-

penses of $600, for a total installment salebasis of $5,000. The part of the mortgage thatis more than your installment sale basis is$1,000 ($6,000 $5,000). This amount is in-cluded in the contract price and treated as apayment received in the year of sale. Thecontract price is $4,000:

Your gross profit on the sale is also$4,000:

Your gross profit percentage is 100%.Report 100% of each payment as gain fromthe sale. Treat the $1,000 difference betweenthe mortgage and your installment sale basisas a payment and report 100% of it as gainin the year of sale.

Mortgage canceled. If the buyer of yourproperty is the person who holds the mort-gage on it, your debt is canceled, not as-

sumed. You are considered to receive apayment equal to the outstanding canceleddebt.

Example. Mary Jones loaned you $4,500in 1993 in exchange for a note mortgaging atract of land you owned. On April 4, 1997, shebought the land for $7,000. At that time,$3,000 of her loan to you was outstanding.She agreed to forgive this $3,000 debt and topay you $2,000 (plus interest) on August 1,1997, and August 1, 1998. She did not as-sume an existing mortgage. She canceled the$3,000 debt you owed her. You are consid-ered to have received a $3,000 payment atthe time of the sale.

Buyer assumes other debts. If the buyerassumes your other debts, such as a loan orback taxes, it may be considered a paymentto you in the year of sale.

If the buyer assumes the debt instead ofpaying it off, only part of it may have to betreated as a payment. Compare the debt toyour installment sale basis in the propertybeing sold. If the debt is less than your in-stallment sale basis, none of it is treated asa payment. If it is more, only the difference istreated as a payment. If the buyer assumesmore than one debt, any part of the total thatis more than your installment sale basis isconsidered a payment. These rules are thesame as the rules discussed earlier underBuyer assumes mortgage. However, theyapply to only two types of debts the buyerassumes:

1) Those acquired from ownership of theproperty you are selling, such as amortgage, lien, overdue interest, or backtaxes.

2) Those acquired in the ordinary courseof your business, such as a balance duefor inventory you purchased.

If the buyer assumes any other type ofdebt, such as a personal loan, it is treated asif the buyer had paid off the debt at the timeof the sale. The value of the assumed debt isthen considered a payment to you in the yearof sale.

Payment of property. If you receive prop-erty rather than money from the buyer, it isstill considered a payment. However, seeLike-Kind Exchange, later. The value of thepayment is the property's fair market valueon the date you receive it.

Fair market value. This is the price atwhich property would change hands betweena buyer and a seller, neither being requiredto buy or sell, and both having reasonableknowledge of all necessary facts. If your in-stallment sale fits this description, the valueassigned to property in your agreement withthe buyer is good evidence of its fair marketvalue.

Third-party note. If the property the buyergives you is a third-party note (or other obli-gation of a third party), you are considered tohave received a payment equal to the note'sfair market value. Because the note is itselfa payment on your installment sale, any pay-ments you later receive from the third partyare not considered payments on your sale.

Example. You sold real estate in an in-stallment sale. As part of the down payment,the buyer assigned to you a $5,000, 8% noteof a third party. The fair market value of thethird-party note at the time of your sale was$3,000. This amount, not $5,000, is a pay-

ment to you in the year of sale. Because thethird-party note had a fair market value equalto 60% of its face value ($3,000 $5,000),60% of each payment of principal you receiveon this note is a return of capital. The re-maining 40% is ordinary income. The interestyou receive is reported in full as ordinary in-come.

Bond. A bond or other evidence of debtyou receive from the buyer that is payable ondemand is treated as a payment in the yearyou receive it. If you receive a governmentor corporate bond that has interest couponsattached or that can be readily traded in anestablished securities market, you are con-sidered to have received payment equal tothe bond's fair market value. Accrual basistaxpayers should see Regulations section15A.4531(e)(2).

Buyer's note. The buyer's note (unlesspayable on demand) is not considered pay-ment on the sale. Its full face value is includedwhen figuring the selling price and the con-tract price. Payments you receive on the noteare used to figure your gain in the year youreceive them.

Guarantee. If a third party or governmentagency guarantees the buyer's payments toyou on an installment obligation, the guaran-tee itself is not considered payment.

Deposit. A deposit you receive before the

year of sale is treated as a payment in theyear of sale if, under the contract, it becomespart of the down payment.

Installment obligation used as security(pledge rule). If you use an installment obli-gation to secure any debt, the net proceedsfrom the debt may be treated as a paymenton the installment obligation. This is knownas the pledge rule and it applies if the sellingprice of the property was over $150,000. Itdoes not apply to the sale of:

1) Property used or produced in farming,or

2) Personal-use property.

Selling price ............................................... $9,000Minus: Mortgage ........................................ (6,000)Amount actually received .......................... $3,000Add difference:

Mortgage ................................... $6,000Less: Installment sale basis ..... 5,000 1,000

Contract price ............................................ $4,000

Selling price ................................................. $9,000Minus: Installment sale basis ...................... (5,000)Gross profit .................................................. $4,000

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The net debt proceeds are the gross debtminus the direct expenses of getting the debt.The amount treated as a payment is consid-ered received on the later of:

1) The date the debt becomes secured, or

2) The date you receive the debt proceeds.

A debt is secured by an installment obli-gation to the extent that payment of principalor interest on the debt is directly secured(under the terms of the loan or any underlying

arrangement) by any interest in the install-ment obligation.Limit. The net debt proceeds treated as

a payment on the pledged installment obli-gation cannot be more than the excess of:

1) The total contract price on the install-ment sale, over

2) Any payments received on the install-ment obligation before the date the netdebt proceeds are treated as a payment.

Installment payments. The pledge ruleaccelerates the reporting of the installmentobligation payments. Do not report paymentsreceived on the obligation after it has beenpledged until the payments received are more

than the amount reported under the pledgerule.Exception. The pledge rule does not

apply to debt incurred after December 17,1987, to refinance a debt that was:

1) Outstanding on December 17, 1987, and

2) Secured by that installment sale obli-gation on that date and at all timesthereafter until the refinancing.

A refinancing as a result of the creditor'scalling of the debt is treated as a continuationof the original debt if the refinancing is pro-vided by a person other than the creditor ora person related to the creditor.

This exception applies only to the refi-

nancing that does not exceed the principal ofthe original debt immediately before the refi-nancing. Any excess is treated as a paymenton the installment obligation.

Escrow AccountIn some cases, the sales agreement, or alater agreement, may call for the buyer toestablish an irrevocable escrow account fromwhich the remaining installment payments(including interest) are to be made. Gener-ally, these sales cannot be reported on theinstallment method. The buyer's obligation ispaid in full when the balance of the purchaseprice is deposited into the escrow account.When an escrow account is established, you

no longer rely on the buyer for the rest of thepayments, but on the escrow arrangement.

Example. You sell property for $10,000.The sales agreement calls for a down pay-ment of $1,000 and payment of $1,500 ineach of the next 6 years to be made from anirrevocable escrow account containing thebalance of the purchase price plus interest.You cannot report the sale on the installmentmethod because the full purchase price isconsidered received in the year of sale. Youmust report the entire gain in the year of sale.

Escrow established in a later year. If youmake an installment sale and in a later yearan irrevocable escrow account is established

to pay the remaining installments plus inter-est, the amount placed in the escrow accountrepresents payment of the balance of the in-stallment obligation. Therefore, you cannotuse the installment method to report anypayments you receive from the escrow ac-count. This is because a disposition has oc-curred. See Disposition of Installment Obli-gation, later.

Substantial restriction. If an escrow ar-rangement imposes a substantial restriction

on your right to receive the sale proceeds, thesale can be reported on the installmentmethod, provided it otherwise qualifies. Foran escrow arrangement to impose a sub-stantial restriction, it must serve a bona fidepurpose of the buyer, that is, a real and defi-nite restriction placed on the seller or a spe-cific economic benefit conferred on the buyer.

Example. You sell your business, in-cluding all of its assets, for $50,000. Thesales agreement provides for a down pay-ment of $8,000 and payments of $7,000 ineach of the next 6 years to be made from anirrevocable escrow account. The salesagreement also provides that you, the seller,will not enter a competing business for a pe-riod of 6 years. If at any time during this pe-riod you enter a competing business, you willforfeit all rights to the amounts then held inescrow. In this situation, the escrow arrange-ment imposes a substantial restriction andyou can use the installment method.

DepreciationRecapture IncomeIf you sell property for which you claimed de-preciation deductions, report any depreciationrecapture income in the year of sale, whetheror not an installment payment was receivedthat year. Figure your depreciation recaptureincome (including the section 179 deductionand the section 179A deduction recapture) in

Part III of Form 4797. Report the recaptureincome in Part II of Form 4797 as ordinaryincome in the year of sale. The recapture in-come is also included in Part I of Form 6252.However, the gain equal to the recapture in-come is not reported on the installmentmethod. Any gain greater than the recaptureincome can be reported on the installmentmethod. For more information on depreciationrecapture, see chapter 4 in Publication 544.

The ordinary recapture income reported inthe year of sale is included in your installmentsale basis in determining your gross profit onthe installment sale. See the discussion underGeneral Rules, earlier.

Sale toRelated PersonTwo special rules apply to an installment salebetween related persons. Test your saleagainst Rule 1 first. If Rule 1 does not apply,test your sale against Rule 2. For purposesof these rules, spouses, children, grandchil-dren, brothers, sisters, and parents are allconsidered related persons. A partnership orcorporation in which you have an interest, oran estate or trust with which you have aconnection, can also be considered a relatedperson.

For more information on these kinds ofsales, see section 453 of the Internal Reve-nue Code.

Rule 1Sale of DepreciablePropertyIf you sell depreciable property to certain re-lated persons, you cannot report the sale us-ing the installment method. Instead, all pay-ments to be received are considered receivedin the year of sale. Depreciable property forthis rule is any property that can be depreci-ated by the person or entity to whom youtransfer it.

Payments to be received include the totalof all noncontingent payments and the fair

market value of any payment contingent asto amount.

In the case of contingent payments forwhich the fair market value cannot be rea-sonably determined, the basis is recoveredratably. The purchaser cannot increase thebasis of any property acquired in the sale byany amount before the seller includes theamount in income.

Exceptions to Rule 1. Rule 1 will not applyif no significant tax deferral benefit will bederived from the sale. It does not apply if youcan show to the satisfaction of IRS thatavoidance of federal income tax was not oneof the principal purposes of the sale.

Rule 2Sale and ResaleGenerally, a special rule applies if you makea first disposition (sale or exchange) you re-port under the installment method to a relatedperson who then makes a second disposition(sale, exchange, gift, or cancellation of in-stallment note):

1) Before making all payments on the firstdisposition, and

2) Within 2 years of the first disposition.

Under this rule, you treat part or all of theamount the related person realizes (or the fairmarket value if disposed property is not soldor exchanged) from the second dispositionas if you received it from the first dispositionat the time of the second disposition.

Example 1. In 1996, Harvey Green soldfarm land to his son Bob for $500,000, whichwas to be paid in five equal payments over 5years, plus adequate stated interest on thebalance due. His installment sale basis for thefarm land was $250,000 and the property wasnot subject to any outstanding liens or mort-gages. His gross profit percentage is 50%(gross profit of $250,000 contract price of$500,000). He received $100,000 in 1996 andincluded $50,000 in income for that year($100,000 0.50). Bob made no improve-ments to the property and sold it to Alfalfa Inc.in 1997 for $600,000 after making the pay-

ment for that year. The amount realized fromthe second disposition is $600,000. Harveyfigures his installment sale income for 1997as follows:

Lesser of: 1) Amount realized on seconddisposition, or 2) Contract price on firstdisposition .............................................. $500,000Subtract: Sum of payments from Bob in1996 and 1997 ....................................... 200,000Amount treated as payment because ofsecond disposition ................................. $300,000

Add: Payment from Bob in 1997 ........... + 100,000Total payments received and treated asreceived for 1997 ................................... $400,000

Multiply by gross profit % ............. ......... .50Installment sale income for 1997 .......... $200,000

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Harvey will not include in his installmentsale income any principal payments he re-ceives on the installment obligation for 1998,1999, and 2000 because he has already re-ported the total payments of $500,000 fromthe first disposition ($100,000 in 1996 and$400,000 in 1997).

Example 2. Assume the facts are thesame as Example 1 except that Bob sells theproperty for only $400,000. The gain for 1997is figured as follows:

Harvey receives a $100,000 payment in1998 and another in 1999. They are not taxedbecause he treated the $200,000 from thedisposition in 1997 as a payment receivedand paid tax on the gain. In 2000, he receivesthe final $100,000 payment. He figures thegain he must recognize in 2000 as follows:

Exceptions to Rule 2. These rules do notapply to a second disposition, and any latertransfer, if you can show, to the satisfactionof the IRS, that neither the first disposition (tothe related person) nor the second dispositionhad as one of its principal purposes theavoidance of federal income tax. Generally,an involuntary second disposition will qualifyunder the nontax avoidance exception, suchas when a creditor of the related personforecloses on the property or the related per-son declares bankruptcy.

The nontax avoidance exception also ap-plies to a second disposition that is also aninstallment sale if the terms of payment underthe installment resale are substantially equal

to or longer than those for the first installmentsale. However, the exception does not applyif the resale terms permit significant deferralof recognition of gain from the first sale as, forexample, if amounts from the resale are col-lected sooner.

In addition, any sale or exchange of stockto the issuing corporation is not treated as afirst disposition. An involuntary conversion isnot treated as a second disposition if the firstdisposition occurred before threat of conver-sion. A transfer after the death of the person

making the first disposition or the relatedperson's death, whichever is earlier, is nottreated as a second disposition.

Like-Kind ExchangeIf you trade business or investment propertyfor the same kind of property, you can post-pone reporting part of the gain. These tradesare known as like-kind exchanges. Theproperty you receive in a like-kind exchange

is treated as if it were a continuation of theproperty you give up.In a like-kind exchange, you do not have

to report any part of your gain if you receiveonly like-kind property. However, if you alsoreceive money or other property in the ex-change, you must report your gain to the ex-tent of the money and the fair market valueof the other property received.

For more information on like-kind ex-changes, see Like-Kind Exchangesin chapter1 of Publication 544.

Installment payments. If, in addition tolike-kind property, you receive an installmentobligation in the exchange, the following rulesapply:

1) The contract price is reduced by the fairmarket value of the like-kind propertyreceived in the trade.

2) The gross profit is reduced by any gainon the trade that can be postponed.

3) Like-kind property received in the tradeis not considered payment on the in-stallment obligation.

Example. In 1997, George Brown tradespersonal property with an installment salebasis of $400,000 for like-kind property hav-ing a fair market value of $200,000. He also

receives an installment note for $800,000 inthe trade. Under the terms of the note, he isto receive $100,000 (plus interest) in 1998and the balance of $700,000 (plus interest) in1999.

George's gross profit is $600,000($1,000,000 selling price $400,000 install-ment sale basis). The contract price is$800,000 ($1,000,000 $200,000 fair marketvalue of like-kind property received). Thegross profit percentage is 75% ($600,000 $800,000). He reports no gain in 1997 be-cause the like-kind property he receives is nottreated as a payment for figuring gain. Hereports $75,000 gain for 1998 (75% of$100,000) and $525,000 gain for 1999 (75%of $700,000).

Deferred exchanges. A deferred exchangeis one in which you have transferred theproperty and are to receive like-kind propertyat a later date. Under this type of exchange,the person receiving your property may berequired to place funds in an escrow accountor trust. If certain rules are met, these fundswill not be considered a payment until youhave the right to receive the funds or, if ear-lier, the end of the exchange period. SeeRegulations section 1.1031(k)1(j)(2) forthese rules.

Contingent SaleFor installment sales, a contingent sale is onewhose total selling price cannot be deter-mined by the end of the tax year in which thesale takes place.

If the selling price cannot be determinedby the end of the tax year, the contract priceand the gross profit percentage cannot bedetermined (using the same rules that applyto an installment sale with a fixed sellingprice). This happens, for example, if you sellyour business and the selling price includesa percentage of its profits in future years.

For rules on using the installment methodfor a contingent sale or a contingent sale withunstated interest, see Regulations section15A.4531(c).

Single Saleof Several AssetsIf you sell different types of assets in a singlesale, you must identify each asset to deter-mine whether you can use the installmentmethod to report the sale of that asset. Youalso have to allocate part of the selling priceto each asset. If you sell assets that constitute

a trade or business, see Sale of a Business,next.Unless an allocation of the selling price

has been agreed to by both parties in anarm's-length transaction, you must allocatethe selling price to an asset based on its fairmarket value (FMV). If the buyer assumes adebt, or takes the property subject to a debt,you must reduce the fair market value by thedebt. This is the net fair market value.

A sale of separate and unrelated assetsof the same type under a single contract isreported as one transaction for the installmentmethod. However, if an asset is sold at a loss,its disposition cannot be reported on the in-stallment method. It must be reported sepa-rately. The remaining assets sold at a gainare reported together.

Example. You sold three separate andunrelated parcels of real property (A, B, andC) under a single contract calling for a totalselling price of $130,000. The total sellingprice consisted of a cash payment of $20,000,the buyer's assumption of a $30,000 mort-gage on parcel B, and an installment obli-gation of $80,000 payable in eight annual in-stallments, plus interest at 8% a year.

Your installment sale basis for each parcelwas $15,000. Your net gain was $85,000($130,000 $45,000). You report the gain onthe installment method.

The sales contract did not allocate theselling price or the cash payment received inthe year of sale among the individual parcels.The FMV of parcels A, B, and C were$60,000, $60,000, and $10,000, respectively.

Since the installment sale basis for parcelC was more than its FMV, it was sold at a lossand must be treated separately. You mustallocate the total selling price and theamounts received in the year of sale betweenparcel C and the remaining parcels.

The total selling price of $130,000 is allo-cated $120,000 for parcels A and B togetherand $10,000 for parcel C. The cash paymentof $20,000 received in the year of sale andthe note receivable should be allocated on thebasis of the proportionate net FMV. The allo-cation is as follows:

Lesser of: 1) Amount realized on seconddisposition, or 2) Contract price on firstdisposition .............................................. $400,000Subtract: Sum of payments from Bob in1996 and 1997 ....................................... 200,000Amount treated as payment because ofsecond disposition ................................. $200,000

Add: Payment from Bob in 1997 ........... + 100,000Total payments received and treated asreceived for 1997 ................................... $300,000

Multiply by gross profit % .............. ........ .50Installment sale income for 1997 .......... $150,000

Total payments from the first dispositionreceived by the end of 2000 ................. $500,000

Minus the sum of:Payment from 1996 .......... $100,000Payment from 1997 .......... 100,000Amount treated as pay-ment in 1997 .................... 200,000

Total on which gain was previously re-cognized ................................................ 400,000Payment on which gain is recognizedfor 2000 ................................................. $100,000Multiply by gross profit % .......... ........... .50Installment sale income for 2000 ......... $50,000

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The sale of parcel C cannot be reportedon the installment method because the saleresults in a loss. This loss of $5,000 ($10,000selling price $15,000 installment sale basis)is reported in the year of sale. However, ifparcel C was held for personal use, the lossis not deductible.

The installment obligation of $80,000 isallocated to the property sold based on theirproportionate net FMVs (90% to parcels Aand B, 10% to parcel C).

Sale of a BusinessThe installment sale of an entire business forone overall price under a single contract isnot the sale of a single asset.

Allocation of selling price. The selling pricemust be allocated for each asset class be-cause:

1) The sale of a business generally in-cludes real and personal property thatcan be reported on the installmentmethod and inventory items that cannot.

2) Any depreciation recapture income from

the sale of depreciable property cannotbe reported on the installment method.It is reported in full in the year of the sale.

3) Assets sold at a loss cannot be reportedon the installment method

Inventory. If inventory items are includedin an installment sale, you may have anagreement stating which payments are forinventory and which are for the other assetsbeing sold. If you do not, each payment mustbe allocated between the inventory and theother assets sold.

The sale of inventory items cannot be re-ported on the installment method. All gain orloss on their sale must be reported in the yearof sale, even if you are paid in later years.

The amount you receive (or will receive)on the sale of inventory items is reported asordinary business income. Your basis in theitems is used to figure the cost of goods soldand the part of the selling expenses allocatedto inventory is deducted as an ordinary busi-ness expense.

Residual method. Except for assets ex-changed under the like-kind exchange rules,both the buyer and seller of a business mustuse the residual method to allocate the saleprice to each business asset transferred. Thismethod determines gain or loss from thetransfer of each asset.

The residual method must be used for anytransfer of a group of assets that continues a

Parcels Aand B Parcel C

trade or business and for which the buyer'sbasis is determined only by the amount paidfor the assets. This applies to both direct andindirect transfers, such as the sale of a busi-ness or the sale of a partnership interest inwhich the basis of the buyer's share of thepartnership assets is adjusted for the amountpaid. A group of assets constitutes a tradeor business if goodwill or going concern valuecould, under any circumstances, attach to theassets.

The residual method provides for the saleprice to be reduced first by cash, demanddeposits, and similar accounts transferred bythe seller. The sale price remaining after thisreduction must be allocated among the vari-ous business assets in a specified order.

The allocation must be made among thefollowing assets in proportion to (but not inexcess of) their fair market value on the pur-chase date in the following order:

1) Certificates of deposit, U.S. governmentsecurities, readily marketable stock orsecurities, and foreign currency.

2) All other assets except section 197 in-tangibles.

3) Section 197 intangibles (goodwill, etc.).

More information. For more information,see Sale of a Business in chapter 2 of Publi-cation 544. For more information on section197 intangibles, see chapter 12 of Publication535.

How to report the sale of a business. Boththe seller and buyer must prepare and attachForm 8594, Asset Acquisition Statement Un-der Section 1060, to their income tax returnfor the year the sale occurred.

Sale of partnership interest. A partner whosells a partnership interest at a gain may beable to report the sale on the installment

method. The sale of a partnership interest istreated as the sale of a single capital asset.However, the partner must make an allocationif the partnership's assets included unrealizedreceivables and inventory items. (The termunrealized receivables includes depreciationrecapture income, discussed earlier.)

The gain allocated to the recapture in-come and the inventory cannot be reportedunder the installment method. The gain allo-cated to the other assets can be reportedunder the installment method.

For more information on the treatment ofunrealized receivables and inventory, seePublication 541.

ExampleOn January 4, 1997, you sold the machineshop you operated since 1987. You receiveda $100,000 down payment and the buyer'snote for $120,000. The note payments are$15,000 each, plus 10% interest, due everyJuly 1 and January 1, beginning in 1998. Thetotal selling price is $220,000. Your sellingexpenses are $11,000. The selling expensesare divided among all the assets sold, in-cluding inventory.

Your selling expense for each asset is 5%of the asset's selling price ($11,000 sellingexpense $220,000 total selling price).

The fair market value (FMV), adjustedbasis, and depreciation claimed on each as-set sold are as follows:

Under the residual method, you allocatethe selling price to each of the assets basedon their FMV ($201,500). The remainingamount is allocated among your section 197intangibles, which includes goodwill($18,500).

The assets included in the sale, their sell-ing prices based on their fair market values,the selling expense allocated to each asset,the adjusted basis, and the gain for each as-set are shown in the following chart.

The building was acquired in 1987, theyear the business began, and it is section1250 property. There is no depreciation re-capture income because the building wasdepreciated using the straight line method.

All gain on the truck, machine A, and ma-chine B is depreciation recapture incomesince it is the lesser of the depreciationclaimed or the gain on the sale.

The total depreciation recapture incomereported in Part II of Form 4797 is $5,209.This consists of $3,650 on machine A, $799on the truck, and $760 on machine B (thegain on each item since it was less than thedepreciation claimed). These gains are re-ported in full the year of sale and are not in-cluded in the installment sale computation.

Of the $220,000 total selling price, the$10,000 for inventory assets cannot be re-ported on the installment method. The sellingprices of the truck and machines are also re-moved from the total selling price becausegain on these items is reported in full the yearof sale.

The selling price equals the contract pricefor the installment sale ($108,500). The as-sets included in the installment sale, theirselling price, and their installment sale basisare shown in the following chart.

The gross profit percentage(gross profit contract price) for the installment sale is48% ($52,075 $108,500). The gross profitpercentage for each asset is figured as fol-lows:

Since the sale includes assets sold on theinstallment method and assets for which thegain is reported in full the year of sale, pay-

Depre-ciation Adjusted

FMV ..................................... $120,000 $10,000 Asset FMV Claimed BasisMinus: Mortgage assumed .. 30,000 -0-

Inventory . .. .. .. .. .. .. .. .. .. .. . $10,000 -0- $8,000Net FMV .............................. $90,000 $10,000Land . ... .. ... ... ... ... ... ... ... .. 42,000 -0- 15,000

Proportionate net FMV: Building ........................ 48,000 $9,000 36,000Percentage of total .............. 90% 10% Machine A .................... 71,000 27,200 63,800

Machine B .................... 24,000 12,960 22,040Payments in year of sale: Truck ... .. .. .. .. .. .. .. .. .. .. .. .. . 6,500 18,624 5,376$20,000 90% .................... $18,000$20,000 10% .................... $2,000

Excess of parcel B mortgageover installment sale basis .. 15,000

Allocation of payments re-ceived (or considered re-ceived) in year of sale . .. .. .. .. $33,000 $2,000

SalePrice

SaleExp.

Adj.Basis Gain

Inventory ..... $10,000 $500 $8,000 $1,500Land ........... 42,000 2,100 15,000 24,900Building ....... 48,000 2,400 36,000 9,600Mch. A ........ 71,000 3,550 63,800 3,650Mch. B ........ 24,000 1,200 22,040 760Truck .......... 6,500 325 5,376 799Goodwill ...... 18,500 925 -0- 17,575

$220,000 $11,000 $150,216 $58,784

SellingPrice

Install-mentSale

BasisGrossProfit

Land .......................... $42,000 $17,100 $24,900

Build ing ... .. .. .. .. .. .. .. .. .. 48,000 38,400 9,600Goodwill . ................... 18,500 925 17,575Total .......................... $108,500 $56,425 $52,075

PercentageLand $24,900 $108,500 .......................... 22.95Building $9,600 $108,500 ....................... 8.85Goodwill $17,575 $108,500 .................... 16.20Total ............................................................... 48.00

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ments must be allocated between the install-ment part of the sale and the part reported inthe year of sale. The selling price for the in-stallment sale is $108,500. This is 49.3% ofthe total selling price of $220,000 ($108,500 $220,000). The selling price of assets notreported on the installment method is$111,500. This is 50.7% ($111,500 $220,000) of the total selling price.

Multiply principal payments by 49.3% todetermine the part of the payment for the in-stallment sale. The balance, 50.7%, is for thepart reported in the year of the sale.

The gain on the sale of the inventory,machines, and truck is reported in full the yearof sale. When you receive principal paymentsin later years, no part of the payment for thesale of these assets is included in gross in-come. Only the part for the installment sale(49.3%) is used in the installment sale com-putation.

The only payment received in 1997 is thedown payment of $100,000. The part of thepayment for the installment sale is $49,300($100,000 49.3%). This amount is used inthe installment sale computation.

Installment income for 1997. Your install-ment income for each asset is the gross profitpercentage for that asset times $49,300, the

installment income received in 1997.

Installment income after 1997. You figureinstallment income for years after 1997 byapplying the same gross profit percentagesto 49.3% of the total payments you receiveon the buyer's note during the year.

Unstated InterestAn installment sale contract generally pro-

vides that each deferred payment on the salewill include interest or that there will be aninterest payment in addition to the principalpayment. Interest provided in the contract iscalled stated interest.

If an installment sale contract with someor all payments due more than one year afterthe date of sale does not provide for interest,part of each payment due more than 6months after the date of sale may be treatedas interest. The amount treated as interest iscalled unstated interest.

When the stated interest rate in the con-tract is lower than the applicable federal rate(AFR), defined below, unstated interest is thedifference between interest figured at thefederal rate and any interest figured at therate specified in the sales contract.

Generally, the unstated interest rules donot apply to a debt given in consideration fora sale or exchange of personal-use property.Personal-use property is any property sub-stantially all of the use of which by the buyeris not in a trade or business or an investmentactivity.

Applicable federal rate (AFR). The AFRdepends on the month the binding contract forthe sale or exchange of property is made andthe term of the instrument. For an installmentobligation, the term of the instrument is itsweighted average maturity, as defined inRegulations section 1.12731(e)(3). If theterm is:

3 years or less, the AFR is the federalshort-term rate.

Over 3 years, but not over 9 years, theAFR is the federal mid-term rate.

Over 9 years, the AFR is the federallong-term rate.

The applicable federal rates are publishedmonthly in the Internal Revenue Bulletin. Youcan get this information by contacting an IRSoffice.

Effects of Unstated InterestIf the unstated interest rules apply, you andthe buyer must treat part of the installmentsale price as interest. The unstated interestrules require you to treat part of each pay-ment as interest, even though it is not calledinterest in your agreement with the buyer.Unstated interest reduces the stated sellingprice of the property and increases your in-terest income. It also reduces the buyer'sbasis in the property and increases the buy-er's interest expense.

If you do not use the installment methodto report the sale, you report the entire gainin the year of sale. You must reduce theselling price by the total unstated interest be-fore you can determine the gain.

You must report the unstated interest plusany interest specified under the contract onyour tax return.

Figuring Unstated InterestA debt instrument must provide for adequatestated interest. If not, unstated interest is fig-ured on the debt. Generally, a debt instrumentprovides for adequate stated interest if it callsfor interest at a rate no lower than the test rateof interest applicable to the debt instrument.

Test rate of interest. The test rate of interestfor a debt instrument is the 3-month rate. The3-month rate is the lower of:

1) The lowest AFR in effect during the3-month period ending with the firstmonth in which there is a binding writtencontract that substantially sets forth theterms under which the sale or exchangeis ultimately consummated, or

2) The lowest AFR in effect during the3-month period ending with the month inwhich the sale or exchange occurs.

Special rules. For sales or exchangesof property (other than new section 38 prop-erty, which includes most tangible personalproperty) involving seller financing of$3,723,800 or less, the test rate of interestcannot be more than 9%, compoundedsemiannually. For seller financing over$3,723,800, and for all sales or exchangesof new section 38 property, the test rate ofinterest is 100% of the AFR.

For information on new section 38 prop-erty, see section 48(b) of the Internal Reve-nue Code, as in effect before the enactmentof Public Law 101508.

Relationship of Internal Revenue Codesections 1274 and 483. Unstated interest isimposed under section 1274 or 483 of theCode, depending on the characteristics(amount, kind of property, etc.) of the debtinstrument and the sale or exchange forwhich it is given in consideration.

Section 1274 applies to any debt instru-ment issued for the sale or exchange of

property if some or all payments due underthe debt instrument are due more than 6months after the date of sale or exchange.The applicable federal rate is determined un-der section 1274 and interest determined un-der that section is treated as original issuediscount.

Section 483 applies to sales or exchangesof property not covered by the provisions ofsection 1274. Interest determined under sec-tion 483 is treated as unstated interest.

Section 483 rules. The section 483 rulesapply to payments on the sale or exchangeof property under a contract in which:

1) Some or all payments are due more thanone year after the date of sale or ex-change, and

2) There is total unstated interest (or inad-equate stated interest).

Unstated interest is figured on any paymentthat:

1) Constitutes all or part of the selling price,and

2) Is due more than 6 months after the dateof sale or exchange.

Total unstated interest. Total unstatedinterest is the amount equal to the excess of:

1) The sum of payments due under thecontract, over

2) The sum of the present values of thepayments and the present values of anyinterest payments due under the con-tract.

Transactions to which section 483 rulesapply. The section 483 rules apply to:

1) Debt instruments from sales or ex-changes of:

a) A farm for $1,000,000 or less by:

i) An individual.ii) An estate.

iii) A small business corporation(defined in section 1244(c)(3)of the Internal Revenue Code).

iv) A domestic partnership thatmeets requirements similar tothose of section 1244(c)(3).

b) A main home by the owner.

c) Property with total payments (prin-cipal and interest) of $250,000 orless.

d) Land between related parties.

2) A cash method debt instrument.

Sale of a farm. The section 483 rulesapply to the sale of a farm if the selling pricecannot exceed $1,000,000. If the selling pricecan exceed $1,000,000, the section 1274rules (discussed later) apply. For determiningthe selling price, all sales and exchanges thatare part of the same transaction (or a seriesof transactions) are treated as one sale orexchange.

Sale with total payments of $250,000or less. The section 483 rules apply if thefollowing cannot exceed $250,000:

1) The total payments (interest and princi-pal) due under the debt instrument andunder all other debt instruments received

IncomeLand22.95% of $49,300 ................. ........ $11,314Building8.85% of $49,300 ...................... 4,363Goodwill16.2% of $49,300 ..................... 7,987Total installment income for 1997 ........ ..... $23,664

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as consideration for the sale or ex-change, and

2) The total other consideration to be re-ceived for the sale or exchange.

The section 1274 rules apply if the amountcan exceed $250,000.

Any consideration (other than a debt in-strument) is taken into account at its fairmarket value. All sales and exchanges thatare part of the same transaction (or series ofrelated transactions) are treated as one sale

or exchange.Land sale between related parties. The

section 483 rules apply to debt instrumentsissued in a land sale between related partiesto the extent the stated principal of the debtinstrument issued in the sale or exchangedoes not exceed $500,000 when added to thetotal stated principal of any other debt instru-ments for prior land sales between these in-dividuals during the calendar year. The sec-tion 1274 rules, if otherwise applicable, applyto debt instruments issued in a sale of landto the extent the stated principal amount is inexcess of $500,000, or if any party to the saleis a nonresident alien.

Related parties include an individual andthe members of the individual's family and

their spouses. Members of an individual'sfamily include the individual's spouse, brotherand sister (whether by whole or half blood),ancestors, and lineal descendants.

Cash method debt instrument. This isany debt instrument given as considerationfor the sale or exchange of property (otherthan new section 38 property) with a statedprincipal of $2,659,900 or less and:

1) The lender (holder) does not use an ac-crual method of accounting and is not adealer in the type of property sold orexchanged.

2) Both the borrower (issuer) and the lenderjointly elect to account for interest on thedebt instrument under the cash method

of accounting.3) Section 1274 of the Internal Revenue

Code would apply except for the electionin (2) above.

Exceptions to section 483 rules. The un-stated interest rules do not apply to the fol-lowing types of transactions.

Sale price of $3,000 or less. If it can bedetermined at the time of sale or exchangeof the property that the selling price will notexceed $3,000, the unstated interest rules donot apply to the sale or exchange.

Carrying charges. The buyer of personalproperty does not figure unstated interest ifany part of the payment includes separatelystated carrying charges.

Additional exceptions. See the dis-cussion of the exceptions that apply to bothsections 483 and 1274, later.

Section 1274 rules. The section 1274 rulesapply to any debt instrument given in consid-eration for the sale or exchange of propertyif:

1) The stated redemption price at maturityfor the debt instrument exceeds:

a) The stated principal when there isadequate stated interest, or

b) The imputed principal in all othercases, and

2) Some or all payments under the debtinstrument are due more than 6 monthsafter the date of the sale or exchange.

Imputed principal. There is adequatestated interest under section 1274 if thestated principal for a debt instrument is lessthan or equal to the imputed principal. Theimputed principal of any debt instrument isequal to the sum of the present values of allpayments under the debt instrument. Thepresent value of any payment is determinedby using the AFR for the date of sale or ex-

change. If a debt instrument has a single fixedinterest rate paid or compounded at leastannually, and the rate is equal to or greaterthan the test rate, there is adequate statedinterest.

Issue price. In transactions to whichsection 1274 applies, the issue price of thedebt instrument must be determined. Wherethere is adequate stated interest, the issueprice is the stated principal. If the debt in-strument does not provide for adequatestated interest, the issue price of the instru-ment is the imputed principal of the debt in-strument. The issue price of a debt instrumentis generally used to determine the sale price(in whole or in part) of any property acquiredfor the debt instrument.

Exceptions to imputed principal rules.The imputed principal rules do not apply toany of the debt instruments involved intransactions listed earlier under Transactionsto which section 483 rules apply. (Also seeExceptions to sections 483 and 1274, below.)

Assumption of debt instrument. Do notapply the imputed principal rules to the as-sumption of a debt instrument or if propertyis taken subject to the debt instrument. How-ever, these rules do apply if the terms orconditions of the debt instrument are modifiedor the nature of the transaction is changed.

Exceptions to sections 483 and 1274. Theunstated interest and imputed principal rulesdo not apply in the following circumstances.

Publicly traded debt instruments orproperty. Transactions involving publiclytraded debt instruments or any debt instru-ment issued in consideration for the sale orexchange of publicly traded property are notsubject to these rules. A publicly traded in-strument is one that is traded on an estab-lished securities market.

Patents. When all substantial rights to apatent, or an undivided interest in propertythat includes part of all substantial rights to apatent, are sold or exchanged, do not figureunstated interest or imputed principal on anyamount contingent on the productivity, use,or disposition of the property transferred. Thisrule applies only if long-term capital gain orloss treatment applies to the sale (see Publi-cation 544).

Annuities. Payments that depend inwhole or in part on the life expectancy of anyindividual do not require the computation ofunstated interest or imputed principal.

Personal-use property. Debt instru-ments issued in consideration for the sale orexchange of personal-use property wheresubstantially all of its use by the buyer is forother than a trade or business or as income-producing property are not subject to the un-stated interest or imputed principal rules.

More information. For information on figur-ing unstated interest and other special rules,see sections 483 and 1274 of the InternalRevenue Code and their regulations.

Disposition ofInstallment ObligationA disposition generally includes a sale, ex-change, cancellation, bequest, distribution,or transmission of an installment obligation.An installment obligation is the buyer's note,deed of trust, or other evidence the buyer willmake future payments to you.

If you are using the installment methodand you dispose of the installment obligation,you generally have a gain or loss to report. It

is considered gain or loss on the sale of theproperty for which you received the install-ment obligation. If the original installment saleproduced ordinary income, the disposition ofthe obligation will result in ordinary incomeor loss. If the original sale resulted in a capitalgain, the disposition of the obligation will re-sult in a capital gain or loss.

Use the following rules to figure your gainor loss from the disposition of an installmentobligation.

1) If you sell or exchange the obligation,or if you accept less than face value insatisfaction of the obligation, the gain orloss is the difference between your basisin the obligation and the amount you re-

alize.2) If you dispose of the obligation in any

other way, the gain or loss is the differ-ence between your basis in the obli-gation and its fair market value at thetime of the disposition. This rule applies,for example, when you give the install-ment obligation to someone else orcancel the buyer's debt to you.

Basis. Figure your basis in an installmentobligation by multiplying the unpaid balanceon the obligation by your gross profit per-centage. Subtract that amount from the un-paid balance. The result is your basis in theinstallment obligation.

Example. Several years ago, you soldproperty on the installment method. Thebuyer still owes you $10,000 of the sale price.This is the unpaid balance on the buyer's in-stallment obligation to you. Because yourgross profit percentage is 60%, $6,000 (60% $10,000) is the profit owed you on the obli-gation. The rest of the unpaid balance,$4,000, is your basis in the obligation.

Transfer between spouses or formerspouses. No gain or loss is recognized onthe transfer of an installment obligation be-tween a husband and wife or a former hus-band and wife if incident to a divorce. Atransfer is incident to a divorce if it occurs

within one year after the date on which themarriage ends or is related to the end of themarriage. The same tax treatment for thetransferred obligation applies to the spouseor former spouse receiving it as applied to thetransferor spouse or former spouse. The ba-sis of the obligation to the transferee spouse(or former spouse) is the adjusted basis of thetransferor spouse.

The nonrecognition rule does not apply ifthe spouse or former spouse receiving theobligation is a nonresident alien.

Gift. A gift of an installment obligation is adisposition. The gain or loss is the differencebetween your basis in the obligation and its

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fair market value at the time you make thegift.

For gifts between spouses or formerspouses, see Transfers between spouses orformer spouses, above.

Cancellation. If an installment obligation iscanceled or otherwise becomes unenforce-able, it is treated as a disposition other thana sale or exchange. Your gain or loss is thedifference between your basis in the obli-gation and its fair market value at the time youcancel it. If the parties are related, the fairmarket value of the obligation is consideredto be no less than its full face value.

Forgiving part of the buyer's debt. If youaccept part payment on the balance of thebuyer's installment debt to you and forgive therest of the debt, you treat the settlement asa disposition of the installment obligation. Thegain or loss is the difference between yourbasis in the obligation and the amount yourealize on the settlement.

If you reduce the selling price but do notcancel the rest of the buyer's debt to you, itis not considered a disposition of the install-ment obligation. You must refigure the grossprofit percentage and apply it to paymentsyou receive after the reduction. See Selling

price reducedunder General Rules, earlier.

Assumption. If the buyer of your propertysells it to someone else and you agree to letthe new buyer assume the original buyer'sinstallment obligation, you have not disposedof the installment obligation. It is not a dispo-sition even if the new buyer pays you a higherrate of interest than the original buyer.

Transfer due to death. The transfer of aninstallment obligation (other than to the buyer)as a result of the death of the seller (or otherholder of the obligation) is not a disposition.Any unreported gain from the installment ob-ligation is not treated as gross income to thedecedent. No income is reported on the

decedent's return due to the transfer. Thismeans whoever receives the installment obli-gation as a result of the seller's death is taxedon the installment payments the same as theseller would have been if the seller had livedto receive the payments.

However, if an installment obligation iscanceled, becomes unenforceable, or istransferred to the buyer because of the deathof the holder of the obligation, it is a disposi-tion. The estate must figure its gain or losson the disposition. If the holder and the buyerwere related, the fair market value of the in-stallment obligation is considered to be noless than its full face value.

RepossessionIf you repossess your property after makingan installment sale, you must figure:

1) Your gain (or loss) on the repossession,and

2) Your basis in the repossessed property.

The rules for figuring these amounts de-pend on the kind of property you repossess.The rules for repossessions of personalproperty differ from those for real property.Special rules may apply if you repossessproperty that was your main home before thesale.

The repossession rules apply whether ornot title to the property was ever transferred

to the buyer. It does not matter how you re-possess the property, whether you forecloseor the buyer voluntarily surrenders the prop-erty to you. However, it is not a repossessionif the buyer puts the property up for sale andyou repurchase it.

For the repossession rules to apply, therepossession must at least partially discharge(satisfy) the buyer's installment obligation toyou. The discharged obligation must be se-cured by the property you repossess. Thisrequirement is met if the property is auctionedoff after you foreclose and you apply the in-stallment obligation to your bid price at theauction.

Reporting the repossession. You reportgain or loss from a repossession on the sameform you used to report the original sale. Ifyou reported the sale on Form 4797, useForm 4797 to report the gain or loss on therepossession.

Personal PropertyIf you repossess personal property, you mayhave a gain or a loss on the repossession. Insome cases, you may also have a bad debt.

To figure your gain or loss, subtract thetotal of your basis in the installment obligation

and any expenses you have for the repos-session from the fair market value of theproperty. If you receive anything from thebuyer besides the repossessed property, it isadded to the property's fair market value be-fore making this calculation.

How you figure your basis in the install-ment obligation depends on whether or notyou reported the original sale on the install-ment method. The method you used to reportthe original sale also affects the character ofyour gain or loss on the repossession.

For sales not reported on the installmentmethod: (see Electing Out of InstallmentMethod, earlier)

Basis in installment obligation. Your basisis figured on its full face value or its fairmarket value at the time of the originalsale, whichever you used to figure yourgain or loss in the year of sale. From thisamount, subtract all payments of principalyou have received on the obligation. Theresult is your basis in the installment obli-gation. If only part of the obligation is dis-charged by the repossession, figure yourbasis in only that part.

Gain or loss. To your basis in the obligation,add any repossession costs. If the fairmarket value of the property you repos-sess is more than this total, you have again. Because it is gain on the installmentobligation, it is all ordinary income. If the

fair market value of the repossessedproperty is less than the total of your basisplus repossession costs, you have a loss.Because you included the full gain in in-come in the year of sale, the loss is a baddebt. How you deduct the bad debt de-pends on whether you sold business ornonbusiness property in the original sale.See Publication 550 for information onnonbusiness bad debts and chapter 14 ofPublication 535 for information on businessbad debts.

For sales reported on the installmentmethod:

Basis in installment obligation. Multiply the

unpaid balance of your installment obli-gation by your gross profit percentage.Subtract that amount from the unpaid bal-ance. The result is your basis in the in-stallment obligation.

Gain or loss. If the fair market value (FMV)of the repossessed property is more thanthe total of your basis in the obligation plusany repossession costs, you have a gain.If the FMV is less, you have a loss. Yourgain or loss on the repossession is thesame character (long-term or ordinary) as

your gain on the original sale.

Use the following worksheet to deter-mine the taxable gain or loss on arepossession of personal property re-

ported on the installment method.

Example. You sold your piano for $1,500in December 1996 for $300 down and $100a month (plus interest). The payments beganin January 1997. Your gross profit percentageis 40%. You reported the sale on the install-ment method on your 1996 income tax return.After the fourth monthly payment, the buyerdefaults on the contract (which has an unpaidbalance of $800) and you are forced to fore-close on the piano. The FMV of the piano onthe date of repossession is $1,400. The legalcosts of foreclosure and the expense ofmoving the piano back to your home total$75. You figure your gain on the repossessionas follows:

Basis in repossessed property. Your basisin repossessed personal property is its fairmarket value at the time of the repossession.

Fair market value. The fair market value ofrepossessed property is a question of fact tobe established in each case. If you bid for theproperty at a lawful public auction or judicial

sale, its fair market value is presumed to bethe price it sells for, unless there is clear andconvincing evidence to the contrary.

Real PropertyThe rules for the repossession of real prop-erty allow you to keep essentially the sameadjusted basis in the repossessed propertyas you had before the original sale. You canrecover this entire adjusted basis when youresell the property. This, in effect, cancels outthe tax treatment you had on the original saleand puts you in the same tax position youwere in before that sale.

Therefore, the total payments you havereceived from the buyer on the original sale

1) FMV of property repossessed .................2) Unpaid balance of installment

obligation .....................................3) Unrealized profit

(line 2 gross profit %) ..............4) Basis of obligation

(line 2 line 3) ............................5) Plus: Repossession costs ...........6) Gain or loss on repossession

(line 1 line 5) ........................................

1) FMV of property repossessed ................ $1,400

2) Unpaid balance of installmentobligation .................................... $8003) Unrealized profit

(line 2 gross profit %) .............. 3204) Basis of obligation

(line 2 line 3) ........................... 4805) Plus: Repossession costs ... ... ... . 75 5556) Gain on repossession

(line 1 line 5) ........................................ $845

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must be regarded as income to you. You re-port, as gain on the repossession, any partof the payments you have not yet included inincome. This is considered a return of youradjusted basis rather than gross profit. How-ever, the total gain you report is limited, asdiscussed later.

Conditions. The following rules are man-datory. You must use them to figure yourbasis in the repossessed real property andyour gain on the repossession. They apply

whether or not you reported the sale on theinstallment method. However, they apply onlyif all of the following conditions are met.

1) The repossession must be to protectyour security rights in the property.

2) The installment obligation satisfied bythe repossession must have been re-ceived in the original sale.

3) You cannot pay any additional consid-eration to the buyer to get your propertyback, unless either:

a) The reacquisition and payment ofthe additional consideration wereprovided for in the original contractof sale, or

b) The buyer has defaulted, or defaultis imminent.

Additional consideration includes moneyand other property you pay or transfer to thebuyer. For example, additional considerationis present if you reacquire the property sub-

ject to a debt that arose after the original sale.Conditions not met. If any one of these

three conditions is not met, use the rulesdiscussed under Personal Property, earlier,as if the property you repossess were per-sonal rather than real property. Do not use therules for real property.

Figuring gain on repossession. Your gainon repossession is the difference between:

1) The total payments received, or consid-ered received, on the sale, and

2) The total gain already reported as in-come.

See the earlier discussions under PaymentsReceived for items considered payment onthe sale.

Limit on taxable gain. Taxable gain islimited to your gross profit on the original saleminus the sum of:

1) The gain on the sale you reported asincome before the repossession, and

2) Your repossession costs.

This method of figuring taxable gain, in es-sence, treats all payments received on thesale as income, but limits your total taxablegain to the gross profit you originally expectedon the sale.

Indefinite selling price. The limit ontaxable gain does not apply if the selling priceis indefinite and cannot be determined at thetime of repossession. For example, a sellingprice stated as a percentage of the profits tobe realized from the buyer's development ofthe property is an indefinite selling price.

Character of gain. The taxable gain onrepossession is ordinary income or capitalgain, the same as the gain on the originalsale. However, if you did not report the sale

on the installment method, the gain is ordi-nary income.

Repossession costs. Your repossessioncosts include money or property you pay toreacquire the real property. This includesamounts paid to the buyer of the property, aswell as amounts paid to others for such itemsas:

1) Court costs.

2) Legal fees.

3) Publishing, acquiring, filing, or recordingof title.

4) Lien clearance.

Repossession costs do not include the fairmarket value of the buyer's obligations to youthat are secured by the real property.

Use the following worksheet to deter-mine the taxable gain on a repos-session of real property reported on

the installment method.

Example. You sold a tract of land inJanuary 1995 for $25,000. You accepted fromthe buyer a $5,000 down payment, plus a$20,000 mortgage secured by the propertyand payable at the rate of $4,000 annuallyplus interest (9.5%). The payments began onJanuary 1, 1996. Your adjusted basis in theproperty was $19,000 and you reported thetransaction as an installment sale. Your sell-ing expenses were $1,000. You figured yourgross profit as follows:

For this sale, the contract price equals theselling price. The gross profit percentage is20% ($5,000 gross profit $25,000 contractprice).

In 1995, you included $1,000 in income(20% $5,000 down payment). In 1996, youreported a profit of $800 (20% $4,000 an-nual installment). In 1997, the buyer defaultedand you repossessed the property. You paid$500 in legal fees to get your property back.Your taxable gain on the repossession is fig-ured as follows:

Basis. Your basis in the repossessed prop-erty is determined as of the date of repos-session. It is the sum of your:

1) Adjusted basis in the installment obli-gation.

2) Repossession costs.

3) Taxable gain on the repossession.

To figure your adjusted basis on the install-ment obligation at the time of repossession,multiply the unpaid balance by the gross profitpercentage. Subtract that amount from theunpaid balance.

Use the following worksheet to deter-mine the basis of real property re-possessed.

Example. Assume the same facts as thepreceding example. The unpaid balance ofthe installment obligation (the $20,000 note)is $16,000 at the time of repossession be-cause the buyer made a $4,000 payment.The gross profit percentage on the originalsale was 20%. Therefore, $3,200 (20% $16,000 still due on the note) is unrealizedprofit. You figure your basis in the repos-sessed property as follows:

Holding period for resales. If you resell therepossessed property, the resale may resultin a capital gain or loss. To figure whether thegain or loss is long-term or short-term, yourholding period includes the period you ownedthe property before the original sale plus theperiod after the repossession. It does not in-clude the period the buyer owned the prop-erty.

If the buyer made improvements to thereacquired property, the holding period forthese improvements begins on the