Capital Gains, Installment Sales, Unrecaptured Section 1250 Gain

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8836] RIN 1545-AW85

TITLE: Capital Gains, Installment Sales, Unrecaptured Section 1250
Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to the
taxation of capital gains on installment sales of depreciable real
property. The regulations interpret changes made by the Taxpayer
Relief Act of 1997, as amended by the Internal Revenue Service
Restructuring and Reform Act of 1998 and the Omnibus Consolidated
and Emergency Supplemental Appropriations Act of 1999. The
regulations affect persons required to report capital gain from an
installment sale where a portion of the capital gain is unrecaptured
section 1250 gain and a portion is adjusted net capital gain.

DATES: Effective Date: These regulations are effective August 23,
1999.

Applicability Date: These regulations apply to installment payments
properly taken into account after August 23, 1999.

FOR FURTHER INFORMATION CONTACT: Susan Kassell, (202) 622-4930 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26
CFR Part 1). On January 22, 1999, a notice of proposed rulemaking
relating to the taxation of capital gains on installment sales of
depreciable real property was published in the Federal Register (64
FR 3457). No comments were received from the public in response to
the notice of proposed rulemaking.

No public hearing was requested or held. The proposed regulations
are adopted without substantive change by this Treasury decision.

Explanation of Provisions

In 1997 Congress amended section 1(h) generally to reduce the
maximum capital gain tax rates for individuals. As amended, section
1(h) generally divides a taxpayer's net capital gain into several
rate groups. A maximum marginal rate of 28 percent applies to 28-
percent rate gain, which is not pertinent to these final
regulations. A maximum marginal rate of 25 percent applies to
unrecaptured section 1250 gain (25-percent gain), which is defined
in section 1(h)(7)(A) as the amount of long-term capital gain (not
otherwise treated as ordinary income) that would be treated as
ordinary income if section 1250(b)(1) included all depreciation and
the applicable percentage under section 1250(a) were 100 percent,
reduced by any net loss in the 28-percent rate category. A maximum
marginal rate of 20 percent applies to adjusted net capital gain
(20/10-percent gain), defined in section 1(h)(4) as the portion of
net capital gain that is not taxed at the 28-percent or 25-percent
rates. A reduced rate of 10 percent is applied to the portion of the
taxpayer's adjusted net capital gain that would otherwise be taxed
at a 15-percent rate.

Under the final regulations, if a portion of the capital gain from
an installment sale of real depreciable property consists of 25-
percent gain, and a portion consists of 20/10- percent gain, the
taxpayer is required to take the 25-percent gain into account before
the 20/10-percent gain, as payments are received. In addition, an
example in the regulations illustrates that section 1231 gain from
an installment sale that is recharacterized as ordinary gain under
section 1231(c) is deemed to consist first of 25-percent gain, and
then 20/10-percent gain.

Consistent with this treatment and with the general rule that 25-
percent gain is taken into account first, another example in the
regulations illustrates that, where there is installment gain that
is characterized as ordinary gain under section 1231(a) because
there is a net section 1231 loss for the year, the gain is treated
as consisting of 25-percent gain first, before 20/10- percent gain,
for purposes of determining how much 25-percent gain remains to be
taken into account in later payments.

The final regulations also provide that the capital gain rates
applicable to installment payments that are received on or after the
effective date of the 1997 Act from sales prior to the effective
date are determined as if, for all payments received after the date
of sale but before the effective date, 25-percent gain had been
taken into account before 20/10-percent gain. The regulations
further provide that, in the event the cumulative amount of 25-
percent gain actually reported in installment payments received
during the period between the effective date of section 1(h) and the
effective date of these regulations was less than the amount that
would have been reported using the front-loaded allocation method of
the regulations, the amount of 25- percent gain actually reported,
rather than an amount determined under a front-loaded allocation
method, must be used in determining the amount of 25-percent gain
that remains to be reported.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and
because these regulations do not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, the notice of proposed rulemaking preceding these
regulations was submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.

Drafting Information

The principal authors of these regulations are Susan Kassell and Rob
Laudeman, Office of Assistant Chief Counsel (Income Tax &
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1
is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.453-12 is added to read as follows:

§1.453-12 Allocation of unrecaptured section 1250 gain reported on
the installment method.

(a) General rule. Unrecaptured section 1250 gain, as defined in
section 1(h)(7), is reported on the installment method if that
method otherwise applies under section 453 or 453A and the
corresponding regulations. If gain from an installment sale includes
unrecaptured section 1250 gain and adjusted net capital gain (as
defined in section 1(h)(4)), the unrecaptured section 1250 gain is
taken into account before the adjusted net capital gain.

(b) Installment payments from sales before May 7, 1997. The amount
of unrecaptured section 1250 gain in an installment payment that is
properly taken into account after May 6, 1997, from a sale before
May 7, 1997, is determined as if, for all payments properly taken
into account after the date of sale but before May 7, 1997,
unrecaptured section 1250 gain had been taken into account before
adjusted net capital gain.

(c) Installment payments received after May 6, 1997, and on or
before August 23, 1999. If the amount of unrecaptured section 1250
gain in an installment payment that is properly taken into account
after May 6, 1997, and on or before August 23, 1999, is less than
the amount that would have been taken into account under this
section, the lesser amount is used to determine the amount of
unrecaptured section 1250 gain that remains to be taken into
account.

(d) Examples. In each example, the taxpayer, an individual whose
taxable year is the calendar year, does not elect out of the
installment method. The installment obligation bears adequate stated
interest, and the property sold is real property held in a trade or
business that qualifies as both section 1231 property and section
1250 property. In all taxable years, the taxpayer's marginal tax
rate on ordinary income is 28 percent.

The following examples illustrate the rules of this section:

Example 1. General rule. This example illustrates the rule of
paragraph (a) of this section as follows:

(i) In 1999, A sells property for $10,000, to be paid in ten equal
annual installments beginning on December 1, 1999. A originally
purchased the property for $5000, held the property for several
years, and took straight-line depreciation deductions in the amount
of $3000. In each of the years 1999-2008, A has no other capital or
section 1231 gains or losses.

(ii) A's adjusted basis at the time of the sale is $2000.

Of A's $8000 of section 1231 gain on the sale of the property, $3000
is attributable to prior straight-line depreciation deductions and
is unrecaptured section 1250 gain. The gain on each installment
payment is $800.

(iii) As illustrated in the table in this paragraph (iii) of this
Example 1., A takes into account the unrecaptured section 1250 gain
first. Therefore, the gain on A's first three payments, received in
1999, 2000, and 2001, is taxed at 25 percent. Of the $800 of gain on
the fourth payment, received in 2002, $600 is taxed at 25 percent
and the remaining $200 is taxed at 20 percent. The gain on A's
remaining six installment payments is taxed at 20 percent. The table
is as follows:

                    1999  2000  2001  2002  2003  2004-  Total
                                                  2008   gain
Installment gain     800   800   800   800   800  4000   8000
Taxed at 25%         800   800   800   600               3000
Taxed at 20%                           200   800  4000   5000
Remaining to be     2200  1400   600
taxed at 25%

Example 2. Installment payments from sales prior to May 7, 1997.
This example illustrates the rule of paragraph (b) of this section
as follows:

(i) The facts are the same as in Example 1 except that A sold the
property in 1994, received the first of the ten annual installment
payments on December 1, 1994, and had no other capital or section
1231 gains or losses in the years 1994-2003.

(ii) As in Example 1, of A's $8000 of gain on the sale of the
property, $3000 was attributable to prior straight-line depreciation
deductions and is unrecaptured section 1250 gain.

(iii) As illustrated in the following table, A's first three
payments, in 1994, 1995, and 1996, were received before May 7, 1997,
and taxed at 28 percent. Under the rule described in paragraph (b)
of this section, A determines the allocation of unrecaptured section
1250 gain for each installment payment after May 6, 1997, by taking
unrecaptured section 1250 gain into account first, treating the
general rule of paragraph (a) of this section as having applied
since the time the property was sold, in 1994. Consequently, of the
$800 of gain on the fourth payment, received in 1997, $600 is taxed
at 25 percent and the remaining $200 is taxed at 20 percent. The
gain on A's remaining six installment payments is taxed at 20
percent. The table is as follows:

                   1994  1995  1996  1997  1998  1999-  Total
                                                 2003   gain
                                                 
Installment gain    800   800   800   800   800  4000   8000
Taxed at 28%        800   800   800                     2400
Taxed at 25%                          600                600
Taxed at 20%                          200   800  4000   5000
Remaining to       2200  1400   600
be taxed at 25%

Example 3. Effect of section 1231(c) recapture. This example
illustrates the rule of paragraph (a) of this section when there are
non-recaptured net section 1231 losses, as defined in section
1231(c)(2), from prior years as follows:

(i) The facts are the same as in Example 1, except that in 1999 A
has non-recaptured net section 1231 losses from the previous four
years of $1000.

(ii) As illustrated in the table in paragraph (iv) of this Example
3, in 1999, all of A's $800 installment gain is recaptured as
ordinary income under section 1231(c). Under the rule described in
paragraph (a) of this section, for purposes of determining the
amount of unrecaptured section 1250 gain remaining to be taken into
account, the $800 recaptured as ordinary income under section
1231(c) is treated as reducing unrecaptured section 1250 gain,
rather than adjusted net capital gain. Therefore, A has $2200 of
unrecaptured section 1250 gain remaining to be taken into account.

(iii) In the year 2000, A's installment gain is taxed at two rates.
First, $200 is recaptured as ordinary income under section 1231(c).
Second, the remaining $600 of gain on A's year 2000 installment
payment is taxed at 25 percent. Because the full $800 of gain
reduces unrecaptured section 1250 gain, A has $1400 of unrecaptured
section 1250 gain remaining to be taken into account.

(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent. Of the $800 of gain on the fourth payment, received
in 2002, $600 is taxed at 25 percent and the remaining $200 is taxed
at 20 percent. The gain on A's remaining six installment payments is
taxed at 20 percent. The table is as follows:

                    1999  2000  2001  2002  2003  2004-  Total
                                                  2008   gain

Installment gain     800   800   800   800   800  4000   8000
Taxed at             800   200                           1000
ordinary rates
under section 1231(c)
Taxed at 25%               600   800   600               2000
Taxed at 20%                           200   800  4000   5000
Remaining non-       200
recaptured net
section 1231 losses
Remaining to be     2200  1400   600
taxed at 25%

Example 4. Effect of a net section 1231 loss. This example
illustrates the application of paragraph (a) of this section when
there is a net section 1231 loss as follows:

(i) The facts are the same as in Example 1 except that A has section
1231 losses of $1000 in 1999.

(ii) In 1999, A's section 1231 installment gain of $800 does not
exceed A's section 1231 losses of $1000. Therefore, A has a net
section 1231 loss of $200. As a result, under section 1231(a) all of
A's section 1231 gains and losses are treated as ordinary gains and
losses. As illustrated in the following table, A's entire $800 of
installment gain is ordinary gain.

Under the rule described in paragraph (a) of this section, for
purposes of determining the amount of unrecaptured section 1250 gain
remaining to be taken into account, A's $800 of ordinary section
1231 installment gain in 1999 is treated as reducing unrecaptured
section 1250 gain. Therefore, A has $2200 of unrecaptured section
1250 gain remaining to be taken into account.

(iii) In the year 2000, A has $800 of section 1231 installment gain,
resulting in a net section 1231 gain of $800.

A also has $200 of non-recaptured net section 1231 losses. The $800
gain is taxed at two rates. First, $200 is taxed at ordinary rates
under section 1231(c), recapturing the $200 net section 1231 loss
sustained in 1999. Second, the remaining $600 of gain on A's year
2000 installment payment is taxed at 25 percent. As in Example 3,
the $200 of section 1231(c) gain is treated as reducing unrecaptured
section 1250 gain, rather than adjusted net capital gain. Therefore,
A has $1400 of unrecaptured section 1250 gain remaining to be taken
into account.

(iv) The gain on A's installment payment received in 2001 is taxed
at 25 percent, reducing the remaining unrecaptured section 1250 gain
to $600. Of the $800 of gain on the fourth payment, received in
2002, $600 is taxed at 25 percent and the remaining $200 is taxed at
20 percent. The gain on A's remaining six installment payments is
taxed at 20 percent. The table is as follows:

                    1999  2000  2001  2002  2003  2004-  Total
                                                  2008   gain

Installment gain     800   800   800   800   800  4000   8000
Ordinary gain        800                                  800
under section
1231(a)
Taxed at                   200                            200
ordinary rates
under section 1231(c)
Taxed at 25%               600   800   600               2000
Taxed at 20%                           200   800  4000   5000
Net                  200
section 1231 loss
Remaining to be     2200  1400   600
taxed at 25%.

(e) Effective date. This section applies to installment payments
properly taken into account after August 23, 1999.

Deputy Commissioner of Internal Revenue
Approved:
Assistant Secretary of the Treasury

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