The rules discussed in this part of the publication apply only in
certain circumstances or to certain types of property. The rules cover
the following topics.
- Electing out of the installment method.
- Payments received, including those considered
received.
- An escrow account.
- Depreciation recapture income.
- A sale to a related person.
- A like-kind exchange.
- A contingent payment sale.
- A single sale of several assets.
- The sale of a business.
- Unstated interest and original interest discount.
- Disposition of an installment obligation.
- A repossession.
Electing Out of the
Installment Method
If you elect not to use the installment method, you generally
report the entire gain in the year of sale, even though you do not
receive all the sale proceeds in that year.
To figure the gain to report, use the fair market value (FMV) of
the buyer's installment obligation. Notes, mortgages, and land
contracts are examples of obligations that are included at FMV.
You must figure the FMV of the buyer's installment obligation,
whether or not you would actually be able to sell it. If you use the
cash method of accounting, the FMV of the obligation will never be
considered to be less than the FMV of the property sold (minus any
other consideration received).
Example.
You sold a parcel of land for $50,000. You received a $10,000 down
payment and will receive the balance over the next 10 years at $4,000
a year, plus 8% interest. The buyer gave you a note for $40,000. The
note had an FMV 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 for more than one year. You decide to elect out of the installment
method and report the entire gain in the year of sale.
|
Gain realized: |
| Selling price |
$50,000 |
| Minus: |
Property's adj. basis |
$25,000 |
|
Commission |
3,000 |
28,000 |
| Gain realized |
$22,000 |
|
Gain recognized in year of sale: |
| Cash |
$10,000 |
| Market value of note |
40,000 |
| Total realized in year of sale |
$50,000 |
| Minus: |
Property's adj. basis |
$25,000 |
| Commission |
3,000 |
28,000 |
| Gain recognized |
$22,000 |
The recognized gain of $22,000 is long-term capital gain. Since you
include the entire gain in income in the year of sale, you do not
include in income any principal payments you receive in later tax
years. The interest on the note is ordinary income and is reported as
interest income each year.
How to elect out.
To make this election, do not report your sale on Form 6252.
Instead, report it on Schedule D (Form 1040) or Form 4797, whichever
applies.
When to elect out.
Make this election by the due date, including extensions, for
filing your tax return for the year the sale takes place.
Automatic six-month extension.
If you timely file your tax return without making the election, you
can still make the election by filing an amended return within 6
months of the due date of your return (excluding extensions). Write
"FILED PURSUANT TO SECTION 301.9100-2" at the top of the
amended return and file it where the original return was filed.
Revoking the election.
Once made, the election can only be revoked with IRS approval. You
will not be allowed to revoke the election in either of the following
situations.
- One of the purposes is to avoid federal income tax.
- The tax year in which any payment was received has
closed.
Payments
Received
You must figure your gain each year on the payments you receive, or
are treated as receiving, from an installment sale. These payments
include the down payment and each later payment of principal on the
buyer's debt to you.
In certain situations, you are considered to have received a
payment, even though the buyer does not pay you directly. These
situations occur when the buyer assumes or pays any of your debts,
such as a loan, or pays any of your expenses, such as a sales
commission.
Buyer pays seller's expenses.
If the buyer pays any of your expenses related to the sale of your
property, it is considered a payment to you in the year of sale.
Include these expenses in the selling and contract prices when
figuring the gross profit percentage.
Buyer assumes mortgage.
If the buyer assumes or pays off your mortgage, or otherwise takes
the property subject to the mortgage, the following rules apply.
Mortgage less than basis.
If the buyer assumes a mortgage that is less than your installment
sale basis in the property, it is not considered a payment to you. The
contract price equals the selling price minus the mortgage. This
difference is all you will directly collect from the buyer.
Example.
You sell property with an adjusted basis of $19,000. You have
selling expenses of $1,000. The buyer assumes your existing mortgage
of $15,000 and agrees to pay you $10,000 (a cash down payment of
$2,000 and $2,000 (plus 12% interest) in each of 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
contract price is $10,000 ($25,000 - $15,000 mortgage). Your
gross profit percentage is 50% ($5,000 x $10,000). You report
half of each $2,000 payment received as gain from the sale. You also
report all interest you receive as ordinary income.
Mortgage more than basis.
If the buyer assumes a mortgage that is more than your installment
sale basis in the property, you recover your entire basis. You are
also relieved of the obligation to repay the amount borrowed. The part
of the mortgage greater than your basis is treated as a payment
received in the year of sale.
To figure the contract price, subtract the mortgage from the
selling price. This is the total amount you will actually receive from
the buyer. Add to this amount the payment you are considered to
receive (the difference between the mortgage and your installment sale
basis). The contract price is then the same as your gross profit from
the sale.
If the mortgage the buyer assumes is equal to or more than your
installment sale basis, the gross profit percentage will always be
100%.
Example.
The selling price for your property is $9,000. The buyer will pay
you $1,000 annually (plus 8% interest) over the next 3 years and
assume an existing mortgage of $6,000. Your adjusted basis in the
property is $4,400. You have selling expenses of $600, for a total
installment sale basis of $5,000. The part of the mortgage that is
more than your installment sale basis is $1,000 ($6,000 -
$5,000). This amount is included in the contract price and treated as
a payment received in the year of sale. The contract price is $4,000:
| Selling price |
$9,000 |
| Minus: Mortgage |
(6,000) |
| Amount actually received |
$3,000 |
| Add difference: |
| Mortgage |
$6,000 |
| Less: Installment sale basis |
5,000 |
1,000 |
| Contract price |
$4,000 |
Your gross profit on the sale is also $4,000:
| Selling price |
$9,000 |
| Minus: Installment sale basis |
(5,000) |
| Gross profit |
$4,000 |
Your gross profit percentage is 100%. Report 100% of each payment
as gain from the sale. Treat the $1,000 difference between the
mortgage and your installment sale basis as a payment and report 100%
of it as gain in the year of sale.
Mortgage canceled.
If the buyer of your property is the person who holds the mortgage
on it, your debt is canceled, not assumed. You are considered to
receive a payment equal to the outstanding canceled debt.
Example.
Mary Jones loaned you $4,500 in 1995 in exchange for a note
mortgaging a tract of land you owned. On April 4, 2000, she bought 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 to pay you
$2,000 (plus interest) on August 1, 2000, and $2,000 on August 1,
2001. She did not assume an existing mortgage. She canceled the $3,000
debt you owed her. You are considered to have received a $3,000
payment at the time of the sale.
Buyer assumes other debts.
If the buyer assumes any other debts, such as a loan or back taxes,
it may be considered a payment to you in the year of sale.
If the buyer assumes the debt instead of paying it off, only part
of it may have to be treated as a payment. Compare the debt to your
installment sale basis in the property being sold. If the debt is less
than your installment sale basis, none of it is treated as a payment.
If it is more, only the difference is treated as a payment. If the
buyer assumes more than one debt, any part of the total that is more
than your installment sale basis is considered a payment. These rules
are the same as the rules discussed earlier under Buyer assumes
mortgage. However, they apply only to the following types of
debts the buyer assumes.
- Those acquired from ownership of the property you are
selling, such as a mortgage, lien, overdue interest, or back
taxes.
- Those acquired in the ordinary course of your business, such
as a balance due for inventory you purchased.
If the buyer assumes any other type of debt, such as a personal
loan, it is treated as if the buyer had paid off the debt at the time
of the sale. The value of the assumed debt is then considered a
payment to you in the year of sale.
Payment of property.
If you receive property rather than money from the buyer, it is
still considered a payment. However, see Like-Kind Exchange,
later. The amount of the payment is the property's FMV on the
date you receive it.
Fair market value (FMV).
This is the price at which property would change hands between a
buyer and a seller, neither being required to buy or sell, and both
having a reasonable knowledge of all the necessary facts. If your
installment sale fits this description, the value assigned to property
in your agreement with the buyer is good evidence of its FMV.
Third-party note.
If the property the buyer gives you is a third-party note (or other
obligation of a third party), you are considered to have received a
payment equal to the note's FMV. Because the note is itself a payment
on your installment sale, any payments you later receive from the
third party are not considered payments on the sale.
Example.
You sold real estate in an installment sale. As part of the down
payment, the buyer assigned to you a $5,000, 8% interest note of a
third party. The FMV of the third-party note at the time of the sale
was $3,000. This amount, not $5,000, is a payment to you in the year
of sale. Because the third-party note had an FMV equal to 60% of its
face value ($3,000 x $5,000), 60% of each principal payment you
receive on this note is a nontaxable return of capital. The remaining
40% is ordinary income.
Bond.
A bond or other evidence of debt you receive from the buyer that is
payable on demand is treated as a payment in the year you receive it.
If you receive a government or corporate bond that has interest
coupons attached or that can be readily traded in an established
securities market, you are considered to have received payment equal
to the bond's FMV.
Buyer's note.
The buyer's note (unless payable on demand) is not considered
payment on the sale. However, its full face value is included when
figuring the selling price and the contract price. Payments you
receive on the note are used to figure your gain in the year received.
Guarantee.
If a third party or government agency guarantees the buyer's
payments to you on an installment obligation, the guarantee itself is
not considered payment.
Installment obligation used as security (pledge rule).
If you use an installment obligation to secure any debt, the net
proceeds from the debt may be treated as a payment on the installment
obligation. This is known as the pledge rule and it applies if the
selling price of the property is over $150,000. It does not apply to
the following dispositions.
- Sales of property used or produced in farming.
- Sales of personal-use property.
- Qualifying sales of timeshares and residential lots.
The net debt proceeds are the gross debt minus the direct expenses
of getting the debt. The amount treated as a payment is considered
received on the later of the following dates.
- The date the debt becomes secured.
- The date you receive the debt proceeds.
A debt is secured by an installment obligation to the extent that
payment of principal or interest on the debt is directly secured
(under the terms of the loan or any underlying arrangement) by any
interest in the installment obligation. For sales after December 16,
1999, if you have the right to transfer an installment
obligation in payment of a loan, the loan is considered directly
secured.
Limit.
The net debt proceeds treated as a payment on the pledged
installment obligation cannot be more than the excess of item (1) over
item (2), below.
- The total contract price on the installment sale.
- Any payments received on the installment obligation before
the date the net debt proceeds are treated as a payment.
Installment payments.
The pledge rule accelerates the reporting of the installment
obligation payments. Do not report payments received on the obligation
after it has been pledged until the payments received exceed the
amount reported under the pledge rule.
Exception.
The pledge rule does not apply to debt incurred after December 17,
1987, to refinance a debt under the following circumstances.
- The debt was outstanding on December 17, 1987.
- The debt was secured by that installment sale obligation on
that date and at all times thereafter until the refinancing
occurred.
A refinancing as a result of the creditor's calling of the debt is
treated as a continuation of the original debt so long as a person
other than the creditor or a person related to the creditor provides
the refinancing.
This exception applies only to the refinancing that does not exceed
the principal of the original debt immediately before the refinancing.
Any excess is treated as a payment on the installment obligation.
Escrow Account
In some cases, the sales agreement, or a later agreement, may call
for the buyer to establish an irrevocable escrow account from which
the remaining installment payments (including interest) are to be
made. These sales cannot be reported on the installment method. The
buyer's obligation is paid in full when the balance of the purchase
price is deposited into the escrow account. When an escrow account is
established, you no longer rely on the buyer for the rest of the
payments, but on the escrow arrangement.
Example.
You sell property for $10,000. The sales agreement calls for a down
payment of $1,000 and payment of $1,500 in each of the next 6 years to
be made from an irrevocable escrow account containing the balance of
the purchase price plus interest. You cannot report the sale on the
installment method because the full purchase price is considered
received in the year of sale. You must report the entire gain in the
year of sale.
Escrow established in a later year.
If you make an installment sale and in a later year an irrevocable
escrow account is established to pay the remaining installments plus
interest, the amount placed in the escrow account represents payment
of the balance of the installment obligation.
Substantial restriction.
If an escrow arrangement imposes a substantial restriction on your
right to receive the sale proceeds, the sale can be reported on the
installment method, provided it otherwise qualifies. For an escrow
arrangement to impose a substantial restriction, it must serve a bona
fide purpose of the buyer, that is, a real and definite restriction
placed on the seller or a specific economic benefit conferred on the
buyer.
Depreciation
Recapture Income
If you sell property for which you claimed a depreciation
deduction, you must report any depreciation recapture income in the
year of sale, whether or not an installment payment was received that
year. Figure your depreciation recapture income (including the section
179 deduction and the section 179A deduction recapture) in Part III of
Form 4797. Report the recapture income in Part II of Form 4797 as
ordinary income in the year of sale. The recapture income is also
included in Part I of Form 6252. However, the gain equal to the
recapture income is reported in full in the year of the sale. Only the
gain greater than the recapture income is reported on the installment
method. For more information on depreciation recapture, see chapter 3
in Publication 544.
The recapture income reported in the year of sale is included in
your installment sale basis in determining your gross profit on the
installment sale. Determining gross profit is discussed under
General Rules, earlier.
Sale to a
Related Person
Two special rules apply to an installment sale between related
persons. Test your sale against Rule 1 first. If Rule 1 does not
apply, test your sale against Rule 2. For purposes of these rules,
spouses, children, grandchildren, brothers, sisters, and parents are
all considered related persons. A partnership or corporation in which
you have an interest, or an estate or trust with which you have a
connection, can also be considered a related person.
For more information on these kinds of sales, see section 453 of
the Internal Revenue Code.
Rule 1--Sale of Depreciable Property
If you sell depreciable property to certain related persons, you
cannot report the sale using the installment method. Instead, all
payments to be received are considered received in the year of sale.
Depreciable property for this rule is any property that the purchaser
can depreciate.
Payments to be received include the total of all noncontingent
payments and the FMV of any payments contingent as to amount.
In the case of contingent payments for which the FMV cannot be
reasonably determined, your basis in the property is recovered
ratably. The purchaser cannot increase the basis of the property
acquired in the sale before the seller includes a like amount in
income.
Exceptions to Rule 1.
Rule 1 will not apply if no significant tax deferral benefit will
be derived from the sale. You must show to the satisfaction of the IRS
that avoidance of federal income tax was not one of the principal
purposes of the sale.
Rule 2--Sale and Resale
Generally, a special rule applies if you (an installment seller)
make a first disposition (sale or exchange) to a related person who
then makes a second disposition (sale, exchange, or gift) under the
following circumstances.
- The related person makes the second disposition before
making all payments on the first disposition.
- The related person disposes of the property within 2 years
of the first disposition.
Under this rule, you treat part or all of the amount the
related person realizes (or the FMV if the disposed property is not
sold or exchanged) from the second disposition as if you received it
from the first disposition at the time of the second disposition.
Example 1.
In 1999, Harvey Green sold farm land to his son Bob for $500,000,
which was to be paid in five equal payments over 5 years, plus
adequate stated interest on the balance due. His installment sale
basis for the farm land was $250,000 and the property was not subject
to any outstanding liens or mortgages. His gross profit percentage is
50% (gross profit of $250,000 x contract price of $500,000). He
received $100,000 in 1999 and included $50,000 in income for that year
($100,000 x 0.50). Bob made no improvements to the property and
sold it to Alfalfa Inc., in 2000 for $600,000 after making the payment
for that year. The amount realized from the second disposition is
$600,000. Harvey figures his installment sale income for 2000 as
follows:
| Lesser of: 1) Amount realized on
second disposition, or 2) Contract price on first disposition |
$500,000 |
| Subtract: Sum of payments from Bob in 1999 and
2000 |
- 200,000 |
| Amount treated as received because of second
disposition |
$300,000 |
| Add: Payment from Bob in 2000 |
+ 100,000 |
| Total payments received and treated as received
for 2000 |
$400,000 |
| Multiply by gross profit % |
x .50 |
| Installment sale income for 2000 |
$200,000 |
Harvey will not include in his installment sale income any
principal payments he receives on the installment obligation for 2001,
2002, and 2003 because he has already reported the total payments of
$500,000 from the first disposition ($100,000 in 1999 and $400,000 in
2000).
Example 2.
Assume the facts are the same as Example 1 except that
Bob sells the property for only $400,000. The gain for 2000 is figured
as follows:
| Lesser of: 1) Amount realized on
second disposition, or 2) Contract price on first disposition |
$400,000 |
| Subtract: Sum of payments from Bob in 1999 and
2000 |
- 200,000 |
| Amount treated as received because of second
disposition |
$200,000 |
| Add: Payment from Bob in 2000 |
+ 100,000 |
| Total payments received and treated as received
for 2000 |
$300,000 |
| Multiply by gross profit % |
x .50 |
| Installment sale income for 2000 |
$150,000 |
Harvey receives a $100,000 payment in 2001 and another in 2002.
They are not taxed because he treated the $200,000 from the
disposition in 2000 as a payment received and paid tax on the gain. In
2003, he receives the final $100,000 payment. He figures the gain he
must recognize in 2003 as follows:
| Total payments from the first disposition
received by the end of 2002 |
$500,000 |
| Minus the sum of: |
| Payment from 1999 |
$100,000 |
| Payment from 2000 |
100,000 |
| Amount treated as received in
2000 |
200,000 |
| Total on which gain was previously
recognized |
- 400,000 |
| Payment on which gain is recognized for
2003 |
$100,000 |
| Multiply by gross profit % |
x .50 |
| Installment sale income for
2003 |
$ 50,000 |
Exceptions to Rule 2.
These rules do not apply to a second disposition, and any later
transfer, if you can show, to the satisfaction of the IRS, that
neither the first disposition (to the related person) nor the second
disposition had as one of its principal purposes the avoidance of
federal income tax. Generally, an involuntary second disposition will
qualify under the nontax avoidance exception, such as when a creditor
of the related person forecloses on the property or the related person
declares bankruptcy.
The nontax avoidance exception also applies to a second disposition
that is also an installment sale if the terms of payment under the
installment resale are substantially equal to or longer than those for
the first installment sale. However, the exception does not apply if
the resale terms permit significant deferral of recognition of gain
from the first sale.
In addition, any sale or exchange of stock to the issuing
corporation is not treated as a first disposition. An involuntary
conversion is not treated as a second disposition if the first
disposition occurred before the threat of conversion. A transfer after
the death of the person making the first disposition or the related
person's death, whichever is earlier, is not treated as a second
disposition.
Like-Kind Exchange
If you trade business or investment property solely for the same
kind of property, you can postpone reporting the gain. These trades
are known as "like-kind exchanges." The property you receive in a
like-kind exchange is treated as if it were a continuation of the
property you gave up.
You do not have to report any part of your gain if you receive only
like-kind property. However, if you also receive money or other
property in the exchange, you must report your gain to the extent of
the money and the FMV of the other property received.
For more information on like-kind exchanges, see Like-Kind
Exchanges in chapter 1 of Publication 544.
Installment payments.
If, in addition to like-kind property, you receive an installment
obligation in the exchange, the following rules apply.
- The contract price is reduced by the FMV of the like-kind
property received in the trade.
- The gross profit is reduced by any gain on the trade that
can be postponed.
- Like-kind property received in the trade is not considered
payment on the installment obligation.
Example.
In 2000, George Brown trades personal property with an installment
sale basis of $400,000 for like-kind property having an FMV of
$200,000. He also receives an installment note for $800,000 in the
trade. Under the terms of the note, he is to receive $100,000 (plus
interest) in 2001 and the balance of $700,000 (plus interest) in 2002.
George's selling price is $1,000,000 ($800,000 installment note +
$200,000 FMV of like-kind property received). His gross profit is
$600,000 ($1,000,000 - $400,000 installment sale basis). The
contract price is $800,000 ($1,000,000 - $200,000). The gross
profit percentage is 75% ($600,000 x $800,000). He reports no
gain in 2000 because the like-kind property he receives is not treated
as a payment for figuring gain. He reports $75,000 gain for 2001 (75%
of $100,000 payment received) and $525,000 gain for 2002 (75% of
$700,000 payment received).
Deferred exchanges.
A deferred exchange is one in which you transfer property and
receive like-kind property later. Under this type of exchange, the
person receiving your property may be required to place funds in an
escrow account or trust. If certain rules are met, these funds will
not be considered a payment until you have the right to receive the
funds or, if earlier, the end of the exchange period. See section
1.1031(k)-1(j)(2) of the regulations for these rules.
Contingent Payment Sale
For installment sales, a contingent payment sale is one whose total
selling price cannot be determined by the end of the tax year in which
the sale takes place.
If the selling price cannot be determined by the end of the tax
year, the contract price and the gross profit percentage cannot be
determined (using the same rules that apply to an installment sale
with a fixed selling price). This happens, for example, if you sell
your business and the selling price includes a percentage of its
profits in future years.
For rules on using the installment method for a contingent payment
sale or a contingent payment sale with unstated interest, see section
15A.453-1(c) of the regulations.
Single Sale
of Several Assets
If you sell different types of assets in a single sale, you must
identify each asset to determine whether you can use the installment
method to report the sale of that asset. You also have to allocate
part of the selling price to 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 an arm's-length transaction, you must allocate the
selling price to an asset based on its FMV. If the buyer assumes a
debt, or takes the property subject to a debt, you must reduce the FMV
of the property by the debt. This becomes the net FMV.
A sale of separate and unrelated assets of the same type under a
single contract is reported as one transaction for the installment
method. However, if an asset is sold at a loss, its disposition cannot
be reported on the installment method. It must be reported separately.
The remaining assets sold at a gain are reported together.
Example.
You sold three separate and unrelated parcels of real property (A,
B, and C) under a single contract calling for a total selling price of
$130,000. The total selling price consisted of a cash payment of
$20,000, the buyer's assumption of a $30,000 mortgage on parcel B, and
an installment obligation of $80,000 payable in eight annual
installments, plus interest at 8% a year.
Your installment sale basis for each parcel was $15,000. Your net
gain was $85,000 ($130,000 - $45,000). You report the gain on
the installment method.
The sales contract did not allocate the selling price or the cash
payment received in the 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 parcel C was more than its
FMV, it was sold at a loss and must be treated separately. You must
allocate the total selling price and the amounts received in the year
of sale between parcel C and the remaining parcels.
Of the total $130,000 selling price, you must allocate $120,000 to
parcels A and B together and $10,000 to parcel C. You should allocate
the cash payment of $20,000 received in the year of sale and the note
receivable on the basis of the proportionate net FMV. The allocation
is figured as follows:
| |
Parcels A and B |
Parcel C |
| FMV |
$120,000 |
$10,000 |
| Minus: Mortgage assumed |
30,000 |
-0- |
| Net FMV |
$ 90,000 |
$10,000 |
| Proportionate net FMV: |
| Percentage of total |
90% |
10% |
| Payments in year of sale: |
| $20,000 x 90% |
$18,000 |
|
| $20,000 x 10% |
|
$2,000 |
| Excess of parcel B mortgage over installment
sale basis |
15,000 |
-0- |
| Allocation of payments
received (or considered
received) in year of sale |
$ 33,000 |
$ 2,000 |
You cannot report the sale of parcel C on the installment method
because the sale results in a loss. You report this loss of $5,000
($10,000 selling price - $15,000 installment sale basis) in the
year of sale. However, if parcel C was held for personal use, the loss
is not deductible.
You allocate the installment obligation of $80,000 to the
properties sold based on their proportionate net FMVs (90% to parcels
A and B, 10% to parcel C).
Sale of a Business
The installment sale of an entire business for one overall price
under a single contract is not the sale of a single asset.
Allocation of selling price.
The selling price must be allocated among each asset class for the
following reasons.
- The sale of a business generally includes real and personal
property that can be reported on the installment method and inventory
items that cannot.
- Any depreciation recapture income from the sale of
depreciable property cannot be reported on the installment method. It
is reported in full in the year of the sale.
- Assets sold at a loss cannot be reported on the installment
method.
Inventory.
The sale of inventory items cannot be reported on the installment
method. All gain or loss on their sale must be reported in the year of
sale, even if you are paid in later years.
If inventory items are included in an installment sale, you may
have an agreement stating which payments are for inventory and which
are for the other assets being sold. If you do not, each payment must
be allocated between the inventory and the other assets sold.
Report the amount you receive (or will receive) on the sale of
inventory items as ordinary business income. Use your basis in the
items to figure the cost of goods sold and deduct the part of the
selling expenses allocated to inventory as an ordinary business
expense.
Residual method.
Except for assets exchanged under the like-kind exchange rules,
both the buyer and seller of a business must use the residual method
to allocate the sale price to each business asset sold. This method
determines gain or loss from the transfer of each asset.
The residual method must be used for any transfer of a group of
assets that constitutes a trade or business and for which the buyer's
basis is determined only by the amount paid for the assets. This
applies to both direct and indirect transfers, such as the sale of a
business or the sale of a partnership interest in which the basis of
the buyer's share of the partnership assets is adjusted for the amount
paid. A group of assets constitutes a trade or business if goodwill or
going concern value could, under any circumstances, attach to the
assets.
The residual method provides for the sale price to first be reduced
by cash, general deposit accounts other than certificates of deposit,
and similar accounts transferred by the seller. The consideration
remaining after this reduction must be allocated among the various
business assets in a certain order.
For asset acquisitions occurring after January 5, 2000,
the allocation must be made among the following assets in
proportion to (but not more than) their fair market value on the
purchase date in the following order.
- Certificates of deposit, U.S. Government securities, foreign
currency, and actively traded personal property, including stock and
securities.
- Accounts receivable, mortgages, and credit card receivables
that arose in the ordinary course of business.
- Property of a kind that would properly be included in
inventory if on hand at the end of the tax year and property held by
the taxpayer primarily for sale to customers in the ordinary course of
business.
- All other assets except section 197 intangibles, goodwill,
and going concern value.
- Section 197 intangibles except goodwill and going concern
value.
- Goodwill and going concern value (whether or not they
qualify as section 197 intangibles).
More information.
For information on the allocation of assets acquired before January
6, 2000, see Sale of a Business in chapter 2 of Publication 544.
For more information on section 197 intangibles, see chapter 9 of
Publication 535.
How to report the sale of a business.
Both the seller and buyer must prepare and attach Form 8594,
Asset Acquisition Statement Under Section 1060, to their
income tax return for the year the sale occurs. If the amount
allocated to any asset is increased or decreased after Form 8594 is
filed, a supplemental statement in Part III of a new Form 8594 must be
completed.
Sale of partnership interest.
A partner who sells a partnership interest at a gain may be able to
report the sale on the installment method. The sale of a partnership
interest is treated as the sale of a single capital asset. However,
the partner must allocate a portion of the proceeds to ordinary income
if the partnership's assets include unrealized receivables and
inventory items. (The term "unrealized receivables" includes
depreciation recapture income, discussed earlier.)
The gain allocated to the unrealized receivables and the inventory
cannot be reported under the installment method. The gain allocated to
the other assets can be reported under the installment method.
For more information on the treatment of unrealized receivables and
inventory, see Publication 541.
Example
On March 4, 2000, you sold the machine shop you had operated since
1990. You received a $100,000 down payment and the buyer's note for
$120,000. The note payments are $15,000 each, plus 10% interest, due
every July 1 and January 1, beginning in 2001. The total selling price
is $220,000. Your selling expenses are $11,000. The selling expenses
are divided among all the assets sold, including inventory.
Your selling expense for each asset is 5% of the asset's selling
price ($11,000 selling expense x $220,000 total selling price).
The FMV, adjusted basis, and depreciation claimed on each asset
sold are as follows:
| | Depreciation |
Adjusted |
|
Asset |
FMV |
Claimed |
Basis |
| Inventory |
$ 10,000 |
-0- |
$ 8,000 |
| Land |
42,000 |
-0- |
15,000 |
| Building |
48,000 |
$ 9,000 |
36,000 |
| Machine A |
71,000 |
27,200 |
63,800 |
| Machine B |
24,000 |
12,960 |
22,040 |
| Truck |
6,500 |
18,624 |
5,376 |
| $201,500 |
$67,784 |
$150,216 |
Under the residual method, you allocate the selling price to each
of the assets based on their FMV ($201,500). The remaining amount is
allocated to your section 197 intangible, goodwill ($18,500).
The assets included in the sale, their selling prices based on
their FMVs, the selling expense allocated to each asset, the adjusted
basis, and the gain for each asset are shown in the following chart.
| Sale Price
|
Sale Exp.
|
Adj.
Basis
|
Gain
|
| Inventory |
$ 10,000 |
$ 500 |
$ 8,000 |
$ 1,500 |
| Land |
42,000 |
2,100 |
15,000 |
24,900 |
| Building |
48,000 |
2,400 |
36,000 |
9,600 |
| Mch. A |
71,000 |
3,550 |
63,800 |
3,650 |
| Mch. B |
24,000 |
1,200 |
22,040 |
760 |
| Truck |
6,500 |
325 |
5,376 |
799 |
| Goodwill |
18,500 |
925 |
-0- |
17,575 |
| $220,000 |
$11,000 |
$150,216 |
$58,784 |
The building was acquired in 1990, the year the business began, and
it is section 1250 property. There is no depreciation recapture income
because the building was depreciated using the straight line method.
All gain on the truck, machine A, and machine B is depreciation
recapture income since it is the lesser of the depreciation claimed or
the gain on the sale. Figure depreciation recapture in Part III of
Form 4797.
The total depreciation recapture income reported in Part II of Form
4797 is $5,209. This consists of $3,650 on machine A, $799 on the
truck, and $760 on machine B (the gain on each item since it was less
than the depreciation claimed). These gains are reported in full in
the year of sale and are not included in the installment sale
computation.
Of the $220,000 total selling price, the $10,000 for inventory
assets cannot be reported on the installment method. The selling
prices of the truck and machines are also removed from the total
selling price because gain on these items is reported in full in the
year of sale.
The selling price equals the contract price for the installment
sale ($108,500). The assets included in the installment sale, their
selling price, and their installment sale bases are shown in the
following chart.
| Selling Price |
Installment Sale
Basis |
Gross Profit |
| Land |
$ 42,000 |
$17,100 |
$24,900 |
| Building |
48,000 |
38,400 |
9,600 |
| Goodwill |
18,500 |
925 |
17,575 |
| Total |
$108,500 |
$56,425 |
$52,075 |
The gross profit percentage (gross profit x
contract price) for the installment sale is 48% ($52,075 x
$108,500). The gross profit percentage for each asset is figured as
follows:
| Percentage
|
| Land-- $24,900 x $108,500 |
22.95 |
| Building-- $9,600 x $108,500 |
8.85 |
| Goodwill-- $17,575 x $108,500 |
16.20 |
| Total |
48.00 |
Since the sale includes assets sold on the installment method and
assets for which the gain is reported in full in the year of sale,
payments must be allocated between the installment part of the sale
and the part reported in the year of sale. The selling price for the
installment sale is $108,500. This is 49.3% of the total selling price
of $220,000 ($108,500 x $220,000). The selling price of assets
not reported on the installment method is $111,500. This is 50.7%
($111,500 x $220,000) of the total selling price.
Multiply principal payments by 49.3% to determine the part of the
payment for the installment sale. The balance, 50.7%, is for the part
reported in the year of the sale.
The gain on the sale of the inventory, machines, and truck is
reported in full in the year of sale. When you receive principal
payments in later years, no part of the payment for the sale of these
assets is included in gross income. Only the part for the installment
sale (49.3%) is used in the installment sale computation.
The only payment received in 2000 is the down payment of $100,000.
The part of the payment for the installment sale is $49,300 ($100,000
x 49.3%). This amount is used in the installment sale
computation.
Installment income for 2000.
Your installment income for each asset is the gross profit
percentage for that asset times $49,300, the installment income
received in 2000.
| Income
|
| Land--22.95% of $49,300 |
$11,314 |
| Building--8.85% of $49,300 |
4,363 |
| Goodwill--16.2% of $49,300 |
7,987 |
| Total installment income for 2000 |
$23,664 |
Installment income after 2000.
You figure installment income for years after 2000 by applying the
same gross profit percentages to 49.3% of the total payments you
receive on the buyer's note during the year.
Unstated Interest and Original Issue Discount
Note: Section references are to the Internal Revenue
Code and regulation references are to the Income Tax Regulations under
the Code.
An installment sale contract generally provides that each deferred
payment on the sale will include interest or there will be an interest
payment in addition to the principal payment. Interest provided in the
contract is called stated interest.
If an installment sale contract does not provide for adequate
stated interest, part of the stated principal amount of the contract
may be recharacterized as interest. If section 483 applies to the
contract, this interest is called unstated interest. If
section 1274 applies to the contract, this interest is called
original issue discount (OID).
An installment sale contract does not provide for adequate stated
interest if the stated interest rate is lower than the test rate
(defined later).
Treatment of unstated interest and OID.
Generally, the unstated interest rules do not apply to a debt given
in consideration for a sale or exchange of personal-use property.
Personal-use property is any property in which substantially all of
its use by the buyer is not in connection with a trade or business or
an investment activity.
Rules for the seller.
If either section 1274 or section 483 applies to the installment
sale contract, you must treat part of the installment sale price as
interest, even though interest is not called for in the sales
agreement. If either section applies, you must reduce the stated
selling price of the property and increase your interest income by
this interest.
Include the unstated interest in income based on your regular
method of accounting. Include OID in income over the term of the
contract.
The OID includible in income each year is based on the constant
yield method described in section 1272. (In some cases, the OID on an
installment sale contract may also include all or part of the stated
interest, especially if the stated interest is not paid at least
annually.)
If you do not use the installment method to report the sale, report
the entire gain under your method of accounting in the year of sale.
Reduce the selling price by any stated principal treated as interest
to determine the gain.
Report unstated interest or OID on your tax return, in addition to
stated interest.
Rules for the buyer.
Any part of the stated selling price of an installment sale
contract treated by the buyer as interest reduces the buyer's basis in
the property and increases the buyer's interest expense. These rules
do not apply to personal-use property (for example, property not used
in a trade or business).
Adequate stated interest.
An installment sale contract generally provides for adequate stated
interest if the contract's stated principal amount is at least equal
to the sum of the present values of all principal and interest
payments called for under the contract. The present value of a payment
is determined based on the test rate of interest, defined next. (If
section 483 applies to the contract, payments due within six months
after the sale are taken into account at face value.) In general, an
installment sale contract provides for adequate stated interest if the
stated interest rate (based on an appropriate compounding period) is
at least equal to the test rate of interest.
Test rate of interest.
The test rate of interest for a contract is the 3-month rate. The
3-month rate is the lower of the following applicable
federal rates (AFRs).
- The lowest AFR (based on the appropriate compounding period)
in effect during the 3-month period ending with the first month in
which there is a binding written contract that substantially provides
the terms under which the sale or exchange is ultimately
completed.
- The lowest AFR (based on the appropriate compounding period)
in effect during the 3-month period ending with the month in which the
sale or exchange occurs.
Applicable federal rate (AFR).
The AFR depends on the month the binding contract for the sale or
exchange of property is made and the term of the instrument. For an
installment obligation, the term of the instrument is its weighted
average maturity, as defined in section 1.1273-1(e)(3) of the
regulations. The AFR for each term is shown below.
- For a term of 3 years or less, the AFR is the federal
short-term rate.
- For a term of over 3 years, but not over 9 years, the AFR is
the federal mid-term rate.
- For a term of over 9 years, the AFR is the federal long-term
rate.
The applicable federal rates are published monthly in the Internal
Revenue Bulletin (IRB). You can get this information by contacting an
IRS office. IRBs are also available on the IRS web site at
www.irs.gov.
Seller financed sales.
For sales or exchanges of property (other than new section 38
property, which includes most tangible personal property) involving
seller financing of $3,960,100 or less, the test rate of interest
cannot be more than 9%, compounded semiannually. For seller financing
over $3,960,100 and for all sales or exchanges of new section 38
property, the test rate of interest is 100% of the AFR.
For information on new section 38 property, see section 48(b) of
the Internal Revenue Code, as in effect before the enactment of Public
Law 101-508.
Certain land transfers between related persons.
In the case of certain land transfers between related persons
(described later), the test rate is no more than 6 percent, compounded
semiannually.
Internal Revenue Code sections 1274 and 483.
If an installment sale contract does not provide for adequate
stated interest, generally either section 1274 or section 483 will
apply to the contract. These sections recharacterize part of the
stated principal amount as interest. Whether either of these sections
apply to a particular installment sale contract depends on several
factors, including the total selling price and the type of property
sold.
Section 1274.
Section 1274 applies to a debt instrument issued for the sale or
exchange of property if any payment under the instrument is due more
than 6 months after the date of the sale or exchange and the
instrument does not provide for adequate stated interest. Section
1274, however, does not apply to an installment sale contract that is
a cash method debt instrument (defined next) or that arises from the
following transactions.
- A sale or exchange for which the total payments are $250,000
or less.
- The sale or exchange of an individual's main home.
- The sale or exchange of a farm for $1,000,000 or less by an
individual, an estate, a testamentary trust, small business
corporation (defined in section 1244(c)(3)), or a domestic partnership
that meets requirements similar to those of section 1244(c)(3).
- Certain land transfers between related persons (described
later).
Cash method debt instrument.
This is any debt instrument given as payment for the sale or
exchange of property (other than new section 38 property) with a
stated principal of $2,828,700 or less if the following items apply.
- The lender (holder) does not use an accrual method of
accounting and is not a dealer in the type of property sold or
exchanged.
- Both the borrower (issuer) and the lender jointly elect to
account for interest under the cash method of accounting.
- Section 1274 would apply except for the election in (2)
above.
Land transfers between related persons.
The section 483 rules (discussed next) apply to debt instruments
issued in a land sale between related persons to the extent the
sum of the following amounts does not exceed $500,000.
- The stated principal of the debt instrument issued in the
sale or exchange.
- The total stated principal of any other debt instruments for
prior land sales between these individuals during the calendar
year.
The section 1274 rules, if otherwise applicable, apply to debt
instruments issued in a sale of land to the extent the stated
principal amount exceeds $500,000, or if any party to the sale is a
nonresident alien.
Related persons include an individual and the members of the
individual's family and their spouses. Members of an individual's
family include the individual's spouse, brother and sister (whole or
half), ancestors, and lineal descendants.
Section 483.
Section 483 generally applies to an installment sale contract that
does not provide for adequate stated interest and is not covered by
section 1274. Section 483, however, generally does not apply to an
installment sale contract that arises from the following transactions.
- A sale or exchange for which no payment is due more than one
year after the date of the sale or exchange.
- A sale or exchange for $3,000 or less.
Exceptions to sections 1274 and 483.
Sections 1274 and 483 do not apply under the following
circumstances.
- An assumption of a debt instrument in connection with a sale
or exchange or the acquisition of property subject to a debt
instrument, unless the terms or conditions of the debt instrument are
modified in a manner that would constitute a deemed exchange under
section 1.1001-3 of the regulations.
- A debt instrument issued in connection with a sale or
exchange of property if either the debt instrument or the property is
publicly traded.
- A sale or exchange of all substantial rights to a patent, or
an undivided interest in property that includes part or all
substantial rights to a patent, if any amount is contingent on the
productivity, use, or disposition of the property transferred. See
Publication 544
for more information.
- An annuity contract issued in connection with a sale or
exchange of property if the contract is described in section
1275(a)(1)(B) of the Code and section 1.1275-1(j) of the
regulations.
- A transfer of property subject to section 1041 of the Code
(relating to transfers of property between spouses or incident to
divorce).
- A demand loan that is a below-market loan described in
section 7872(c)(1) of the Code (for example, gift loans and
corporation-shareholder loans).
- A below-market loan described in section 7872(c)(1) of the
Code issued in connection with the sale or exchange of personal-use
property. This rule applies only to the holder.
Determining whether section 1274 or section 483 applies.
For purposes of determining whether either section 1274 or section
483 applies to an installment sale contract, all sales or exchanges
that are part of the same transaction (or related transactions) are
treated as a single sale or exchange and all contracts arising from
the same transaction (or a series of related transactions) are treated
as a single contract. Also, the total consideration due under an
installment sale contract is determined at the time of the sale or
exchange. Any payment (other than a debt instrument) is taken into
account at its FMV.
More information.
For information on figuring unstated interest and OID and other
special rules, see sections 1274 and 483 of the Internal Revenue Code
and the related regulations. In the case of an installment sale
contract that provides for contingent payments, see sections
1.1275-4(c) and 1.483-4 of the regulations.
Disposition of an
Installment Obligation
A disposition generally includes a sale, exchange, 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 will make future payments to you.
If you are using the installment method and you dispose of the
installment obligation, generally you will have a gain or loss to
report. It is considered gain or loss on the sale of the property for
which you received the installment obligation. If the original
installment sale produced ordinary income, the disposition of the
obligation will result in ordinary income or loss. If the original
sale resulted in a capital gain, the disposition of the obligation
will result in a capital gain or loss.
Use the following rules to figure your gain or loss from the
disposition of an installment obligation.
- If you sell or exchange the obligation, or you
accept less than face value in satisfaction of the obligation, the
gain or loss is the difference between your basis in the obligation
and the amount you realize.
- If you dispose of the obligation in any other way,
the gain or loss is the difference between your basis in the
obligation and its FMV at the time of the disposition. This rule
applies, for example, when you give the installment obligation to
someone else or cancel the buyer's debt to you.
Basis.
Figure your basis in an installment obligation by multiplying the
unpaid balance on the obligation by your gross profit percentage.
Subtract that amount from the unpaid balance. The result is your basis
in the installment obligation.
Example.
Several years ago, you sold property on the installment method. The
buyer still owes you $10,000 of the sale price. This is the unpaid
balance on the buyer's installment obligation to you. Because your
gross profit percentage is 60%, $6,000 (60% x $10,000) is the
profit owed you on the obligation. The rest of the unpaid balance,
$4,000, is your basis in the obligation.
Transfer between spouses or former spouses.
No gain or loss is recognized on the transfer of an installment
obligation between a husband and wife or a former husband and wife if
incident to a divorce. A transfer is incident to a divorce if it
occurs within one year after the date on which the marriage ends or is
related to the end of the marriage. The same tax treatment of the
transferred obligation applies to the transferee spouse or former
spouse as would have applied to the transferor spouse or former
spouse. The basis of the obligation to the transferee spouse (or
former spouse) is the adjusted basis of the transferor spouse.
The nonrecognition rule does not apply if the spouse or former
spouse receiving the obligation is a nonresident alien.
Gift.
A gift of an installment obligation is a disposition. The gain or
loss is the difference between your basis in the obligation and its
FMV at the time you make the gift.
For gifts between spouses or former spouses, see Transfers
between spouses or former spouses, earlier.
Cancellation.
If an installment obligation is canceled or otherwise becomes
unenforceable, it is treated as a disposition other than a sale or
exchange. Your gain or loss is the difference between your basis in
the obligation and its FMV at the time you cancel it. If the parties
are related, the FMV of the obligation is considered to be no less
than its full face value.
Forgiving part of the buyer's debt.
If you accept part payment on the balance of the buyer's
installment debt to you and forgive the rest of the debt, you treat
the settlement as a disposition of the installment obligation. The
gain or loss is the difference between your basis in the obligation
and the amount you realize on the settlement.
If you reduce the selling price but do not cancel the rest of the
buyer's debt to you, it is not considered a disposition of the
installment obligation. You must refigure the gross profit percentage
and apply it to payments you receive after the reduction. See
Selling price reduced under General Rules,
earlier.
Assumption.
If the buyer of your property sells it to someone else and you
agree to let the new buyer assume the original buyer's installment
obligation, you have not disposed of the installment obligation. It is
not a disposition even if the new buyer pays you a higher rate of
interest than the original buyer.
Transfer due to death.
The transfer of an installment obligation (other than to a buyer)
as a result of the death of the seller is not a disposition. Any
unreported gain from the installment obligation is not treated as
gross income to the decedent. No income is reported on the decedent's
return due to the transfer. Whoever receives the installment
obligation as a result of the seller's death is taxed on the
installment payments the same as the seller would have been had the
seller lived to receive the payments.
However, if an installment obligation is canceled, becomes
unenforceable, or is transferred to the buyer because of the death of
the holder of the obligation, it is a disposition. The estate must
figure its gain or loss on the disposition. If the holder and the
buyer were related, the FMV of the installment obligation is
considered to be no less than its full face value.
Repossession
If you repossess your property after making an installment sale,
you must figure the following amounts.
- Your gain (or loss) on the repossession.
- Your basis in the repossessed property.
The rules for figuring these amounts depend on the kind of property
you repossess. The rules for repossessions of personal property differ
from those for real property. Special rules may apply if you repossess
property that was your main home before the sale.
The repossession rules apply whether or not title to the property
was ever transferred to the buyer. It does not matter how you
repossess the property, whether you foreclose or the buyer voluntarily
surrenders the property to you. However, it is not a repossession if
the buyer puts the property up for sale and you repurchase it.
For the repossession rules to apply, the repossession must at least
partially discharge (satisfy) the buyer's installment obligation to
you. The discharged obligation must be secured by the property you
repossess. This requirement is met if the property is auctioned off
after you foreclose and you apply the installment obligation to your
bid price at the auction.
Reporting the repossession.
You report gain or loss from a repossession on the same form you
used to report the original sale. If you reported the sale on Form
4797, use it to report the gain or loss on the repossession.
Personal Property
If you repossess personal property, you may have a gain or a loss
on the repossession. In some cases, you may also have a bad debt.
To figure your gain or loss, subtract the total of your basis in
the installment obligation and any repossession expenses you have from
the FMV of the property. If you receive anything from the buyer
besides the repossessed property, add its' value to the property's FMV
before making this calculation.
How you figure your basis in the installment obligation depends on
whether or not you reported the original sale on the installment
method. The method you used to report the original sale also affects
the character of your gain or loss on the repossession.
For sales not reported on the installment method:
See Electing Out of the Installment Method, earlier.
- Basis in installment obligation.
Your basis is figured
on the obligation's full face value or its FMV at the time of the
original sale, whichever you used to figure your gain or loss in the
year of sale. From this amount, subtract all payments of principal you
have received on the obligation. The result is your basis in the
installment obligation. If only part of the obligation is discharged
by the repossession, figure your basis in only that part.
- Gain or loss. Add any repossession costs to your
basis in the obligation. If the FMV of the property you repossess is
more than this total, you have a gain. Because it is gain on the
installment obligation, it is all ordinary income. If the FMV of the
repossessed property is less than the total of your basis plus
repossession costs, you have a loss. Because you included the full
gain in income in the year of sale, the loss is a bad debt. How you
deduct the bad debt depends on whether you sold business or
nonbusiness property in the original sale. See Publication 550
for
information on nonbusiness bad debts and chapter 11 of Publication 535
for information on business bad debts.
For sales reported on the installment method:
- Basis in installment obligation.
Multiply the unpaid
balance of your installment obligation by your gross profit
percentage. Subtract that amount from the unpaid balance. The result
is your basis in the installment obligation.
- Gain or loss. If the FMV of the repossessed
property is more than the total of your basis in the obligation plus
any repossession costs, you have a gain. If the FMV is less, you have
a loss. Your gain or loss on the repossession is of the same character
(capital or ordinary) as your gain on the original sale.
Use the following worksheet to determine the taxable gain or loss
on a repossession of personal property reported on the installment
method.
| 1) |
FMV of property repossessed |
|
| 2) |
Unpaid balance of installment obligation |
|
| 3) |
Unrealized profit
(line 2 x gross profit %) |
|
| 4) |
Basis of obligation
(line 2 - line 3) |
|
| 5) |
Plus: Repossession costs |
|
|
| 6) |
Gain or loss on repossession
(line 1 - line 5) |
|
Example.
You sold your piano for $1,500 in December 1999 for $300 down and
$100 a month (plus interest). The payments began in January 2000. Your
gross profit percentage is 40%. You reported the sale on the
installment method on your 1999 income tax return. After the fourth
monthly payment, the buyer defaulted on the contract (which has an
unpaid balance of $800) and you are forced to foreclose on the piano.
The FMV of the piano on the date of repossession is $1,400. The legal
costs of foreclosure and the expense of moving the piano back to your
home total $75. You figure your gain on the repossession as follows:
| 1) |
FMV of property repossessed |
$1,400 |
| 2) |
Unpaid balance of installment obligation |
$800 |
| 3) |
Unrealized profit
(line 2 x gross profit %) |
320 |
| 4) |
Basis of obligation
(line 2 - line 3) |
480 |
| 5) |
Plus: Repossession costs |
75 |
555 |
| 6) |
Gain on repossession
(line 1 - line 5) |
$ 845 |
Basis in repossessed property.
Your basis in repossessed personal property is its FMV at the time
of the repossession.
Fair market value (FMV).
The FMV of repossessed property is a question of fact to be
established in each case. If you bid for the property at a lawful
public auction or judicial sale, its FMV is presumed to be the price
it sells for, unless there is clear and convincing evidence to the
contrary.
Real Property
The rules for the repossession of real property allow you to keep
essentially the same adjusted basis in the repossessed property you
had before the original sale. You can recover this entire adjusted
basis when you resell the property. This, in effect, cancels out the
tax treatment that applied to you on the original sale and puts you in
the same tax position you were in before that sale.
Therefore, the total payments you have received from the buyer on
the original sale must be considered income to you. You report, as
gain on the repossession, any part of the payments you have not yet
included in income. These payments are amounts you previously treated
as a return of your adjusted basis and excluded from income. However,
the total gain you report is limited. See Limit on taxable gain,
discussed later.
Mandatory rules.
The rules concerning basis and gain on repossessed real property
are mandatory. You must use them to figure your basis in the
repossessed real property and your gain on the repossession. They
apply whether or not you reported the sale on the installment method.
However, they apply only if all the following conditions
are met.
- The repossession must be to protect your security rights in
the property.
- The installment obligation satisfied by the repossession
must have been received in the original sale.
- You cannot pay any additional consideration to the buyer to
get your property back, unless either of the situations listed below
apply.
- The reacquisition and payment of the additional
consideration were provided for in the original contract of
sale.
- The buyer has defaulted, or default is imminent.
"Additional consideration" includes money and other
property you pay or transfer to the buyer. For example, additional
consideration is paid if you reacquire the property subject to a debt
that arose after the original sale.
Conditions not met.
If any one of these three conditions is not met, use the rules
discussed under Personal Property, earlier, as if the
property you repossess were personal rather than real property. Do not
use the rules for real property.
Figuring gain on repossession.
Your gain on repossession is the difference between the following
amounts.
- The total payments received, or considered received, on the
sale.
- The total gain already reported as income.
See the earlier discussions under Payments Received
for items considered payment on the sale.
Limit on taxable gain.
Taxable gain is limited to your gross profit on the original sale
minus the sum of the following amounts.
- The gain on the sale you reported as income before the
repossession.
- Your repossession costs.
This method of figuring taxable gain, in essence, treats all
payments received on the sale as income, but limits your total taxable
gain to the gross profit you originally expected on the sale.
Indefinite selling price.
The limit on taxable gain does not apply if the selling price is
indefinite and cannot be determined at the time of repossession. For
example, a selling price stated as a percentage of the profits to be
realized from the buyer's development of the property is an indefinite
selling price.
Character of gain.
The taxable gain on repossession is ordinary income or capital
gain, the same as the gain on the original sale. However, if you did
not report the sale on the installment method, the gain is ordinary
income.
Repossession costs.
Your repossession costs include money or property you pay to
reacquire the real property. This includes amounts paid to the buyer
of the property, as well as amounts paid to others for such items as
those listed below.
- Court costs.
- Legal fees.
- Publishing, acquiring, filing, or recording of title.
- Lien clearance.
Repossession costs do not include the FMV of the buyer's
obligations to you that are secured by the real property.
Use the following worksheet to determine the taxable gain on a
repossession of real property reported on the installment method.
| 1) |
Payments received before repossession |
|
| 2) |
Minus: Gain reported |
|
| 3) |
Gain on repossession |
|
| 4) |
Gross profit on sale |
|
| 5) |
Gain reported (line 2) |
|
| 6) |
Plus: Repossession costs |
|
|
| 7) |
Subtract line 6 from line 4 |
|
| 8) |
Taxable gain (lesser of line 3 or
7) |
|
Example.
You sold a tract of land in January 1998 for $25,000. You accepted
a $5,000 down payment, plus a $20,000 mortgage secured by the property
and payable at the rate of $4,000 annually plus interest (9.5%). The
payments began on January 1, 1999. Your adjusted basis in the property
was $19,000 and you reported the transaction as an installment sale.
Your selling expenses were $1,000. You figured your gross profit as
follows:
| Selling price |
$25,000 |
| Minus: |
| Adjusted basis |
$19,000 |
| Selling expenses |
1,000 |
20,000 |
| Gross profit |
$ 5,000 |
For this sale, the contract price equals the selling price. The
gross profit percentage is 20% ($5,000 gross profit x $25,000
contract price).
In 1998, you included $1,000 in income (20% x $5,000 down
payment). In 1999, you reported a profit of $800 (20% x $4,000
annual installment). In 2000, the buyer defaulted and you repossessed
the property. You paid $500 in legal fees to get your property back.
Your taxable gain on the repossession is figured as follows:
| 1) |
Payments received before repossession |
$9,000 |
| 2) |
Minus: Gain reported |
1,800 |
| 3) |
Gain on repossession |
$7,200 |
| 4) |
Gross profit on sale |
$5,000 |
| 5) |
Gain reported (line 2) |
$1,800 |
| 6) |
Plus: Repossession costs |
500 |
2,300 |
| 7) |
Subtract line 6 from line 4 |
$2,700 |
| 8) |
Taxable gain (lesser of line 3 or
7) |
$2,700 |
Basis.
Your basis in the repossessed property is determined as of the date
of repossession. It is the sum of the following amounts.
- Your adjusted basis in the installment obligation.
- Your repossession costs.
- Your taxable gain on the repossession.
To figure your adjusted basis in the installment obligation at
the time of repossession, multiply the unpaid balance by the gross
profit percentage. Subtract that amount from the unpaid balance.
Use the following worksheet to determine the basis of real property
repossessed.
| 1) |
Unpaid balance of obligation |
|
| 2) |
Minus: |
Unrealized profit
(line 1 x gross profit %) |
|
| 3) |
Adjusted basis (date of repossession) |
|
| 4) |
Plus: |
Taxable gain
on repossession |
|
| | Repossession costs |
|
|
| 5) |
Basis of repossessed real
property |
|
Example.
Assume the same facts as in the preceding example. The unpaid
balance of the installment obligation (the $20,000 note) is $16,000 at
the time of repossession because the buyer made a $4,000 payment. The
gross profit percentage on the original sale was 20%. Therefore,
$3,200 (20% x $16,000 still due on the note) is unrealized
profit. You figure your basis in the repossessed property as follows:
| Unpaid balance of obligation |
$16,000 |
| Minus: |
Unrealized profit |
3,200 |
| Adjusted basis (date of repossession) |
$12,800 |
| Plus: |
Taxable gain
on repossession |
$2,700 |
| Repossession costs |
500 |
3,200 |
| Basis of repossessed real
property |
$16,000 |
Holding period for resales.
If you resell the repossessed property, the resale may result in a
capital gain or loss. To figure whether the gain or loss is long-term
or short-term, your holding period includes the period you owned the
property before the original sale plus the period after the
repossession. It does not include the period the buyer owned the
property.
If the buyer made improvements to the reacquired property, the
holding period for these improvements begins on the day after the date
of repossession.
Bad debt.
If you repossess real property under these rules, you cannot take a
bad debt deduction for any part of the buyer's installment obligation.
This is true even if the obligation is not fully satisfied by the
repossession.
If you took a bad debt deduction before the tax year of
repossession, you are considered to have recovered the bad debt when
you repossess the property. You must report the bad debt deduction you
took in the earlier year as income in the year of repossession.
However, if any part of the earlier deduction did not reduce your tax,
you do not have to report that part as income. Your adjusted basis in
the installment obligation is increased by the amount you report as
income from recovering the bad debt.
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