Including Payments Considered 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. See Mortgage less than basis, later for an
exception to this rule.
Buyer pays seller's expenses.
If the buyer pays any of the 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, it is not considered a payment to you. It is actually a
recovery of your basis. The selling price minus the mortgage equals
the contract price. This difference is all that 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 × $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, 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 directly 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 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 is 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 |
|
| Minus: 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.
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. 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.
- 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 business, such as a
balance due for inventory.
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 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 Trading property for
like-kind property, earlier. 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
willing buyer and a willing seller, neither having to buy or sell, who
both have 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 on the note
are not considered payments on your 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% third-party note. The
FMV of the third-party note at the time of your 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
× $5,000), 60% of each payment of principal you receive on this
note is a nontaxable return of capital. The remaining 40% is taxed as
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 you
receive them.
Guarantee.
If a third party or government agency guarantees the buyer's
payments to you, the guarantee itself is not considered payment.
Unstated interest.
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 each payment due more than 6 months after the
date of sale may be treated as interest. The amount treated as
interest is referred to as unstated interest.
When the stated interest rate in the contract is lower than the
applicable federal rate, unstated interest is the difference between
interest figured at the federal rate and interest figured at the rate
specified in the sales contract.
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 Internet at
www.irs.gov.
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.
Unstated interest reduces the stated selling price of the property
and the buyer's basis in the property. It increases the seller's
interest income and the buyer's interest expense.
More information.
For more information, see Unstated Interest and Original Issue
Discount in Publication 537.
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