Limitations on Installment Sales Reporting (Section 453)
A.
An installment sale if defined as a disposition of property where at
least one payment is received after the year of disposition.
1.
There is not minimum payment requirement in the year of sale;
furthermore, a sale where no payments received in the year of sale will
qualify for installment sale reporting.
2. Under the installment method, taxable gain is generally recognized as payments are received.
B.
A deferred payment sale, on the other hand, is similar to an
installment sale in that at least one payment is received after the
close of the taxable year on the sale; however, it differs from an
installment sale because there is either:
1.
Not gain on the sale: If the sale resulted in a loss, the installment
method does not apply since there is not gross profit percentage; or
2. Gain on the sale: The taxpayer elected out of the installment method.
Note: The distinction between an installment sale and a deferred payment sale is critical if the property is later repossessed.
C.
Although the installment method is an effective way to defer the
payment of taxes upon the sale of high value/low basis asset, the
method is governed by a complicated set of tax rules and the proper tax
treatment of an installment sale may vary depending upon many factors:
1. Whether the sale was an installment sale or a deferred payment sale;
2. The type of asset - capital, ordinary or personal;
3. The fair market value and basis of the property;
4. Whether there was a gain or loss;
5. Whether the sale was a related party transaction;
6. Whether the transaction involved a repossession; and
7. Whether the repossession involved personal or real property.
D. Each payment on an installment sale usually consists of three parts:
1. Interest income;
2. Return of basis in the property; and
3. Gain on the sale.
E.
To determine the recognized gain, multiply the gross profit percentage
by the payments received in the year; the gross profit percentage is
computed by dividing the gross profit by the contract price.
1.
The gross profit is the true economic gain from the sale of property
and is measured by the difference between the selling price of the
property and its adjusted basis [Section 1001(a)].
a.
Selling price is the total consideration received including money, fair
market value of other property or service received, and any liabilities
that were assumed by the buyer or liabilities to which the property
sold or exchanged is subject [Section 1001(b)].
b.
Adjusted basis is the property?s original basis (cost or substituted
basis) plus capital improvements, minus capital recoveries, such as
depreciation, amortization, etc.
2.
Contract price is equal to the selling price minus the portion of
qualifying indebtedness assumed on the property is taken subject to,
which does not exceed the seller?s basis.
F.
Mortgage assumed in excess of the seller's basis is considered as
proceeds received in the year of sale and such excess is also added to
the contract price.
1.
Under this condition, the gross profit percentage will always be 100%;
therefore, all payments received by the seller will be fully taxed.
G.
An installment sale of property used in a trade or business or for the
production of income may result in the recognition of capital gain,
ordinary income, or both categories of gain.
H.
Capital asset, as defined in Section 1221, included property held by
the taxpayer, whether or not used in a trade or business; however, the
following properties are specifically excluded and are not capital
assets:
1. Inventory or property held by the taxpayer primarily for the sale to customers in the ordinary course of a trade or business;
2.
Property used in a trade or business subject to depreciation under in
Sections 167 and 168 or real property used in a trade or business
(these properties may receive special tax treatment under Section 1231);
3.
Accounts or notes receivable acquired in the ordinary course of a trade
or business for services rendered or from the sale of inventory;
4. Certain other assets such as copyright, a literary, musical, or artistic composition; and
5. Certain publications of the U.S. governments.
I.
Although property used in a trade or business or property subject to
the allowance for depreciation is specifically excluded from the
definition of a capital asset under Section 1221, special tax treatment
is provided for a sale of Section 1231 assets depending upon the net
results of such gains and losses.
J.
Limitation and Restrictions, Section 453 contains several types of
limitations and restrictions. Certain transactions are either partially
or totally ineligible; and certain types of obligations do not qualify
for installment treatment. There are also special rules that apply to
related party transactions.
1.
Dealer Sales; Dealer dispositions or either personal or real property
are generally not eligible for installment reporting; however, there
are exception for farm property, timeshares and residential loss
[Section 453(1)].
2.
Installment obligation used as security (pledge rule); If taxpayer uses
an installment obligation to secure any debt, the net proceeds from the
debt may be treated as a payment on the installment obligation. This
rule applies if the selling price of the property was over $150,000;
however, it does not apply to the sale of property sold or produced in
farming, or personal-use property.
3.
Escrow Accounts; In some cases, the installment agreement (or a later
agreements) may call for the buyer to establish an irrevocable escrow
account from which the remaining installment payments (including
interest) are to be made. Generally, 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.
4.
Like-Kind Exchange: If, in addition to like-kind property, the taxpayer
receives an installment obligation in the exchange, the contract price
is reduced by the fair market value of the like-kind property received
in the trade; and the gross profit is reduced by any gain on the trade
that can be postponed. The like-kind property received in the trade is
not considered payment on the installment obligation.
5.
Depreciation Recapture: Any gain attributable to depreciation recapture
under Sections 1245 and 1250 must be recognized in full in the year of
sale even if no payments are received in that year.
6.
Single Sale of Several Assets: If taxpayer sells different types of
assets in a single sale, he must identify each of the assets to
determine whether the installment method can be used. Taxpayer also has
to allocate part of the selling price to each asset; and if the assets
sold constitute a trade or business, Section 1060 will apply.
7.
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. The selling price must be allocated for each asset class because
the sale of a business generally included real and personal property
that can be reported on the installment method and inventory items that
cannot
8.
A Sale of Stock in a Closely Held Corporation; Such sale as is eligible
for installment reporting; thus, there is an advantage to a sale of
stock vs. sale of assets if the seller is to carry an installment
obligation.
9.
Sale of Securities in Publicly Traded Corporations; Such sale is not
eligible for installment reporting; thus, gains from sale of publicly
traded securities cannot be deferred by using the installment method.
10.
Sale to Related Party; The installment sales method is not available
for the sale of depreciable assets between related persons other than
family members [Section 453(g)(1)(A)].
