Income and Assets · Property, real and personal

Installment sales

Three features of this regime surprise people. It is not elected into — it applies automatically and must be elected out of. Depreciation recapture never gets the benefit of it: recapture income is taxed in full in the year of sale even where the seller receives almost nothing. And selling to a relative who resells within two years pulls the entire remaining gain into the original seller’s return, in the year of the second sale, whether or not any further money has changed hands.

The rule

The method is the default. Except as otherwise provided, income from an installment sale is taken into account under the installment method (IRC § 453(a)). An installment sale is a disposition of property where at least one payment is to be received after the close of the taxable year of the disposition (§ 453(b)(1)) — one deferred payment is enough. The taxpayer may elect out for any disposition (§ 453(d)(1)), and reporting the whole gain in the year of sale is how that election is made in practice.

The computation. The installment method recognises, for any year, that proportion of the payments received in the year which the gross profit — realised or to be realised when payment is complete — bears to the total contract price (IRC § 453(c)). That fraction is fixed at the outset and applied to every payment received.

Two classes of seller are shut out. The term does not include a dealer disposition, or a disposition of personal property of a kind required to be included in the taxpayer’s inventory (IRC § 453(b)(2)). A dealer disposition means personal property disposed of by a person who regularly sells property of the same type on the installment plan, and real property held for sale to customers in the ordinary course (§ 453(l)(1)).

Recapture income is recognised at once. Notwithstanding the general rule, any recapture income is recognised in the year of the disposition, and only the gain in excess of it is taken under the installment method (IRC § 453(i)(1)). Recapture income means the aggregate amount that would be ordinary income under § 1245 or § 1250 — or so much of § 751 as relates to them — if all payments were received in the year of disposition (§ 453(i)(2)). A seller who receives a small down payment can therefore owe tax on a large ordinary amount in year one.

A related buyer’s resale accelerates everything. Where a person disposes of property to a related person, and before receiving all payments the related person disposes of the property, the amount realised on that second disposition is treated as received by the first seller at the time of the second disposition (IRC § 453(e)(1)).

Except that the rule has a two-year fuse. For property other than marketable securities, paragraph (1) applies only where the second disposition is not more than 2 years after the first (IRC § 453(e)(2)(A)). The two years are suspended for any period during which the related person’s risk of loss is substantially diminished by a put, a short position, or a similar arrangement (§ 453(e)(2)(B)). For marketable securities there is no cutoff at all.

Depreciable property sold to a controlled entity gets nothing. On an installment sale of depreciable property between related persons, the installment method does not apply and all payments to be received are treated as received in the year of the disposition (IRC § 453(g)(1)). And § 1239(a) independently makes the gain ordinary income where the property is depreciable in the transferee’s hands.

A large deferred balance carries an interest charge. Interest is payable on the deferred tax liability on an obligation arising from a disposition under the installment method where the sales price exceeds a statutory floor (IRC § 453A(a)(1), (b)(1)) — but only for a year in which the face amount of such obligations arising that year and outstanding at its close exceeds a much larger threshold (§ 453A(b)(2)(B)), and the charge is computed on the excess over it (§ 453A(c)(4)(A)). Both figures are in the table below.

Pledging is a payment. The pledging rules apply to any obligation to which § 453A applies (§ 453A(a)(2), (d)): borrowing against the note accelerates the gain to the extent of the loan proceeds.

And disposing of the note ends the deferral. Where an installment obligation is satisfied at other than face value, or is distributed, transmitted, sold or otherwise disposed of, gain or loss results to the extent of the difference between the basis of the obligation and the amount realised — or its fair market value where the disposition is not a sale — and is treated as from the sale of the property for which the obligation was received (IRC § 453B(a)).

Current figures

How it works in practice

Build the gross profit ratio once and keep it. Contract price less adjusted basis and selling expenses gives gross profit; gross profit over total contract price gives the ratio; the ratio times each year’s principal receipts gives that year’s gain. Interest stated in the contract is interest, not payment, and where the contract states no adequate interest the imputed interest rules recharacterise part of each payment before the ratio is applied.

Do the recapture computation before the ratio. Section 453(i) takes recapture income out of the deferral entirely, and the practical consequence is a cash-flow problem: a seller of equipment who takes ten percent down can owe tax on the whole § 1245 amount in year one. That is often the decisive reason to negotiate a larger down payment, and it is a conversation to have before the contract is signed.

Where the buyer is related, ask two questions and keep asking them for two years. Is the property depreciable in the buyer’s hands — if so § 453(g) denies the method and § 1239 makes the gain ordinary. And has the buyer resold — if within two years, § 453(e) accelerates. The seller has no control over the second disposition and frequently no knowledge of it, which is why the acceleration is so often discovered late.

Consider electing out where the gain is small, where the seller has expiring capital losses, or where rates are expected to rise. The election is made by reporting the full gain on a timely return, and it is revocable only with consent.

How this has changed

The regime was rebuilt around the default in 1980 and the direction still catches people out. Before that, installment reporting had to be elected; now it is automatic and the election runs the other way. Material describing an “installment sale election” is describing the election out, or is out of date.

Section 453A(b)(1) was broadened in 1988. As originally enacted it applied only to obligations from dispositions of real property used in a trade or business or held for the production of rental income; Pub. L. 100-647 § 5076(a) replaced that with any property whose sales price exceeds the threshold. The amendment note preserves the old text, and it is a good example of a limitation that quietly disappeared.

The dealer exclusion has been stable and is wider than “car dealer”. Section 453(l)(1) reaches any person who regularly sells or otherwise disposes of personal property of the same type on the installment plan, and any disposition of real property held for sale to customers in the ordinary course. A developer selling lots is outside the method entirely.

What has not changed is § 453(e)‘s asymmetry, and it remains the harshest feature of the regime. The acceleration is triggered by an act of the related buyer, over which the seller has no control and of which the seller may have no notice, and it is measured by the buyer’s proceeds rather than the seller’s. The two-year cutoff is the only real protection, and § 453(e)(2)(B) suspends even that where the buyer has hedged away the risk of ownership.

Exam focus

Expect a recapture fact pattern with a small down payment, testing whether you recognise that § 453(i) takes the ordinary amount in year one.

Expect a related-party resale with dates chosen either side of the two-year line, and read whether the property is a marketable security — that removes the cutoff.

Expect a sale to a controlled entity of depreciable property, where both § 453(g) and § 1239 apply and the answer is the full gain, as ordinary income, immediately.

Expect the gross profit ratio to be computed. Gross profit over total contract price, applied to principal received.

Check yourself

1. A taxpayer sells land for 300,000 dollars with a basis of 120,000 dollars, receiving 60,000 dollars this year. How much gain is recognised?

Answer: 36,000 dollars. The gross profit ratio under IRC § 453(c) is 180,000 over 300,000, or 60 percent, applied to the 60,000 dollars of principal received.

2. Equipment with 90,000 dollars of § 1245 recapture is sold on a five-year note with 10,000 dollars down. What is reported in year one?

Answer: The whole 90,000 dollars of recapture income, under IRC § 453(i)(1)(A), because recapture is recognised in the year of disposition notwithstanding the installment method. Only gain in excess of it is deferred.

3. A seller’s brother buys property on an installment note and resells it 30 months later. Does the acceleration apply?

Answer: No, unless the property is a marketable security. IRC § 453(e)(2)(A) confines the rule to a second disposition within 2 years, though § 453(e)(2)(B) suspends that period while the buyer’s risk of loss is substantially diminished.

4. How is the installment method elected?

Answer: It is not. IRC § 453(a) applies it automatically; the taxpayer elects out under § 453(d)(1) by reporting the full gain in the year of disposition.

5. A taxpayer borrows against an installment obligation with a sales price above the § 453A threshold. What is the consequence?

Answer: The pledging rules in IRC § 453A(d) treat the loan proceeds as a payment on the obligation, accelerating the deferred gain to that extent.