In an economy still struggling on many fronts, installment sales offer a useful tool for many taxpayers to create liquidity to buy and sell property in an otherwise "credit-sparse" environment. With correct planning, the installment method can also defer taxable gain on these sales and, therefore, provide an additional reason to commit to an installment sales strategy.
INSTALLMENT METHOD BASICS
For tax purposes, an installment sale is a sale of property for a gain, with at least one payment after the year of sale. An installment sale for tax purposes allows gain to be deferred under the installment method. The gain is deferred in direct proportion to the payments that are deferred. The installment method is a method of accounting that can be used by both cash and accrual-basis taxpayers.
The buyer's obligation to make future payments generally takes the form of an installment note. Each installment payment under the note generally will include a portion of: return of adjusted basis, gain on the sale, and interest (stated, unstated or original issue discount). With the AFR rates historically low, sellers benefit from the interest calculation.
* Excluded property. Some installment sales are not allowed to use the installment method to defer income. The installment sale method is not available for the regular sale of inventory of personal property. Dealer sales are excluded from the installment method, as are sales of stock or securities if traded on an established securities market.
A notable exception to the general rule on sales barred from the installment method is property used or produced in farming. Dealers in time-share properties and residential lots may also treat sales as installment sales, provided they pay a deemed interest charge.
SOME RISK REQUIRED
The objective in using an installment sale is to lock in a sale while deferring recognition of income. To defer income, however, the Tax Code not only requires that receipt of the proceeds must be contractually postponed, but also that receipt of the proceeds must not be a "sure thing" until received. To defer gain under an installment sale, a seller must take some risk that the purchaser will default on the installment obligation. In that respect, a loan by the seller to the buyer to cover part of the purchase price is an integral part of a tax-qualified installment sale.
If the remaining installment payments are paid from an irrevocable escrow account (without "substantial restrictions"), sufficient risk of nonpayment is no longer present and the gain cannot be reported on the installment method. However, some risk protection is allowed. For example, if the purchaser's debt is guaranteed by a third party, it is not treated as an accelerated payment. The same treatment applies to a letter of credit, even one backed up by collateral. This opens up an opportunity for the seller to defer tax while receiving some protection that the buyer will make future payments.
In reporting gain, two variables are key: basis in the property and the sales price. The sales price includes the total cost of the property, which takes into account money and property paid; any debt the buyer pays, assumes or takes; and any selling expenses paid by the buyer. The basis includes selling expenses and depreciation recapture.
"Gross profit" is determined, in turn, first by subtracting the basis from the sales price. Next, the gross profit is divided by the contract price. The contract price is the selling price, minus debt of the seller assumed or taken by the buyer, plus any amount that the debts assumed or taken exceed adjusted basis. The result is the gross profit percentage. After subtracting any interest due from any payment, the gross profit percentage is applied to each payment to determine the amount of reportable gain. The remainder is a nontaxable return of basis.
The character of the gain is determined from the nature of the property sold. If the property is a capital asset, the seller recognizes capital gain income on the income portion of each installment payment. Gain may be ordinary gain for depreciation recapture, or if derived from trade or business property held less than one year or a non-capital asset.
A sale at a loss does not qualify for the installment method. However, a future default on an installment obligation may produce an additional loss at the time of the default.
If other gain property is also sold under the same sales contract, the loss property nonetheless must be separated in determining installment gain. Likewise, gain on the sale of a business or partnership interest from unrealized receivables or inventory items is ordinary income that cannot be reported under the installment method.
One additional benefit gained from the installment sales method presents itself when Section 1231 trade or business property is sold and the taxpayer already has Section 1231 losses for the year. Those Section 1231 losses will be treated as ordinary losses that offset ordinary income, but only if not otherwise offset by 1231 gains for the year. Use of the installment method may help defer that Section 1231 gain.
CHANGE IN TERMS
Especially in a challenging economy, an installment agreement is not always kept. A hard-pressed buyer may come back and insist on some type of "workout," either in the form of a renegotiated purchase price or a forgiveness of a portion of the installment obligation. The seller, too, may want more of the sales price sooner than anticipated, and look to sell the note to a third party.
The gross profit percentage (gross profit divided by contract price) determines each year's reported installment sale income. As long as the agreement is in force, it remains constant unless there is a selling price reduction in a later year. A selling price reduction does not change what gain was initially characterized as long-term capital gain. However, the gross profit percentage is recalculated on all future payments, lowering gross profit and the gain realized on each future payment.
The seller's disposition of the installment obligation may trigger income to the seller. A disposition of an obligation that may trigger income includes a sale, exchange, cancellation, gift or bequest, or distribution of the obligation. On a sale or exchange, the seller has gain or loss equal to the difference between the basis in the obligation and the amount realized. On another type of disposition, the gain or loss is the difference between the basis in the obligation and its fair market value. If the parties are related, the obligation's fair market value must be at least its face value.
The character of the gain or loss on the disposition of an installment obligation is based on the underlying property. A sale for less than the face value of the obligation creates a gain or loss measured by the difference between the basis in the obligation and the amount realized.
Basis in this case is determined by multiplying the unpaid balance by the gross profit percentage and subtracting that amount for the unpaid balance.
A cancellation or partial forgiveness of the debt may also be considered a sale in which gain or loss may be realized and recognized. Gain or loss in that case is measured by the difference between the seller's basis in the obligation and its fair market value at the time of cancellation.
The rules for figuring gain or loss in situations in which the property is repossessed vary depending upon whether personal property or real estate is involved:
* For personal property, gain or loss is determined by subtracting from the fair market value of the repossessed property the seller's basis in the installment obligation. The basis in the installment obligation is equal to the difference between the unpaid balance and the unpaid balance times the gross profit percentage.
* For real property, all payments already received under the original sale are considered income (therefore, the portion previously treated as a return of basis is now treated as income in the year of repossession) and the adjusted basis in the property is kept as it had been before the installment sale.
A seller may elect not to use the installment method. This election-out is made by reporting the entire gain in the year of sale (that is, by not using Form 6252), even though not all the sales proceeds are received in that year. Once all gain is recognized in the first year, future payments (except to the extent of interest) are tax-free. Interest income on the note continues to be paid when received and cannot be accelerated.
While paying tax in advance is usually ill-advised, electing out of the installment method may be worth considering in a variety of circumstances.
* AMT exemption. The Alternative Minimum Tax exemption phases out for AMT income exceeding $150,000 for joint filers and $112,500 for singles. If long-term capital gain pushes an individual over this threshold, AMT liability will be increased to effectively tax long-term gain at more than the maximum 15 percent. Spreading taxable gain over an installment sale period may avoid AMT for any of those years, but might also use up a significant part of the AMT exemption for each of those years. In the latter case, it might make sense to elect out of the installment method in order to exhaust fully one year's AMT exemption and have the exemption fully available in the future.
* Rate changes. While the character of the income is generally determined at the time of sale, the tax rate applied to installment sale income is determined in the year of the payment. While the maximum capital gain rate is currently 15 percent for individuals, this rate officially rises to 20 percent unless Congress intercedes. The expectation is that higher-bracket individuals will see an increase to 20 percent starting in 2011. Likewise, the two top individual income tax rates on ordinary income are expected to increase.
Fortunately, those reporting installment sales in 2009 may postpone their decision until the six-month extended deadline of Oct. 15, 2010, whether to elect out of the installment method. Similarly, sellers entering into an installment sale in 2010 have the benefit of hindsight until Oct. 15, 2011, to elect in or out. Once elected, however, switching out of the installment method requires permission from the IRS.
With credit still tight, use of the installment sales method can provide benefits to both seller and purchaser. In addition to the liquidity that installment sales may provide, the tax benefits derived by the seller from deferring taxable gain and by the purchaser from being able to include the full purchase price in the property's tax basis should not be overlooked in structuring the sale to qualify for the installment sales method.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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