By completing an installment sale, this will allow the Seller to defer recognition of the gain on some sales of real property.
With a few exceptions, the installment sale method is currently allowed only for “non-dealer” sales. Losses cannot be reported using the installment method.
The installment method is generally positive for a taxpayer because it means paying taxes on a current sale in future years, as payments are received by the Seller from the Buyer on the financing they have carried from the sale. It also moves the income into later years when there may be other losses to offset the gain.
A. Dealer Sales
Sales by a dealer do not qualify for the installment method. Exception: This is true even if the Seller carries financing over time. This means, for example, a sub divider who sells lots or condominium units which they subdivided cannot use the installment method to report income or gain. Instead, sub dividers and other dealers must report the full gain from the sale in the year that the sale is made, even though payments will be received over a number of years. Even when the installment method is allowable for reporting gains, losses may not be reported using the installment method.
Dealer sales include (1) sale of property held by the Seller for sale to customers in the ordinary course of the Seller’s trade or business, and (2) any sale of personal property by a Seller who regularly sells or disposes of property on the installment plan.
Even though sales might otherwise be dealer sales, gains from the following types of sales have been excluded from the definition of dealer sales and will still qualify for the installment method: (1) Sales of residential lots provided the dealer and any person related to the dealer are not obligated to make improvements to the lots. (2) Sales of time-share rights to use or own residential real property for up to six weeks per year. (3) Sales of rights to use certain campgrounds for recreational purposes. (4) Sales of property used or produced in the business of farming.
To be able to use the installment method for residential time-share rights and sales of residential lots, the Seller must elect to pay interest to the IRS on the amount of tax that is deferred by using the installment method.
This interest is compounded every six months from the date of sale to the date payment on the installment sale is received. The rate is the “applicable Federal rate” at the time of the sale.
B. Non-Dealer Sales
Most non-dealer sales qualify for the installment method of reporting gains. For installment sales which qualify, the amount which is reportable each year is equal to the principal payment, received on the Seller-Carried financing that year, multiplied by the “gross profit ratio” for the sale.
C. Automatic Unless Taxpayer Elects Out
When the installment method applies, it is automatic unless the taxpayer elects to recognize all income from the sale in the year of sale.
- There is no minimum or maximum portion of the sales price that must be received in the year of sale or any future year.
- The installment method may be used even if the selling price is contingent, or cannot be ascertained at the time of sale.
Calculating Gain on an Installment Note
- Selling price is the total consideration to be received by the Seller, and is not reduced by selling expenses such as commissions. Selling price is not reduced by the amount of any mortgage, lien, or selling expenses. However, the selling price is reduced by the amount of any imputed interest if the contract either does not provide for interest, or if the interest rate is too low. Among the items included in selling price are:
- Cash and the fair market value of other property received
- Face amount of financing carried by the Seller
- Mortgages assumed or taken “subject to” by the Buyer
- Principal scheduled or prepaid on notes from the Buyer or third persons to the Seller
- Debts of the Seller paid by the buyer
- Excess of mortgages assumed or taken “subject to” over Seller’s adjusted basis
- Contract price is usually equal to selling price minus any loan(s) assumed or taken subject to by the buyer (i.e. the seller’s equity). The contract price will be increased by the amount the loan(s) exceed(s) the seller’s adjusted basis and selling expenses.
- Gross profit is equal to the selling price minus the property’s adjusted basis and selling expenses.
- Gross profit ratio is equal to the gross profit on the sale divided by the contract price.
NOTE: GROSS PROFIT IS ALSO EQUAL TO OR, (IS ALSO CONSIDERED) “REALIZED GAIN”
Selling Price $100,000 Adjusted Basis (30,000) Selling Expenses (10,000) Gross Profit $60,000 Gross Profit Ratio $60,000 /$100,000 = 60%
E. Wraparound Mortgages
If the seller receives an installment obligation that includes the amount of existing debt on the property, and the existing debt remains on the property after the sale, the new installment obligation is called a “wraparound” mortgage. Generally, the seller continues to pay the installments on the underlying or wrapped indebtedness using the payments received from the Buyer.
The IRS has announced it will follow the result from the US Tax Court, which has held that the Buyer is not treated as having taken the property “subject to” the existing debt or as having assumed the existing debt. This means the contract price is not reduced by the amount of the existing debt when calculating gain includible each year.
F. Reporting Gain
Not every dollar of principal received is reported as profit or gain, since a portion of the principal received really represents a return of the Seller’s basis. The percentage of principal payments that is reported as profit or gain each year is determined as follows:
|Divided by:||Contact price (equals gross profit ratio)|
|Multiplied by:||Principal received during the year|
If the contract price is $100,000 and the Seller’s gross profit is $40,000. The gross profit ratio (also called inclusion ratio) is 40% ($40,000 gross profit divided by $100,000 contract price = 40%).
40% of the principal payments received in the year of sale and in each following year will be reportable as gain.
The remaining 60% represents return of basis and is not taxable.
G. Imputed (Unstated or Inadequate) Interest
- If the Seller does not change interest on the installment sale, or charges interest at too low a rate, the law will treat the Seller as having received interest at the required rate. To do this, the tax law re-characterizes a part of the sales price received as “imputed” or deemed interest. The minimum interest rate that must be charged (or the rate the Seller will be considered a shaving received if a lower rate is charged) is generally the lower of “applicable Federal rate”(AFR) published monthly by the US Treasury. The AFR in effect when the contract is signed or modified is the rate that applies over the entire length of the financing.
- The AFR applies to a particular sale depending on the length of the financing. There are actually 3 different publications by the US Treasury each month. These are referred to as:
- The Federal short-term rate (0-3 years)
- The Federal mid-term rate (3-9 years)
- The Federal long-term rate (over 9 years)
The published AFR’s are based on the yield of marketable US Government securities traded in the securities markets.
If a lower rate (or no interest) is charged on the note, the Seller will be treated as if interest were charged at the required rate.
In effect, this converts part of the sales price into the interest, for tax purposes. It does not affect the contractual rate of interest. For example, we assume the current published AFR is 10% and a sale is made between unrelated parties, and the Seller-carried note provides for an interest rate at 2%. The Buyer will only have to pay actual interest at 2% because the contract says so. However, the Seller will be treated as having received interest equal to the AFR. The difference is imputed interest, which is ordinary income in the year it is received. The imputed interest reduces the amount of gain the Seller is considered to have received on the sale by the same amount.