Other Rules

The rules discussed in this part of the publication apply only in certain circumstances or to certain types of property. The rules cover the following topics.

• Electing out of the installment method.
• Payments received, including those considered received.
• An escrow account.
• Depreciation recapture income.
• A sale to a related person.
• A like-kind exchange.
• A contingent payment sale.
• A single sale of several assets.
• The sale of a business.
• Unstated interest and original interest discount.
• Disposition of an installment obligation.
• A repossession.

Electing Out of the Installment Method

If you elect not to use the installment method, you generally report the entire gain in the year of sale, even though you do not receive all the sale proceeds in that year.

To figure the gain to report, use the fair market value (FMV) of the buyer's installment obligation that represents the buyer's debt to you. Notes, mortgages, and land contracts are examples of obligations that are included at FMV.

You must figure the FMV of the buyer's installment obligation, whether or not you would actually be able to sell it. If you use the cash method of accounting, the FMV of the obligation will never be considered to be less than the FMV of the property sold (minus any other consideration received).

Example.   You sold a parcel of land for $50,000. You received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8% interest. The buyer gave you a note for $40,000. The note had an FMV of $40,000. You paid a commission of 6%, or $3,000, to a broker for negotiating the sale. The land cost $25,000 and you owned it for more than one year. You decide to elect out of the installment method and report the entire gain in the year of sale.

Gain realized:
Selling price			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain realized			$22,000
Gain recognized in year of sale:
Cash			$10,000
Market value of note			40,000
Total realized in year of sale			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain recognized			$22,000

The recognized gain of $22,000 is long-term capital gain. You include the entire gain in income in the year of sale, so you do not include in income any principal payments you receive in later tax years. The interest on the note is ordinary income and is reported as interest income each year.

How to elect out.   To make this election, do not report your sale on Form 6252. Instead, report it on Schedule D (Form 1040) or Form 4797, whichever applies.

When to elect out.   Make this election by the due date, including extensions, for filing your tax return for the year the sale takes place.

Automatic six-month extension.   If you timely file your tax return without making the election, you still can make the election by filing an amended return within 6 months of the due date of your return (excluding extensions). Write Filed pursuant to section 301.9100-2 at the top of the amended return and file it where the original return was filed.

Revoking the election.   Once made, the election can be revoked only with IRS approval. A revocation is retroactive. You will not be allowed to revoke the election in either of the following situations.

• One of the purposes is to avoid federal income tax.
• The tax year in which any payment was received has closed.

Payments Received

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 for an exception to this rule.

Buyer pays seller's expenses.   If the buyer pays any of your 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 in the property, 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.

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 in the property, 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 receive directly from the buyer. Add to this amount the payment you are considered to have received (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 adjusted 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 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.

Mortgage canceled.   If the buyer of your property is the person who holds the mortgage on it, your debt is canceled, not assumed. You are considered to receive a payment equal to the outstanding canceled debt.

Example.   Mary Jones loaned you $4,500 in 1997 in exchange for a note mortgaging a tract of land you owned. On April 4, 2002, she bought the land for $7,000. At that time, $3,000 of her loan to you was outstanding. She agreed to forgive this $3,000 debt and to pay you $2,000 (plus interest) on August 1, 2002, and $2,000 on August 1, 2003. She did not assume an existing mortgage. She canceled the $3,000 debt you owed her. You are considered to have received a $3,000 payment at the time of the 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 being sold. 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 debt the buyer assumes.

• 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 your business, such as a balance due for inventory you purchased.

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 then 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 Like-Kind Exchange, later. 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 who both have a 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 from the third party are not considered payments on the 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% interest third-party note. The FMV of the third-party note at the time of the sale was $3,000. This amount, not $5,000, is a payment to you in the year of sale. The third-party note had an FMV equal to 60% of its face value ($3,000 ÷ $5,000), so 60% of each principal payment you receive on this note is a nontaxable return of capital. The remaining 40% is 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 received.

Guarantee.   If a third party or government agency guarantees the buyer's payments to you on an installment obligation, the guarantee itself is not considered payment.

Installment obligation used as security (pledge rule).   If you use an installment obligation to secure any debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is known as the pledge rule and it applies if the selling price of the property is over $150,000. It does not apply to the following dispositions.

• Sales of property used or produced in farming.
• Sales of personal-use property.
• Qualifying sales of time-shares and residential lots.

The net debt proceeds are the gross debt minus the direct expenses of getting the debt. The amount treated as a payment is considered received on the later of the following dates.

• The date the debt becomes secured.
• The date you receive the debt proceeds.

A debt is secured by an installment obligation to the extent that payment of principal or interest on the debt is directly secured (under the terms of the loan or any underlying arrangement) by any interest in the installment obligation. For sales after December 16, 1999, if you have the right to transfer an installment obligation in payment of a loan, the loan is considered directly secured.

Limit.   The net debt proceeds treated as a payment on the pledged installment obligation cannot be more than the excess of item (1) over item (2), below.

1. The total contract price on the installment sale.
2. Any payments received on the installment obligation before the date the net debt proceeds are treated as a payment.

Installment payments.   The pledge rule accelerates the reporting of the installment obligation payments. Do not report payments received on the obligation after it has been pledged until the payments received exceed the amount reported under the pledge rule.

Exception.   The pledge rule does not apply to debt incurred after December 17, 1987, to refinance a debt under the following circumstances.

• The debt was outstanding on December 17, 1987.
• The debt was secured by that installment sale obligation on that date and at all times thereafter until the refinancing occurred

A refinancing as a result of the creditor's calling of the debt is treated as a continuation of the original debt so long as a person other than the creditor or a person related to the creditor provides the refinancing.

This exception applies only to the refinancing that does not exceed the principal of the original debt immediately before the refinancing. Any excess is treated as a payment on the installment obligation.

Escrow Account

In some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. 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. When an escrow account is established, you no longer rely on the buyer for the rest of the payments, but on the escrow arrangement.

Example.   You sell property for $10,000. The sales agreement calls for a down payment of $1,000 and payment of $1,500 in each of the next 6 years to be made from an irrevocable escrow account containing the balance of the purchase price plus interest. You cannot report the sale on the installment method because the full purchase price is considered received in the year of sale. You report the entire gain in the year of sale.

Escrow established in a later year.   If you make an installment sale and in a later year an irrevocable escrow account is established to pay the remaining installments plus interest, the amount placed in the escrow account represents payment of the balance of the installment obligation.

Substantial restriction.   If an escrow arrangement imposes a substantial restriction on your right to receive the sale proceeds, the sale can be reported on the installment method, provided it otherwise qualifies. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer.

Depreciation Recapture Income

If you sell property for which you claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544.

The recapture income reported in the year of sale is included in your installment sale basis in determining your gross profit on the installment sale. Determining gross profit is discussed under General Rules, earlier.

Sale to a Related Person

Two special rules apply to an installment sale between related persons. Test your sale against Rule 1 first. If Rule 1 does not apply, test your sale against Rule 2. For purposes of these rules, spouses, children, grandchildren, brothers, sisters, and parents are all considered related persons. A partnership or corporation in which you have an interest, or an estate or trust with which you have a connection, also can be considered a related person.

For more information on these kinds of sales, see section 453 of the Internal Revenue Code.

Rule 1 - Sale of Depreciable Property

If you sell depreciable property to certain related persons, you cannot report the sale using the installment method. See Rule 2 when selling nondepreciable property. Instead, all payments to be received are considered received in the year of sale. Depreciable property for this rule is any property the purchaser can depreciate.

Payments to be received include the total of all noncontingent payments and the FMV of any payments contingent as to amount.

In the case of contingent payments for which the FMV cannot be reasonably determined, your basis in the property is recovered proportionately. The purchaser cannot increase the basis of the property acquired in the sale before the seller includes a like amount in income.

Exceptions to Rule 1.   Rule 1 will not apply if no significant tax deferral benefit will be derived from the sale. You must show to the satisfaction of the IRS that avoidance of federal income tax was not one of the principal purposes of the sale.

Rule 2 - Sale and Resale

Generally, a special rule applies if you sell or exchange property to a related person in the installment method (first disposition) who then sells, exchanges, or gives away the property (second disposition) under the following circumstances.

• The related person makes the second disposition before making all payments on the first disposition.
• The related person disposes of the property within 2 years of the first disposition.

Under this rule, you treat part or all of the amount the related person realizes (or the FMV if the disposed property is not sold or exchanged) from the second disposition as if you received it at the time of the second disposition.

Example 1.   In 2001, Harvey Green sold farm land to his son Bob for $500,000, which was to be paid in five equal payments over 5 years, plus adequate stated interest on the balance due. His installment sale basis for the farm land was $250,000 and the property was not subject to any outstanding liens or mortgages. His gross profit percentage is 50% (gross profit of $250,000 ÷ contract price of $500,000). He received $100,000 in 2001 and included $50,000 in income for that year ($100,000 × 0.50). Bob made no improvements to the property and sold it to Alfalfa Inc., in 2002 for $600,000 after making the payment for that year. The amount realized from the second disposition is $600,000. Harvey figures his installment sale income for 2002 as follows:

Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition	$500,000
Subtract: Sum of payments from Bob in 2001 and 2002	- 200,000
Amount treated as received because of second disposition	$300,000
Add: Payment from Bob in 2002	+ 100,000
Total payments received and treated as received for 2002	$400,000
Multiply by gross profit %	× .50
Installment sale income for 2002	$200,000

Harvey will not include in his installment sale income any principal payments he receives on the installment obligation for 2003, 2004, and 2005 because he has already reported the total payments of $500,000 from the first disposition ($100,000 in 2001 and $400,000 in 2002).

Example 2.   Assume the facts are the same as Example 1 except that Bob sells the property for only $400,000. The gain for 2002 is figured as follows:

Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition	$400,000
Subtract: Sum of payments from Bob in 2001 and 2002	- 200,000
Amount treated as received because of second disposition	$200,000
Add: Payment from Bob in 2002	+ 100,000
Total payments received and treated as received for 2002	$300,000
Multiply by gross profit %	× .50
Installment sale income for 2002	$150,000

Harvey receives a $100,000 payment in 2003 and another in 2004. They are not taxed because he treated the $200,000 from the disposition in 2002 as a payment received and paid tax on the gain. In 2005, he receives the final $100,000 payment. He figures the gain he must recognize in 2005 as follows:

Total payments from the first disposition received by the end of 2004		$500,000
Minus the sum of:
Payment from 2001	$100,000
Payment from 2002	100,000
Amount treated as received in 2002	200,000
Total on which gain was previously recognized		- 400,000
Payment on which gain is recognized for 2005		$100,000
Multiply by gross profit %		× .50
Installment sale income for 2005		$ 50,000

Exceptions to Rule 2.   These rules do not apply to a second disposition, and any later transfer, if you can show to the satisfaction of the IRS that neither the first disposition (to the related person) nor the second disposition had as one of its principal purposes the avoidance of federal income tax. Generally, an involuntary second disposition will qualify under the nontax avoidance exception, such as when a creditor of the related person forecloses on the property or the related person declares bankruptcy.

The nontax avoidance exception also applies to a second disposition that is also an installment sale if the terms of payment under the installment resale are substantially equal to or longer than those for the first installment sale. However, the exception does not apply if the resale terms permit significant deferral of recognition of gain from the first sale.

In addition, any sale or exchange of stock to the issuing corporation is not treated as a first disposition. An involuntary conversion is not treated as a second disposition if the first disposition occurred before the threat of conversion. A transfer after the death of the person making the first disposition or the related person's death, whichever is earlier, is not treated as a second disposition.

Previous | First | Next

Publication Index | 2002 Tax Help Archives | Tax Help Archives | Home