Unstated Interest and Original Issue Discount

Note: Section references are to the Internal Revenue Code and regulation references are to the Income Tax Regulations under the Code.

An installment sale contract generally provides that each deferred payment on the sale will include interest or there will be an interest payment in addition to the principal payment. Interest provided in the contract is called stated interest.

If an installment sale contract does not provide for adequate stated interest, part of the stated principal amount of the contract may be recharacterized as interest. If section 483 applies to the contract, this interest is called unstated interest. If section 1274 applies to the contract, this interest is called original issue discount (OID).

An installment sale contract does not provide for adequate stated interest if the stated interest rate is lower than the test rate (defined later).

Treatment of unstated interest and OID.   Generally, the unstated interest rules do not apply to a debt given in consideration for a sale or exchange of personal-use property. Personal-use property is any property in which substantially all of its use by the buyer is not in connection with a trade or business or an investment activity.

Rules for the seller.   If either section 1274 or section 483 applies to the installment sale contract, you must treat part of the installment sale price as interest, even though interest is not called for in the sales agreement. If either section applies, you must reduce the stated selling price of the property and increase your interest income by this interest.

Include the unstated interest in income based on your regular method of accounting. Include OID in income over the term of the contract.

The OID includible in income each year is based on the constant yield method described in section 1272. (In some cases, the OID on an installment sale contract also may include all or part of the stated interest, especially if the stated interest is not paid at least annually.)

If you do not use the installment method to report the sale, report the entire gain under your method of accounting in the year of sale. Reduce the selling price by any stated principal treated as interest to determine the gain.

Report unstated interest or OID on your tax return, in addition to stated interest.

Rules for the buyer.   Any part of the stated selling price of an installment sale contract treated by the buyer as interest reduces the buyer's basis in the property and increases the buyer's interest expense. These rules do not apply to personal-use property (for example, property not used in a trade or business).

Adequate stated interest.   An installment sale contract generally provides for adequate stated interest if the contract's stated principal amount is at least equal to the sum of the present values of all principal and interest payments called for under the contract. The present value of a payment is determined based on the test rate of interest, defined next. (If section 483 applies to the contract, payments due within six months after the sale are taken into account at face value.) In general, an installment sale contract provides for adequate stated interest if the stated interest rate (based on an appropriate compounding period) is at least equal to the test rate of interest.

Test rate of interest.   The test rate of interest for a contract is the 3-month rate. The 3-month rate is the lower of the following applicable federal rates (AFRs).

• The lowest AFR (based on the appropriate compounding period) in effect during the 3-month period ending with the first month in which there is a binding written contract that substantially provides the terms under which the sale or exchange is ultimately completed.
• The lowest AFR (based on the appropriate compounding period) in effect during the 3-month period ending with the month in which the sale or exchange occurs.

Applicable federal rate (AFR).   The AFR depends on the month the binding contract for the sale or exchange of property is made and the term of the instrument. For an installment obligation, the term of the instrument is its weighted average maturity, as defined in section 1.1273-1(e)(3) of the regulations. The AFR for each term is shown below.

• For a term of 3 years or less, the AFR is the federal short-term rate.
• For a term of over 3 years, but not over 9 years, the AFR is the federal mid-term rate.
• For a term of over 9 years, the AFR is the federal long-term rate.

The applicable federal rates are published monthly in the Internal Revenue Bulletin (IRB). You can get this information by contacting an IRS office. IRBs are also available on the IRS web site at www.irs.gov.

Seller financed sales.   For sales or exchanges of property (other than new section 38 property, which includes most tangible personal property) involving seller financing of $4,217,500 or less, the test rate of interest cannot be more than 9%, compounded semiannually. For seller financing over $4,217,500 and for all sales or exchanges of new section 38 property, the test rate of interest is 100% of the AFR.

For information on new section 38 property, see section 48(b) of the Internal Revenue Code, as in effect before the enactment of Public Law 101-508.

Certain land transfers between related persons.   In the case of certain land transfers between related persons (described later), the test rate is no more than 6 percent, compounded semiannually.

Internal Revenue Code sections 1274 and 483.   If an installment sale contract does not provide for adequate stated interest, generally either section 1274 or section 483 will apply to the contract. These sections recharacterize part of the stated principal amount as interest. Whether either of these sections applies to a particular installment sale contract depends on several factors, including the total selling price and the type of property sold.

Section 1274.   Section 1274 applies to a debt instrument issued for the sale or exchange of property if any payment under the instrument is due more than 6 months after the date of the sale or exchange and the instrument does not provide for adequate stated interest. Section 1274, however, does not apply to an installment sale contract that is a cash method debt instrument (defined next) or that arises from the following transactions.

• A sale or exchange for which the total payments are $250,000 or less.
• The sale or exchange of an individual's main home.
• The sale or exchange of a farm for $1,000,000 or less by an individual, an estate, a testamentary trust, small business corporation (defined in section 1244(c)(3)), or a domestic partnership that meets requirements similar to those of section 1244(c)(3).
• Certain land transfers between related persons (described later).

Cash method debt instrument.   This is any debt instrument given as payment for the sale or exchange of property (other than new section 38 property) with a stated principal of $3,012,500 or less if the following items apply.

1. The lender (holder) does not use an accrual method of accounting and is not a dealer in the type of property sold or exchanged.
2. Both the borrower (issuer) and the lender jointly elect to account for interest under the cash method of accounting.
3. Section 1274 would apply except for the election in (2) above.

Land transfers between related persons.   The section 483 rules (discussed next) apply to debt instruments issued in a land sale between related persons to the extent the sum of the following amounts does not exceed $500,000.

• The stated principal of the debt instrument issued in the sale or exchange.
• The total stated principal of any other debt instruments for prior land sales between these individuals during the calendar year.

The section 1274 rules, if otherwise applicable, apply to debt instruments issued in a sale of land to the extent the stated principal amount exceeds $500,000, or if any party to the sale is a nonresident alien.

Related persons include an individual and the members of the individual's family and their spouses. Members of an individual's family include the individual's spouse, brother and sister (whole or half), ancestors, and lineal descendants.

Section 483.   Section 483 generally applies to an installment sale contract that does not provide for adequate stated interest and is not covered by section 1274. Section 483, however, generally does not apply to an installment sale contract that arises from the following transactions.

• A sale or exchange for which no payments are due more than one year after the date of the sale or exchange.
• A sale or exchange for $3,000 or less.

Exceptions to sections 1274 and 483.   Sections 1274 and 483 do not apply under the following circumstances.

• An assumption of a debt instrument in connection with a sale or exchange or the acquisition of property subject to a debt instrument, unless the terms or conditions of the debt instrument are modified in a manner that would constitute a deemed exchange under section 1.1001-3 of the regulations.
• A debt instrument issued in connection with a sale or exchange of property if either the debt instrument or the property is publicly traded.
• A sale or exchange of all substantial rights to a patent, or an undivided interest in property that includes part or all substantial rights to a patent, if any amount is contingent on the productivity, use, or disposition of the property transferred. See Publication 544 for more information.
• An annuity contract issued in connection with a sale or exchange of property if the contract is described in section 1275(a)(1)(B) of the Code and section 1.1275-1(j) of the regulations.
• A transfer of property subject to section 1041 of the Code (relating to transfers of property between spouses or incident to divorce).
• A demand loan that is a below-market loan described in section 7872(c)(1) of the Code (for example, gift loans and corporation-shareholder loans).
• A below-market loan described in section 7872(c)(1) of the Code issued in connection with the sale or exchange of personal-use property. This rule applies only to the holder.

Determining whether section 1274 or section 483 applies.   For purposes of determining whether either section 1274 or section 483 applies to an installment sale contract, all sales or exchanges that are part of the same transaction (or related transactions) are treated as a single sale or exchange and all contracts arising from the same transaction (or a series of related transactions) are treated as a single contract. Also, the total consideration due under an installment sale contract is determined at the time of the sale or exchange. Any payment (other than a debt instrument) is taken into account at its FMV.

More information.   For information on figuring unstated interest and OID and other special rules, see sections 1274 and 483 of the Internal Revenue Code and the related regulations. In the case of an installment sale contract that provides for contingent payments, see sections 1.1275-4(c) and 1.483-4 of the regulations.

Disposition of an Installment Obligation

A disposition generally includes a sale, exchange, cancellation, bequest, distribution, or transmission of an installment obligation. An installment obligation is the buyer's note, deed of trust, or other evidence the buyer will make future payments to you.

If you are using the installment method and you dispose of the installment obligation, generally you will have a gain or loss to report. It is considered gain or loss on the sale of the property for which you received the installment obligation. If the original installment sale produced ordinary income, the disposition of the obligation will result in ordinary income or loss. If the original sale resulted in a capital gain, the disposition of the obligation will result in a capital gain or loss.

Use the following rules to figure your gain or loss from the disposition of an installment obligation.

1. If you sell or exchange the obligation, or you accept less than face value in satisfaction of the obligation, the gain or loss is the difference between your basis in the obligation and the amount you realize.
2. If you dispose of the obligation in any other way, the gain or loss is the difference between your basis in the obligation and its FMV at the time of the disposition. This rule applies, for example, when you give the installment obligation to someone else or cancel the buyer's debt to you.

Basis.   Figure your basis in an installment obligation by multiplying the unpaid balance on the obligation by your gross profit percentage. Subtract that amount from the unpaid balance. The result is your basis in the installment obligation.

Example.   Several years ago, you sold property on the installment method. The buyer still owes you $10,000 of the sale price. This is the unpaid balance on the buyer's installment obligation to you. Your gross profit percentage is 60%, so $6,000 (60% × $10,000) is the profit owed you on the obligation. The rest of the unpaid balance, $4,000, is your basis in the obligation.

Transfer between spouses or former spouses.   No gain or loss is recognized on the transfer of an installment obligation between a husband and wife or a former husband and wife if incident to a divorce. A transfer is incident to a divorce if it occurs within one year after the date on which the marriage ends or is related to the end of the marriage. The same tax treatment of the transferred obligation applies to the transferee spouse or former spouse as would have applied to the transferor spouse or former spouse. The basis of the obligation to the transferee spouse (or former spouse) is the adjusted basis of the transferor spouse.

The nonrecognition rule does not apply if the spouse or former spouse receiving the obligation is a nonresident alien.

Gift.   A gift of an installment obligation is a disposition. The gain or loss is the difference between your basis in the obligation and its FMV at the time you make the gift.

For gifts between spouses or former spouses, see Transfers between spouses or former spouses, earlier.

Cancellation.   If an installment obligation is canceled or otherwise becomes unenforceable, it is treated as a disposition other than a sale or exchange. Your gain or loss is the difference between your basis in the obligation and its FMV at the time you cancel it. If the parties are related, the FMV of the obligation is considered to be no less than its full face value.

Forgiving part of the buyer's debt.   If you accept part payment on the balance of the buyer's installment debt to you and forgive the rest of the debt, you treat the settlement as a disposition of the installment obligation. The gain or loss is the difference between your basis in the obligation and the amount you realize on the settlement.

If you reduce the selling price but do not cancel the rest of the buyer's debt to you, it is not considered a disposition of the installment obligation. You must refigure the gross profit percentage and apply it to payments you receive after the reduction. See Selling price reduced under General Rules, earlier.

Assumption.   If the buyer of your property sells it to someone else and you agree to let the new buyer assume the original buyer's installment obligation, you have not disposed of the installment obligation. It is not a disposition even if the new buyer pays you a higher rate of interest than the original buyer.

Transfer due to death.   The transfer of an installment obligation (other than to a buyer) as a result of the death of the seller is not a disposition. Any unreported gain from the installment obligation is not treated as gross income to the decedent. No income is reported on the decedent's return due to the transfer. Whoever receives the installment obligation as a result of the seller's death is taxed on the installment payments the same as the seller would have been had the seller lived to receive the payments.

However, if an installment obligation is canceled, becomes unenforceable, or is transferred to the buyer because of the death of the holder of the obligation, it is a disposition. The estate must figure its gain or loss on the disposition. If the holder and the buyer were related, the FMV of the installment obligation is considered to be no less than its full face value.

Repossession

If you repossess your property after making an installment sale, you must figure the following amounts.

• Your gain (or loss) on the repossession.
• Your basis in the repossessed property.

The rules for figuring these amounts depend on the kind of property you repossess. The rules for repossessions of personal property differ from those for real property. Special rules may apply if you repossess property that was your main home before the sale.

The repossession rules apply whether or not title to the property was ever transferred to the buyer. It does not matter how you repossess the property, whether you foreclose or the buyer voluntarily surrenders the property to you. However, it is not a repossession if the buyer puts the property up for sale and you repurchase it.

For the repossession rules to apply, the repossession must at least partially discharge (satisfy) the buyer's installment obligation to you. The discharged obligation must be secured by the property you repossess. This requirement is met if the property is auctioned off after you foreclose and you apply the installment obligation to your bid price at the auction.

Reporting the repossession.   You report gain or loss from a repossession on the same form you used to report the original sale. If you reported the sale on Form 4797, use it to report the gain or loss on the repossession.

Personal Property

If you repossess personal property, you may have a gain or a loss on the repossession. In some cases, you also may have a bad debt.

To figure your gain or loss, subtract the total of your basis in the installment obligation and any repossession expenses you have from the FMV of the property. If you receive anything from the buyer besides the repossessed property, add its value to the property's FMV before making this calculation.

How you figure your basis in the installment obligation depends on whether or not you reported the original sale on the installment method. The method you used to report the original sale also affects the character of your gain or loss on the repossession.

Sales not reported on the installment method:   See Electing Out of the Installment Method, earlier.

• Basis in installment obligation. Your basis is figured on the obligation's full face value or its FMV at the time of the original sale, whichever you used to figure your gain or loss in the year of sale. From this amount, subtract all payments of principal you have received on the obligation. The result is your basis in the installment obligation. If only part of the obligation is discharged by the repossession, figure your basis in only that part.
• Gain or loss. Add any repossession costs to your basis in the obligation. If the FMV of the property you repossess is more than this total, you have a gain. This is gain on the installment obligation, so it is all ordinary income. If the FMV of the repossessed property is less than the total of your basis plus repossession costs, you have a loss. You included the full gain in income in the year of sale, so the loss is a bad debt. How you deduct the bad debt depends on whether you sold business or nonbusiness property in the original sale. See Publication 550 for information on nonbusiness bad debts and chapter 11 of Publication 535 for information on business bad debts.

Sales reported on the installment method:  

• Basis in installment obligation. Multiply the unpaid balance of your installment obligation by your gross profit percentage. Subtract that amount from the unpaid balance. The result is your basis in the installment obligation.
• Gain or loss. If the FMV of the repossessed property is more than the total of your basis in the obligation plus any repossession costs, you have a gain. If the FMV is less, you have a loss. Your gain or loss on the repossession is of the same character (capital or ordinary) as your gain on the original sale.

Use the following worksheet to determine the taxable gain or loss on a repossession of personal property reported on the installment method.

1)	FMV of property repossessed
2)	Unpaid balance of installment obligation
3)	Unrealized profit (line 2 × gross profit %)
4)	Basis of obligation (line 2 - line 3)
5)	Plus: Repossession costs
6)	Gain or loss on repossession (line 1 - line 5)

Example.   You sold your piano for $1,500 in December 2001 for $300 down and $100 a month (plus interest). The payments began in January 2002. Your gross profit percentage is 40%. You reported the sale on the installment method on your 2001 income tax return. After the fourth monthly payment, the buyer defaulted on the contract (which has an unpaid balance of $800) and you are forced to foreclose on the piano. The FMV of the piano on the date of repossession is $1,400. The legal costs of foreclosure and the expense of moving the piano back to your home total $75. You figure your gain on the repossession as follows:

1)	FMV of property repossessed		$1,400
2)	Unpaid balance of installment obligation	$800
3)	Unrealized profit (line 2 × gross profit %)	320
4)	Basis of obligation (line 2 - line 3)	480
5)	Plus: Repossession costs	75	555
6)	Gain on repossession (line 1 - line 5)		$ 845

Basis in repossessed property.   Your basis in repossessed personal property is its FMV at the time of the repossession.

Fair market value (FMV).   The FMV of repossessed property is a question of fact to be established in each case. If you bid for the property at a lawful public auction or judicial sale, its FMV is presumed to be the price it sells for, unless there is clear and convincing evidence to the contrary.

Real Property

The rules for the repossession of real property allow you to keep essentially the same adjusted basis in the repossessed property you had before the original sale. You can recover this entire adjusted basis when you resell the property. This, in effect, cancels out the tax treatment that applied to you on the original sale and puts you in the same tax position you were in before that sale.

Therefore, the total payments you have received from the buyer on the original sale must be considered income to you. You report, as gain on the repossession, any part of the payments you have not yet included in income. These payments are amounts you previously treated as a return of your adjusted basis and excluded from income. However, the total gain you report is limited. See Limit on taxable gain, discussed later.

Mandatory rules.   The rules concerning basis and gain on repossessed real property are mandatory. You must use them to figure your basis in the repossessed real property and your gain on the repossession. They apply whether or not you reported the sale on the installment method. However, they apply only if all of the following conditions are met.

1. The repossession must be to protect your security rights in the property.
2. The installment obligation satisfied by the repossession must have been received in the original sale.
3. You cannot pay any additional consideration to the buyer to get your property back, unless either of the situations listed below apply.
   1. The requisition and payment of the additional consideration were provided for in the original contract of sale.
   2. The buyer has defaulted, or default is imminent.

Additional consideration includes money and other property you pay or transfer to the buyer. For example, additional consideration is paid if you reacquire the property subject to a debt that arose after the original sale.

Conditions not met.   If any one of these three conditions is not met, use the rules discussed under Personal Property, earlier, as if the property you repossess were personal rather than real property. Do not use the rules for real property.

Figuring gain on repossession.   Your gain on repossession is the difference between the following amounts.

• The total payments received, or considered received, on the sale.
• The total gain already reported as income.

See the earlier discussions under Payments Received for items considered payment on the sale.

Limit on taxable gain.   Taxable gain is limited to your gross profit on the original sale minus the sum of the following amounts.

• The gain on the sale you reported as income before the repossession.
• Your repossession costs.

This method of figuring taxable gain, in essence, treats all payments received on the sale as income, but limits your total taxable gain to the gross profit you originally expected on the sale.

Indefinite selling price.   The limit on taxable gain does not apply if the selling price is indefinite and cannot be determined at the time of repossession. For example, a selling price stated as a percentage of the profits to be realized from the buyer's development of the property is an indefinite selling price.

Character of gain.   The taxable gain on repossession is ordinary income or capital gain, the same as the gain on the original sale. However, if you did not report the sale on the installment method, the gain is ordinary income.

Repossession costs.   Your repossession costs include money or property you pay to reacquire the real property. This includes amounts paid to the buyer of the property, as well as amounts paid to others for such items as those listed below.

• Court costs and legal fees.
• Publishing, acquiring, filing, or recording of title.
• Lien clearance.

Repossession costs do not include the FMV of the buyer's obligations to you that are secured by the real property or the costs of reacquiring those obligations.

Use the following worksheet to determine the taxable gain on a repossession of real property reported on the installment method.

1)	Payments received before repossession
2)	Minus: Gain reported
3)	Gain on repossession
4)	Gross profit on sale
5)	Gain reported (line 2)
6)	Plus: Repossession costs
7)	Subtract line 6 from line 4
8)	Taxable gain (lesser of line 3 or 7)

Example.   You sold a tract of land in January 2000 for $25,000. You accepted a $5,000 down payment, plus a $20,000 mortgage secured by the property and payable at the rate of $4,000 annually plus interest (9.5%). The payments began on January 1, 2001. Your adjusted basis in the property was $19,000 and you reported the transaction as an installment sale. Your selling expenses were $1,000. You figured your gross profit as follows:

Selling price			$25,000
Minus:
Adjusted basis		$19,000
Selling expenses		1,000	20,000
Gross profit			$ 5,000

For this sale, the contract price equals the selling price. The gross profit percentage is 20% ($5,000 gross profit ÷ $25,000 contract price).

In 2000, you included $1,000 in income (20% × $5,000 down payment). In 2001, you reported a profit of $800 (20% × $4,000 annual installment). In 2002, the buyer defaulted and you repossessed the property. You paid $500 in legal fees to get your property back. Your taxable gain on the repossession is figured as follows:

1)	Payments received before repossession		$9,000
2)	Minus: Gain reported		1,800
3)	Gain on repossession		$7,200
4)	Gross profit on sale		$5,000
5)	Gain reported (line 2)	$1,800
6)	Plus: Repossession costs	500	2,300
7)	Subtract line 6 from line 4		$2,700
8)	Taxable gain (lesser of line 3 or 7)		$2,700

Basis.   Your basis in the repossessed property is determined as of the date of repossession. It is the sum of the following amounts.

• Your adjusted basis in the installment obligation.
• Your repossession costs.
• Your taxable gain on the repossession.

To figure your adjusted basis in the installment obligation at the time of repossession, multiply the unpaid balance by the gross profit percentage. Subtract that amount from the unpaid balance.

Use the following worksheet to determine the basis of real property repossessed.

1)	Unpaid balance of obligation
2)	Minus:	Unrealized profit (line 1 × gross profit %)
3)	Adjusted basis (date of repossession)
4)	Plus:	Taxable gain on repossession
		Repossession costs
5)	Basis of repossessed real property

Example.   Assume the same facts as in the preceding example. The unpaid balance of the installment obligation (the $20,000 note) is $16,000 at the time of repossession because the buyer made a $4,000 payment. The gross profit percentage on the original sale was 20%. Therefore, $3,200 (20% × $16,000 still due on the note) is unrealized profit. You figure your basis in the repossessed property as follows:

Unpaid balance of obligation			$16,000
Minus:	Unrealized profit		3,200
Adjusted basis (date of repossession)			$12,800
Plus:	Taxable gain on repossession	$2,700
	Repossession costs	500	3,200
Basis of repossessed real property			$16,000

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