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Income Tax
Seller’s income tax liability on gain may be spread over term of installment payments
One of the main tax benefits to an installment sale is that the seller may spread the taxable gain over the term of the installment payments. For income tax purposes, each payment will be broken into three parts: (1) a tax-free return of the seller’s investment, (2) taxable profit, and (3) taxable interest income. To determine what part of each payment will be a taxable gain, you must determine the gross profit ratio. This is the proportion that the gross profit (selling price minus seller’s adjusted basis) bears to the total contract price (amount to be received by seller). Any interest received is separated and taxed as ordinary income.
You sell a piece of land to your daughter for $200,000. Your adjusted basis in the land is $100,000. You arrange an installment sale where you will receive $20,000 per year for ten years. The gross profit is $100,000 ($200,000 selling price minus $100,000 adjusted basis). The gross profit ratio is 50% ($100,000 gross profit divided by the $200,000 to be received over the life of the installment payments). Therefore, 50% of each payment will be a tax-free return of investment, and 50% will either be capital gains or ordinary income, depending on whether the property sold was a capital asset or not. (For the sake of simplicity, interest has been ignored in this example.)
Interest portion of each payment, whether stated or imputed, will be taxed as ordinary income
The interest portion of each payment is segregated from the principal portion and then taxed as ordinary income. If the interest rate is stated in the contract and is not a below-market rate, the actual interest charged will be taxed as ordinary income to the seller and potentially deductible by the buyer. Often, the installment sale agreement will not specify an interest rate or will have a below-market interest rate. In this case, the tax code imputes interest on each payment using a statutory rate of interest, and compounds the interest semi-annually. A portion of the payment will then be treated as interest to both the seller and buyer. The interest portion of each payment is taxed as ordinary income to the seller, and the buyer may be able to deduct the interest payments (subject to the same restrictions and limitations on deductibility that apply to all interest payments). The remaining portion of the payment is considered principal, and the gross profit ratio is applied to this portion of the payment to determine what percentage is a tax-free return of investment and what portion is either a capital gain or ordinary income.
You sell land to your neighbor for $100,000. Your adjusted basis in the land is $25,000. You set up an installment sale agreement where you will receive ten annual payments of $10,000. There is no mention in the agreement about interest on the unpaid balance. The IRS will impute a statutory rate of interest to the balance and compound it twice a year. Let’s assume that $1,000 of the $10,000 annual payment is determined by the IRS to be interest. The seller must then report this $1,000 each year as ordinary income. The gross profit ratio (75% in this instance — $75,000 divided by $100,000) is next applied to the remaining $9,000 principal payment. This 75% of $9,000 (or $6,750) is considered either a capital gain or ordinary income, and 25% (or $2,250) is considered a tax-free return of investment.
Buyer may be able to deduct interest portion of installment payments
In general, the interest portion of the installment payment is not deductible by the buyer if the interest is considered personal. Interest is deductible by the buyer if the debt is properly allocated to (1) investment activities, but only to the extent of investment income, (2) the conduct of a trade or business, and (3) purchase of a qualified residence.
Your tax advisor should be consulted before you deduct the interest payments on an installment sale. The rules allowing interest deductions are very complex.
You buy your parents’ house from them on an installment sale basis. You intend to use the house as your principal residence. The installment sale agreement sets an interest rate on the unpaid balance that is equal to the going market rate for fixed-rate mortgages. You will be able to deduct the interest portion of each installment payment from your income (as long as the acquisition indebtedness does not exceed $750,000) because the debt is allocable to the purchase of a qualified residence.
If sale results in loss, installment sale treatment does not apply
If the sale transaction results in a loss for the seller, then the seller cannot use the installment sale method to spread the loss over the term of the installment payments. The full loss deduction must be taken in the year of the sale.
You own a piece of land with a basis of $100,000. Land prices in the area have been falling in recent years. You sell the land for $60,000 in an installment sale for ten annual payments of $6,000. You are not allowed to spread the $40,000 loss over the ten-year term of the installment sale. Rather, the entire $40,000 loss must be deducted in the year of the sale.
Installment sale treatment does not apply to sale of listed securities
Installment sale treatment is not available for the sale of securities that are traded on established securities markets (e.g., the New York Stock Exchange, the American Stock Exchange, over-the-counter markets). The entire gain from the sale of the securities must be recognized in the year of the sale.
You sell $100,000 worth of IBM stock to your grandson in an installment sale. Your basis is $30,000, and the $100,000 will be paid in ten installments of $10,000 each. Your entire gain of $70,000 must be reported in the year of the sale. You are not allowed to spread the gain over the term of the installment payments.
Installment sale treatment not allowed for depreciation recapture of real or personal property
If you sell any personal or real property that you have depreciated, recapture of that depreciation up to the amount of your gain must be recognized by you in the year of the sale, even if other gain on the sale is spread out over the term of the installment payments. The amount that is recaptured and reported as taxable income in the year of the sale may be added to the basis of the property. Thus, the gain that will have to be reported each year will be reduced.
You sell a building to another person for $100,000, to be paid in four annual installments. Your original basis for the building was $120,000, but you have taken $40,000 in depreciation deductions over the years, bringing your adjusted basis down to $80,000. You have a gain of $20,000 ($100,000 selling price minus your adjusted basis of $80,000). You could normally spread this gain out over the four years of the installment payments. However, you must recapture your depreciation up to the amount of your gain. Therefore, the entire gain of $20,000 must be reported in the year of the sale. This reported gain of $20,000 may then be added to your adjusted basis of $80,000, bringing your basis up to $100,000. Because your new basis now equals the sale price, there is no gain, and you do not have to report any taxable gain from the four installment payments. If you had sold the property for $150,000, the entire depreciation recapture amount of $40,000 would have to be reported in the year of the sale. The remaining gain of the $30,000 could then be spread out over the four installment payments.
Installment sale treatment not allowed for sale of depreciable property to certain controlled entities
Installment sale treatment is not allowed for the sale of depreciable property to a controlled entity. A controlled entity includes a partnership or corporation in which you have more than a 50% ownership interest. A controlled entity may also be a trust in which you or your spouse is a beneficiary. All payments to be received (even if set up as an installment plan) are considered, for tax purposes, to be received in the year of the sale. This tax result is true even if you have not depreciated the property. As long as the property is eligible to be depreciated, then the entire gain must be reported in the year of the sale.
You sell personal tangible property to a corporation in which you are an 80% owner. The sale price is $50,000, and your basis is $10,000. The property is eligible to be depreciated. The corporation buys the property on an installment plan, paying $10,000 a year for five years. For tax purposes, you have to report the entire $40,000 gain in the year of the sale. You have sold depreciable property to a controlled entity.
Estate Tax
Present value of installment payments still due must be included in gross estate of deceased seller
Unlike a private annuity, the present value of any installments still outstanding at the time of the death of the seller of the property must be included in the seller’s gross estate. In an installment sale, the buyer must continue to make the payments even if the seller dies before the end of the installment payments. The decedent must include the present value of these post-mortem payments in his or her gross estate. However, the installment sale can still be a valuable estate-freezing tool because the property itself and any future appreciation in the property are removed from the seller’s estate.
You have sold a piece of property to your daughter in an installment sale for $500,000. The original sale agreement calls for your daughter to make ten annual payments of $50,000 each. After five payments have been made, you die. The present value of the five remaining payments is included in your gross estate. Your daughter must continue to make the payments to your estate or the recipient of the installment note. However, the value of the property and any appreciation in that property are not included in your gross estate. If the property was worth $700,000 at the time of your death, you have removed this $200,000 of appreciation from your gross estate. The installment sale can therefore be a very effective estate freezing technique. A further tip is that you can use the annual exclusion gift to return part of each payment back to your daughter, tax free.
Upon death of seller, remaining payments must be reported by beneficiary as income in respect of a decedent
Upon the death of the seller of the property, the beneficiary who received the installment note from the seller must report the remaining payments in the same manner as the seller did during life. In other words, the beneficiary must divide each payment that is received into a tax-free return of investment, gain, and taxable interest. The beneficiary will be allowed an income tax deduction to the extent that the seller’s estate was liable for any estate taxes on the unpaid installments.
Gift and Estate Tax
Gift and estate tax liability may arise if property is sold for less than fair market value
When property is sold for less than its fair market value, the difference between the fair market value (FMV) and the consideration received may be a gift from the seller to the buyer. In an installment sale transaction, if the present value of the installment payments is less than the FMV of the property sold, then the seller is considered to have made a gift of the difference to the buyer. The seller will incur gift and estate tax on this difference, which will be currently due and payable if the applicable exclusion amount has been fully utilized.
Because the FMV of the property should be the selling price, you should hire an experienced, objective appraiser to value any property for which there may be a question about the true value.
You sell a piece of property with a fair market value of $100,000 to your son in an installment sale. The present value of the installment payments that your son will make to you is only $70,000. You have made a gift to your son of the $30,000 difference.
Installment payments with low interest rates may trigger gift and estate tax liability
If the installment payments carry a very low interest rate, this may trigger gift and estate tax liability because the present value of the payments will be worth less than the face value of those payments. The IRS considers the difference to be a gift from the seller to the buyer (the buyer is paying less than what he or she would with a fair market rate of interest). Unfortunately, it is not clear at the present time what interest rate should be charged to avoid tax consequences. You could use the prevailing market rate, the applicable federal rate, the rate for sales of farm land under $500,000, or the rates that are imputed for income-tax purposes on installment sales. There is a split between the IRS, the tax court, and some appellate courts as to which rates should be used. You should consult your tax advisor before you set up an installment sale. You should be aware, though, that if you use a very low interest rate, you might run into tax problems.
You sell a commercial building to your daughter in an installment sale. The installment agreement states that the interest rate on the unpaid balance will be 2%. The prevailing market rate is 7%, and the applicable federal rate and other rates are all well above 2%. Under this transaction, the IRS may consider this installment sale to be a partial gift from you to your daughter because of the low interest rate. Consequently, you may owe gift and estate tax.
Transaction structured as installment sale may be disregarded by IRS and treated as a gift
The IRS may treat an installment sale as an outright gift if it believes that the transaction lacks substance. The IRS is especially suspicious of intrafamily transfers where the seller takes back notes from the buyer (usually the child of the seller) but the seller has no intention of enforcing the notes. The IRS treats this type of transaction as an outright gift to the child, and the seller may owe a gift tax on the fair market value of the property transferred. You should therefore be very careful to structure the sale with valid, enforceable, interest-bearing notes to avoid nullification by the IRS.
In community property states, both spouses should join in conveyance of real property
In a community property state, if the real property that is being transferred in an installment sale is community property, then both spouses must join in the conveyance of the community real property. If the real property is held in the name of one spouse only and that spouse tries to transfer the property without the consent of the other spouse, then the other spouse has the right to void the sale in certain community property states. If the community property is held in both spouses’ names, then the transfer by one spouse will be void only with respect to the interest of the other spouse. Therefore, you should be very careful when structuring an installment sale in a community property state.
One community property owner may sell interest as an installment sale while other owner sells interest outright
In a community property state, it’s possible that each person may separately sell his or her interest in community property. One spouse, for example, may sell his or her interest outright and would then have to recognize his or her entire gain in the year of the sale. The other spouse could sell his or her interest in an installment sale and spread the gain over the term of the installment payments. There may be situations where this strategy would make tax sense.
Unmarried partners may have joint property rights similar to community property states
Some recent court decisions have found that there may be implied agreements between unmarried individuals to treat their property similar to that of community property states. You should therefore be cautious when purchasing property from an individual involved in such a relationship. It is possible that the other person may be able to void the entire sale or at least void the sale with respect to his or her interest in the joint property. You may want to get the other person to transfer his or her interest as well.