There are occasions when taxpayer has an accession to wealth, but does not receive any cash with which to pay the income tax due on the gain. Perhaps a purchaser did not have cash to make the purchase and could not procure a bank loan. Taxpayer agrees to permit the purchaser to make installment payments over the course of several years plus interest on the declining balance (§ 163(b)). Section 453 requires taxpayer to defer recognition of “income” 1 until receipt of installment payments. § 453(a). Taxpayer may elect out of the installment method of reporting income. § 453(d)(1).
- The installment method applies to an “installment sale.” An “installment sale” is one where at least one payment is to be received after the close of the taxable year of disposition of
the property. § 453(b)(1).
- However, the installment method does not apply to a “dealer disposition” or to sales of “inventory.” § 453(b)(2).
- Moreover, the installment method does not apply to property dispositions where the seller will have the wherewithal to pay the income tax due on gain.
- Section 453 does not apply to a disposition of personal property under a revolving credit plan. § 453(k)(1).
- Section 453 does not apply to a disposition of stock or securities traded on an established securities market. § 453(k)(2)(A). Such property is so liquid that it is its own source of cash.
- The “installment” method is a “method under which the income recognized for any taxable year from a disposition is that proportion of the payments received in that year which the gross
profits (realized or to be realized when payment is completed) bears to the total contract price.” § 453(c).
- Multiply every payment received by this ratio: (AR − AB)/(Contract Price)
- where AR is the amount taxpayer will eventually realize upon fulfillment of the contract.
- Include the product in gross income in the year of payment of the installment.
- There are some important definitions in the regulations. See Reg. § 15A.453-1(b).
- “Gross profit” is the selling price less adjusted basis. Reg. §15A.453-1(b)(2)(v).
- “Selling price” is the gross selling price without reduction “to reflect any existing mortgage or other encumbrance on the property ...” Reg. § 15A.453-1(b)(2)(ii).
- The “contract price” is the total selling price
- reduced by the debt that the buyer assumes
- which does not exceed the seller’s basis in the property. Reg. § 15A.453-1(b)(2)(iii). Hence, if the debt exceeds the seller’s basis, the contract price is reduced by the seller’s basis, not the amount of the debt. AND: the amount by which the debt exceeds basis is treated as a payment. Reg. § 15A.453-1(b)(3)(i) (11th sentence).
- You can see that the effect of the installment method is to pro-rate the recovery of basis according to the portion of the amount realized of the total selling price.
- Section 453B(a) provides that the disposition of an installment obligation is a recognition event to the one who disposed of it. That person would determine his/her basis in the obligation disposed of and subtract that amount from the amount s/he realizes to determine gain or loss.
Do the CALI Lesson, Basic Federal Income Taxation: Timing: Fundamentals of Installment Sales
- Do not worry about question 19 on wrap-around mortgages. When prevailing interest rates increase, read Reg. § 15A.453-1(b)(3)(ii).
The installment method of § 453 enables a taxpayer to defer recognition of gain until s/he has the wherewithal to pay the tax. However, when taxpayer enters into transactions with related persons with a view towards avoiding income tax, the Code denies the benefits of the installment method.
- Consider: Father (a high bracket taxpayer) sells daughter (a low bracket taxpayer) Blackacre. Father’s basis in Blackacre is $20,000. The selling price is $100,000. Daughter is to make
annual payments of $10,000 plus interest on the declining balance. Daughter makes no payments and one week later, sells Blackacre to a third party for $100,000 cash.
- Notice: daughter has no gain/loss to recognize. She also has $100,000 cash in hand with which to fulfill her obligation to pay father $10,000 per year for the next nine years.
- Father has essentially sold Blackacre at a substantial gain. A person related to him holds the cash from the sale. Father may spread recognition of gain over the ensuing ten years.
Section 453(e) addresses so-called “second dispositions by related persons.”
- Section 453(e)(1) requires taxpayer to treat the amount realized in the “second disposition” (i.e., sale by daughter in the example) as received by the person making the “first
disposition” (i.e., father in the example).
- Thus in our example, father would be treated as realizing $100,000 upon daughter’s sale of Blackacre.
- This rule applies only to a disposition made within two years after the first disposition. § 453(e)(2). However, the running of this two-year period is suspended in the event the risk of loss to the transferee is substantially diminished – as defined.
- A person is “related” if he or she bears a relationship to the transferor described in either § 318(a) or § 267(b). § 453(f)(1).
- Section 453(e)(3) limits the amount realized by the transferor making the first disposition to the lesser of
- the amount realized in the second disposition, or the total contract price for the first disposition
- the aggregate amount of payments received with respect to the first disposition, plus the aggregate amount treated as received under § 453(e).
- Installment payments received after the second disposition are not treated as payments with respect to the first disposition to the extent that such payments are less than the amount
treated as received on the second disposition. Further payments are treated as payments with respect to the first disposition. § 453(e)(5).
- Example: Same facts as above. Daughter sells Blackacre in year 1 for $80,000. Father is treated as realizing $80,000. Daughter makes payments under the installment contract. The first eight payments are not treated as payments with respect to the first disposition. Father will pay no income tax for receiving these payments. The last two payments will produce taxable income for father as before.
Do the CALI Lesson, Basic Federal Income Taxation: Timing Installment Sales: Second Dispositions by Related Parties and Contingent Payments
- Do not worry about questions 8-16 on contingent payments.