us internal revenue service: p537--2000

8/14/2019 US Internal Revenue Service: p537--2000

1/16

ContentsImportant Changes ............................ 1

Introduction ........................................ 1

What Is an Installment Sale? ............ 2

General Rules ..................................... 2Figuring Installment Income ........... 2Reporting Installment Income ......... 3

Other Rules ......................................... 3Electing Out of the Installment

Method ..................................... 3Payments Received ........................ 4Escrow Account .............................. 5Depreciation Recapture Income ..... 5Sale to a Related Person ............... 5Like-Kind Exchange ........................ 6Contingent Payment Sale ............... 6Single Sale of Several Assets ........ 6Sale of a Business .......................... 7Unstated Interest and Original Issue

Discount ................................... 8Disposition of an Installment

Obligation ................................. 9Repossession ................................. 10

Reporting an Installment Sale .......... 12

How To Get Tax Help ......................... 13

Index .................................................... 16

Important ChangesNew rule for accrual basis taxpayers. Ef-fective for all sales occurring after December16, 1999, accrual basis taxpayers generallycannot use the installment method of ac-counting. See General Rules, later.

Accounting methods. Certain small busi-ness taxpayers may be eligible to adopt orchange to the cash method of accounting andmay not be required to account for invento-ries. For more information, including the defi-nition of a small business taxpayer, see Pub-lication 553, Highlights of 2000 TaxChanges.

Photographs of missing children. TheInternal Revenue Service is a proud partnerwith the National Center for Missing and Ex-ploited Children. Photographs of missingchildren selected by the Center may appearin this publication on pages that would other-wise be blank. You can help bring thesechildren home by looking at the photographsand calling 1800THELOST (1800843

5678) if you recognize a child.

IntroductionAn installment sale is a sale of property whereyou receive at least one payment after the taxyear of the sale. If you dispose of property inan installment sale, you report part of yourgain when you receive each installment pay-ment. You cannot use the installment methodto report a loss.

This publication discusses the generalrules that apply to all installment sales. It alsodiscusses more complex rules that apply onlywhen certain conditions exist or certain types

Departmentof theTreasury

InternalRevenueService

Publication 537Cat. No. 15067V

Installment

Sales

For use in preparing

2000 Returns


2/16

of property are sold. There are two examplesof reporting installment sales on Form 6252at the end of the publication.

If you sold your home or other nonbusi-ness property under an installment plan, youwill need to read only the General Rules. Ifyou sold business or rental property or had alike-kind exchange or other complex situation,see the appropriate discussion under OtherRules, later.

If you sold your entire interest in a passiveactivity, special rules apply to the treatmentof passive activity losses. See Publication 925for information on this topic.

Comments and suggestions. We welcomeyour comments about this publication andyour suggestions for future editions.

You can e-mail us while visiting our website at www.irs.gov/help/email2.html.

You can write to us at the following ad-dress:

Internal Revenue ServiceTechnical Publications BranchW:CAR:MP:FP:P1111 Constitution Ave. NWWashington, DC 20224

We respond to many letters by telephone.

Therefore, it would be helpful if you wouldinclude your daytime phone number, includ-ing the area code, in your correspondence.

Useful ItemsYou may want to see:

Publication

523 Selling Your Home

538 Accounting Periods and Methods

541 Partnerships

544 Sales and Other Dispositions ofAssets

550 Investment Income and Expenses 551 Basis of Assets

925 Passive Activity and At-Risk Rules

Form (and Instructions)

4797 Sales of Business Property

6252 Installment Sale Income

See How To Get Tax Help near the endof this publication for information about get-ting publications and forms.

What Is anInstallment Sale?An installment sale is a sale of property whereyou receive at least one payment after the taxyear of the sale. The installment sale rulesdo not apply to the regular sale of inventory.See Sale of a Business under Other Rules,later.

TIP

If you finance the purchase of yourproperty, instead of having the buyerget a loan or mortgage from a third

party, you probably have an installment sale.It is not an installment sale if the buyer bor-rows the money from a third party and thenpays you the total selling price.

General RulesIf a sale qualifies as an installment sale, thegain must be reported under the installmentmethod unless:

1) You elect out of using the installmentmethod, or

2) You use an accrual method of account-ing.

See Electing Out of the InstallmentMethod under Other Rules, later, for infor-mation on recognizing the entire gain in theyear of sale.

If you use an accrual method of account-ing, you cannot use the installment methodto report gain on any property sold or dis-posed of after December 16, 1999. However,this rule does not apply to the following sales.

1) Sale of property used or produced infarming.

2) Sale of timeshares or residential lots ifyou elect to pay a special interestcharge. See section 453(l) of the InternalRevenue Code.

CAUTION

!As this publication was being pre-pared for print, Congress was con-sidering legislation that would repeal

the disallowance of the use of the installmentmethod by accrual method taxpayers. Formore information about this and other impor-tant tax changes, see Publication 553, High-lights of 2000 Tax Changes.

Installment obligation. The buyer's obli-gation to make future payments to you canbe in the form of a deed of trust, note, landcontract, mortgage, or other evidence of the

buyer's debt to you. The rules discussed inthis publication generally apply regardless ofthe form of the installment obligation.

Stock or securities. You cannot use the in-stallment method to report gain from the saleof stock or securities traded on an establishedsecurities market. You must report the entiregain on the sale in the year in which the tradedate falls.

Dealer sales. Sales of personal property bya person who regularly sells or otherwisedisposes of the same type of property on theinstallment plan cannot be reported under theinstallment method. This rule also applies toreal property held for sale to customers in the

ordinary course of a trade or business.However, the rule does not apply to an in-stallment sale of property used or producedin farming.

Special rule. Dealers of timeshares andresidential lots can report certain sales on theinstallment method if they elect to pay a spe-cial interest charge. For more information, seesection 453(l) of the Internal Revenue Code.

Sale at a loss. If your sale results in a loss,you cannot use the installment method. If theloss is on an installment sale of business as-sets, you can deduct it only in the tax yearof sale. You cannot deduct a loss on the saleof property owned for personal use.

Unstated interest. If your sale calls forpayments in a later year and the sales con-tract provides for little or no interest, you mayhave to figure unstated interest, even if youhave a loss. See Unstated Interest and Ori-ginal Issue Discount, later.

FiguringInstallment IncomeEach payment on an installment sale usuallyconsists of the following three parts.

1) Interest income.

2) Return of your adjusted basis in theproperty.

3) Gain on the sale.

In each year you receive a payment, you mustinclude the interest part in income, as well asthe part that is your gain on the sale. You donot include in income the part that is the re-turn of your basis in the property.

Interest income. You must report interestas ordinary income. Interest is generally notincluded in a down payment. However, youmay have to treat part of each later paymentas interest, even if it is not called interest in

your agreement with the buyer. See UnstatedInterest and Original Issue Discount, later.

Return of basis and gain on sale. The restof each payment is treated as if it were madeup of two parts. One part is a tax-free returnof your adjusted basis in the property. Theother part is your gain.

Figuring gain part of payment. Tofigure what part of any payment isgain, multiply the payment (less in-

terest) by the gross profit percentage. Use thefollowing worksheet to figure the gross profitpercentage.

Selling price. The selling price is the totalcost of the property to the buyer. It includesany money and the fair market value of anyproperty you are to receive. Fair market value(FMV) is discussed later. It also includes anydebt the buyer pays, assumes, or takes, towhich the property is subject. The debt couldbe a note, mortgage, or any other liability,

such as a lien, accrued interest, or taxes youowe on the property. If the buyer pays anyof your selling expenses, that amount is alsoincluded in the selling price. The selling pricedoes not include interest, whether stated orunstated.

Installment sale basis. Three itemscomprise installment sale basis.

Adjusted basis

Selling expenses

Depreciation recapture

Adjusted basis. Basis is a way ofmeasuring your investment in the property.The way you figure basis depends on how

1) Selling price ...........................................2) Installment sale basis:

Adjusted basis of property ...Selling expenses ..................Depreciation recapture .........

3) Gross profit (line 1 line 2) ...................4) Contract price .........................................5) Gross profit percentage

(line 3 line 4) ......................................

Page 2


3/16

you first acquired the property. The basis ofproperty you bought is generally its cost. Thebasis of property you inherited, received asa gift, built yourself, or received in a tax-freeexchange is figured differently.

While you own personal-use property,various events may change your original ba-sis. Some events, such as adding rooms ormaking permanent improvements, increasebasis. Others, such as deductible casualtylosses or depreciation previously allowed orallowable, decrease basis. The result is ad-

justed basis.For more information on how to figure

basis and adjusted basis, see Publication551.

Selling expenses. Selling expenses areany expenses that relate to the sale of theproperty. They include commissions, attorneyfees, and any other expenses paid on thesale. Selling expenses are added to the basisof the sold property.

Depreciation recapture. If you took de-preciation deductions on the asset, you mayneed to recapture part of the gain on the saleas ordinary income. See Depreciation Re-capture Income, later.

Gross profit. Gross profit is the total gainyou report on the installment method.

To figure your gross profit, subtract your

installment sale basis from the selling price.If the property you sold was your home, sub-tract from the gross profit any gain you canexclude. See Sale of your home, later, underReporting Installment Income.

Contract price. The contract price is thetotal of all principal payments you are to re-ceive on the installment sale. It includes pay-ments you are considered to receive, eventhough you are not paid anything directly. SeePayments Received, later.

If part of the selling price is paid in cashand you hold a mortgage payable from thebuyer to you for the remainder, then the con-tract price equals the selling price.

Gross profit percentage. A certain per-centage of each payment (after subtracting

interest) is reported as gain from the sale. Itis called the gross profit percentage and isfigured by dividing your gross profit from thesale by the contract price.

The gross profit percentage generally re-mains the same for each payment you re-ceive. However, see the example under Sell-ing price reduced, later, for a situation wherethe gross profit percentage changes.

Example. You sell property at a contractprice of $2,000 and your gross profit is $500.Your gross profit percentage is 25% ($500 $2,000). After subtracting interest, you report25% of each payment, including the downpayment, as gain from the sale for the taxyear you receive the payment.

Amount to include in income. Each yearas you receive payments on the installmentsale, multiply the payments (less interest) bythe gross profit percentage to determine theamount you must include in income for the taxyear. In certain circumstances, you may beconsidered to have received a payment, eventhough you received nothing directly. A re-ceipt of property or the assumption of amortgage on the property sold may be con-sidered a payment. For a detailed discussion,see Payments Received, later.

Selling price reduced. If the selling price isreduced at a later date, the gross profit on thesale will also change. You must then refigure

the gross profit percentage for the remainingpayments. Refigure your gross profit usingthe reduced sale price and then subtract thegain already reported. Spread the remaininggain over the future installments.

Example. In 1998, you sold land with abasis of $40,000 for $100,000. Your grossprofit was $60,000. You received a $20,000down payment and the buyer's note for$80,000. The note provides for four annualpayments of $20,000 each, plus 12% interest,beginning in 1999. Your gross profit percent-

age is 60%. You reported a gain of $12,000on each payment received in 1998 and 1999.

In 2000, you and the buyer agreed to re-duce the purchase price to $85,000 and pay-ments during 2000, 2001, and 2002 are re-duced to $15,000 for each year.

The new gross profit percentage, 46.67%,is figured as follows.

You will report a gain of $7,000 (46.67%of $15,000) on each of the $15,000 install-ments due in 2000, 2001, and 2002.

ReportingInstallment Income

Form 6252. Use Form 6252 to report an in-stallment sale in the year it takes place andto report payments received in later years.Attach it to your tax return for each year.

Form 6252 will help you determine thegross profit, contract price, gross profit per-centage, and how much of each payment re-

ceived during the tax year to include in in-come.Form 6252 is divided into the following

parts.

1) Part I, Gross Profit and Contract Price,is completed for the year of sale.

2) Part I I, Installment Sale Income, is com-pleted for the year of sale and for anyyear you receive a payment or are con-sidered to have received a payment.

3) Part III , Related Party Installment SaleIncome, is completed if you sold theproperty to a related person, as dis-cussed later under Sale to a RelatedPerson.

Year of sale. Answer the questions at thebeginning of the form and complete Part I andPart II. Line 3 asks whether you sold theproperty to a related party. If you answerYes, answer the question on line 4 andcomplete Part III.

Later years. Answer the questions at thebeginning of the form and complete Part II foreach year in which you receive a payment onthe sale. If you sold the property to a relatedperson, you may have to complete Part IIIalso.

Schedule D (Form 1040). Enter the gainfigured on Form 6252 (line 26) for personal-use property (capital assets) on Schedule D

(Form 1040), Capital Gains and Losses. Ifyour gain from the installment sale qualifiesfor long-term capital gain treatment in theyear of sale, it will continue to qualify in latertax years. Your gain is long-term if you ownedthe property for more than one year when yousold it.

Form 4797. An installment sale of propertyused in your business or that earns rent orroyalty income may result in a capital gain,an ordinary gain, or both. All or part of anygain from its disposition may be ordinary gainfrom depreciation recapture. Use Form 4797to report these transactions and to determinethe ordinary or capital gain or loss.

Sale of your home. If you sell your home,you may be able to exclude all or part of thegain on the sale. See Publication 523 for in-formation about excluding the gain. If the saleis an installment sale, any gain you excludeis not included in gross profit when figuringyour gross profit percentage.

Seller-financed mortgage. Special re-porting procedures apply if you finance thesale of your home to an individual.

When you report interest income receivedfrom a buyer who uses the property as apersonal residence, write the buyer's name,

address, and social security number (SSN)on line 1 of Schedule B (Form 1040) orSchedule 1 (Form 1040A).

When deducting the mortgage interest,the buyer must write your name, address, andSSN on line 11 of Schedule A (Form 1040).

If either person fails to include the otherperson's SSN, a $50 penalty will be as-sessed.

Other RulesThe rules discussed in this part of the publi-cation apply only in certain circumstances orto certain types of property. The rules coverthe following topics.

Electing out of the installment method.

Payments received, including those con-sidered 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 interestdiscount.

Disposition of an installment obligation.

A repossession.

Electing Out of theInstallment MethodIf you elect not to use the installment method,you generally report the entire gain in the yearof sale, even though you do not receive all thesale proceeds in that year.

To figure the gain to report, use the fairmarket value (FMV) of the buyer's installmentobligation. Notes, mortgages, and land con-tracts are examples of obligations that areincluded at FMV.

1) Reduced selling price ........................... $85,0002) Minus: Basis .......................................... 40,0003) Adjusted gross profit ............................. $45,0004) Minus: Gain reported in 1998 & 1999 .. 24,0005) Gain to be reported ............................... $21,0006) Selling price to be received:

Reduced selling price ......... $85,000Minus: Payments receivedin 1998 and 1999 ............... 40,000 $45,000

7) New gross profit percentage

(line 5 line 6) ..................................... 46.67%

Page 3


4/16

You must figure the FMV of the buyer'sinstallment obligation, whether or not youwould actually be able to sell it. If you use thecash method of accounting, the FMV of theobligation will never be considered to be lessthan the FMV of the property sold (minus anyother consideration received).

Example. You sold a parcel of land for$50,000. You received a $10,000 down pay-ment and will receive the balance over thenext 10 years at $4,000 a year, plus 8% in-terest. 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, toa broker for negotiating the sale. The landcost $25,000 and you owned it for more thanone year. You decide to elect out of the in-stallment method and report the entire gainin the year of sale.

The recognized gain of $22,000 is long-term capital gain. Since you include the entiregain in income in the year of sale, you do notinclude in income any principal payments youreceive in later tax years. The interest on thenote is ordinary income and is reported asinterest income each year.

How to elect out. To make this election, donot report your sale on Form 6252. Instead,report it on Schedule D (Form 1040) or Form4797, whichever applies.

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

Automatic six-month extension. If youtimely file your tax return without making theelection, you can still make the election byfiling an amended return within 6 months ofthe due date of your return (excluding exten-sions). Write FILED PURSUANT TO SEC-TION 301.91002 at the top of the amendedreturn and file it where the original return wasfiled.

Revoking the election. Once made, theelection can only be revoked with IRS ap-proval. You will not be allowed to revoke theelection in either of the following situations.

One of the purposes is to avoid federalincome tax.

The tax year in which any payment wasreceived has closed.

Payments ReceivedIncluding Payments ConsideredReceived

You must figure your gain each year on thepayments you receive, or are treated as re-ceiving, from an installment sale. These pay-ments include the down payment and eachlater payment of principal on the buyer's debtto you.

In certain situations, you are consideredto have received a payment, even though thebuyer does not pay you directly. These situ-ations occur when the buyer assumes or paysany of your debts, such as a loan, or pays anyof your expenses, such as a sales commis-sion.

Buyer pays seller's expenses. If the buyerpays any of your expenses related to the saleof your property, it is considered a paymentto you in the year of sale. Include these ex-penses in the selling and contract priceswhen figuring the gross profit percentage.

Buyer assumes mortgage. If the buyer as-sumes or pays off your mortgage, or other-wise takes the property subject to the mort-gage, the following rules apply.

Mortgage less than basis. If the buyerassumes a mortgage that is less than yourinstallment sale basis in the property, it is notconsidered a payment to you. The contractprice equals the selling price minus the mort-gage. This difference is all you will directlycollect from the buyer.

Example. You sell property with an ad-justed basis of $19,000. You have selling ex-penses of $1,000. The buyer assumes yourexisting mortgage of $15,000 and agrees topay you $10,000 (a cash down payment of$2,000 and $2,000 (plus 12% interest) ineach 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 con-tract price is $10,000 ($25,000 $15,000mortgage). Your gross profit percentage is50% ($5,000 $10,000). You report half ofeach $2,000 payment received as gain fromthe sale. You also report all interest you re-ceive as ordinary income.

Mortgage more than basis. If the buyerassumes a mortgage that is more than yourinstallment sale basis in the property, you re-cover your entire basis. You are also relievedof the obligation to repay the amount bor-rowed. The part of the mortgage greater thanyour basis is treated as a payment receivedin the year of sale.

To figure the contract price, subtract themortgage from the selling price. This is thetotal amount you will actually receive from thebuyer. Add to this amount the payment youare considered to receive (the difference be-tween the mortgage and your installment salebasis). The contract price is then the sameas your gross profit from the sale.

If the mortgage the buyer assumes isequal to or more than your installment sale

basis, the gross profit percentage will alwaysbe 100%.

Example. The selling price for yourproperty is $9,000. The buyer will pay you$1,000 annually (plus 8% interest) over thenext 3 years and assume an existing mort-gage of $6,000. Your adjusted basis in theproperty is $4,400. You have selling ex-penses of $600, for a total installment salebasis of $5,000. The part of the mortgage thatis more than your installment sale basis is$1,000 ($6,000 $5,000). This amount is in-cluded in the contract price and treated as apayment received in the year of sale. Thecontract price is $4,000:

Your gross profit on the sale is also$4,000:

Your gross profit percentage is 100%.Report 100% of each payment as gain fromthe sale. Treat the $1,000 difference betweenthe mortgage and your installment sale basisas a payment and report 100% of it as gainin the year of sale.

Mortgage canceled. If the buyer of yourproperty is the person who holds the mort-gage on it, your debt is canceled, not as-sumed. You are considered to receive apayment equal to the outstanding canceleddebt.

Example. Mary Jones loaned you $4,500in 1995 in exchange for a note mortgaging atract of land you owned. On April 4, 2000, shebought 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 topay you $2,000 (plus interest) on August 1,2000, and $2,000 on August 1, 2001. She didnot assume an existing mortgage. She can-celed the $3,000 debt you owed her. You areconsidered to have received a $3,000 pay-ment at the time of the sale.

Buyer assumes other debts. If the buyerassumes any other debts, such as a loan orback taxes, it may be considered a paymentto you in the year of sale.

If the buyer assumes the debt instead ofpaying it off, only part of it may have to betreated as a payment. Compare the debt toyour installment sale basis in the property

being sold. If the debt is less than your in-stallment sale basis, none of it is treated asa payment. If it is more, only the difference istreated as a payment. If the buyer assumesmore than one debt, any part of the total thatis more than your installment sale basis isconsidered a payment. These rules are thesame as the rules discussed earlier underBuyer assumes mortgage. However, theyapply only to the following types of debts thebuyer assumes.

1) Those acquired from ownership of theproperty you are selling, such as amortgage, lien, overdue interest, or backtaxes.

2) Those acquired in the ordinary courseof your business, such as a balance duefor inventory you purchased.

If the buyer assumes any other type ofdebt, such as a personal loan, it is treated asif the buyer had paid off the debt at the timeof the sale. The value of the assumed debt isthen considered a payment to you in the yearof sale.

Payment of property. If you receive prop-erty rather than money from the buyer, it isstill considered a payment. However, seeLike-Kind Exchange, later. The amount of thepayment is the property's FMV on the dateyou receive it.

Selling price ............................................... $9,000Minus: Mortgage ........................................ (6,000)Amount actually received .......................... $3,000Add difference:

Mortgage ................................... $6,000Less: Installment sale basis ..... 5,000 1,000

Contract price .......................................... $4,000

Selling price ................................................. $9,000Minus: Installment sale basis ...................... (5,000)Gross profit ................................................ $4,000

Gain realized:

Selling price ............................................... $50,000Minus: Property's adj. basis ........ $25,000

Commission ..................... 3,000 28,000Gain realized ............................................ $22,000

Gain recognized in year of sale:

Cash ........................................................... $10,000Market value of note .................................. 40,000Total realized in year of sale ..................... $50,000

Minus: Property's adj. basis ........ $25,000Commission ..................... 3,000 28,000

Gain recognized ....................................... $22,000

Page 4


5/16

Fair market value (FMV). This is theprice at which property would change handsbetween a buyer and a seller, neither beingrequired to buy or sell, and both having areasonable knowledge of all the necessaryfacts. If your installment sale fits this de-scription, the value assigned to property inyour agreement with the buyer is good evi-dence of its FMV.

Third-party note. If the property thebuyer gives you is a third-party note (or otherobligation of a third party), you are consideredto have received a payment equal to thenote's FMV. Because the note is itself a pay-ment on your installment sale, any paymentsyou later receive from the third party are notconsidered payments on the sale.

Example. You sold real estate in an in-stallment sale. As part of the down payment,the buyer assigned to you a $5,000, 8% in-terest note of a third party. The FMV of thethird-party note at the time of the sale was$3,000. This amount, not $5,000, is a pay-ment to you in the year of sale. Because thethird-party note had an FMV equal to 60% ofits face value ($3,000 $5,000), 60% of eachprincipal payment you receive on this note isa nontaxable return of capital. The remaining40% is ordinary income.

Bond. A bond or other evidence of debtyou receive from the buyer that is payable ondemand is treated as a payment in the yearyou receive it. If you receive a governmentor corporate bond that has interest couponsattached or that can be readily traded in anestablished securities market, you are con-sidered to have received payment equal tothe bond's FMV.

Buyer's note. The buyer's note (unlesspayable on demand) is not considered pay-ment on the sale. However, its full face valueis included when figuring the selling price andthe contract price. Payments you receive onthe note are used to figure your gain in theyear received.

Guarantee. If a third party or governmentagency guarantees the buyer's payments toyou on an installment obligation, the guaran-tee itself is not considered payment.

Installment obligation used as security(pledge rule). If you use an installment obli-gation to secure any debt, the net proceedsfrom the debt may be treated as a paymenton the installment obligation. This is knownas the pledge rule and it applies if the sellingprice of the property is over $150,000. It doesnot apply to the following dispositions.

1) Sales of property used or produced infarming.

2) Sales of personal-use property.

3) Qualifying sales of timeshares and resi-dential lots.

The net debt proceeds are the gross debtminus the direct expenses of getting the debt.The amount treated as a payment is consid-ered received on the later of the followingdates.

1) The date the debt becomes secured.

2) The date you receive the debt proceeds.

A debt is secured by an installment obli-gation to the extent that payment of principal

or interest on the debt is directly secured(under the terms of the loan or any underlyingarrangement) by any interest in the install-ment obligation. For sales after December 16,1999, if you have the right to transfer an in-stallment obligation in payment of a loan, theloan is considered directly secured.

Limit. The net debt proceeds treated asa payment on the pledged installment obli-gation cannot be more than the excess ofitem (1) over item (2), below.

1) The total contract price on the install-

ment sale.

2) Any payments received on the install-ment obligation before the date the netdebt proceeds are treated as a payment.

Installment payments. The pledge ruleaccelerates the reporting of the installmentobligation payments. Do not report paymentsreceived on the obligation after it has beenpledged until the payments received exceedthe amount reported under the pledge rule.

Exception. The pledge rule does notapply to debt incurred after December 17,1987, to refinance a debt under the followingcircumstances.

1) The debt was outstanding on December17, 1987.

2) The debt was secured by that installmentsale obligation on that date and at alltimes thereafter until the refinancing oc-curred.

A refinancing as a result of the creditor'scalling of the debt is treated as a continuationof the original debt so long as a person otherthan the creditor or a person related to thecreditor provides the refinancing.

This exception applies only to the refi-nancing that does not exceed the principal ofthe original debt immediately before the refi-nancing. Any excess is treated as a paymenton the installment obligation.

Escrow AccountIn some cases, the sales agreement, or alater agreement, may call for the buyer toestablish an irrevocable escrow account fromwhich the remaining installment payments(including interest) are to be made. Thesesales cannot be reported on the installmentmethod. The buyer's obligation is paid in fullwhen the balance of the purchase price isdeposited into the escrow account. When anescrow account is established, you no longerrely 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 pay-

ment of $1,000 and payment of $1,500 ineach of the next 6 years to be made from anirrevocable escrow account containing thebalance of the purchase price plus interest.You cannot report the sale on the installmentmethod because the full purchase price isconsidered received in the year of sale. Youmust report the entire gain in the year of sale.

Escrow established in a later year. If youmake an installment sale and in a later yearan irrevocable escrow account is establishedto pay the remaining installments plus inter-est, the amount placed in the escrow accountrepresents payment of the balance of the in-stallment obligation.

Substantial restriction. If an escrow ar-rangement imposes a substantial restrictionon your right to receive the sale proceeds, thesale can be reported on the installmentmethod, provided it otherwise qualifies. Foran escrow arrangement to impose a sub-stantial restriction, it must serve a bona fidepurpose of the buyer, that is, a real and defi-nite restriction placed on the seller or a spe-cific economic benefit conferred on the buyer.

DepreciationRecapture IncomeIf you sell property for which you claimed adepreciation deduction, you must report anydepreciation recapture income in the year ofsale, whether or not an installment paymentwas received that year. Figure your depreci-ation recapture income (including the section179 deduction and the section 179A de-duction recapture) in Part III of Form 4797.Report the recapture income in Part II of Form4797 as ordinary income in the year of sale.The recapture income is also included in PartI of Form 6252. However, the gain equal tothe recapture income is reported in full in theyear of the sale. Only the gain greater thanthe recapture income is reported on the in-

stallment method. For more information ondepreciation recapture, see chapter 3 inPublication 544.

The recapture income reported in the yearof sale is included in your installment salebasis in determining your gross profit on theinstallment sale. Determining gross profit isdiscussed under General Rules, earlier.

Sale to aRelated PersonTwo special rules apply to an installment salebetween related persons. Test your saleagainst Rule 1 first. If Rule 1 does not apply,test your sale against Rule 2. For purposesof these rules, spouses, children, grandchild-

ren, brothers, sisters, and parents are allconsidered related persons. A partnershipor corporation in which you have an interest,or an estate or trust with which you have aconnection, can also be considered a relatedperson.

For more information on these kinds ofsales, see section 453 of the Internal Reve-nue Code.

Rule 1Sale of DepreciablePropertyIf you sell depreciable property to certain re-lated persons, you cannot report the sale us-ing the installment method. Instead, all pay-ments to be received are considered receivedin the year of sale. Depreciable property forthis rule is any property that the purchasercan depreciate.

Payments to be received include the totalof all noncontingent payments and the FMVof any payments contingent as to amount.

In the case of contingent payments forwhich the FMV cannot be reasonably deter-mined, your basis in the property is recoveredratably. The purchaser cannot increase thebasis of the property acquired in the sale be-fore the seller includes a like amount in in-come.

Exceptions to Rule 1. Rule 1 will not applyif no significant tax deferral benefit will bederived from the sale. You must show to the

Page 5


6/16

satisfaction of the IRS that avoidance of fed-eral income tax was not one of the principalpurposes of the sale.

Rule 2Sale and ResaleGenerally, a special rule applies if you (aninstallment seller) make a first disposition(sale or exchange) to a related person whothen makes a second disposition (sale, ex-change, or gift) under the following circum-stances.

The related person makes the seconddisposition before making all paymentson the first disposition.

The related person disposes of the prop-erty within 2 years of the first disposition.

Under this rule, you treat part or all of theamount the related person realizes (or theFMV if the disposed property is not sold orexchanged) from the second disposition as ifyou received it from the first disposition at thetime of the second disposition.

Example 1. In 1999, Harvey Green soldfarm land to his son Bob for $500,000, whichwas to be paid in five equal payments over 5years, plus adequate stated interest on the

balance due. His installment sale basis forthe farm land was $250,000 and the propertywas not subject to any outstanding liens ormortgages. His gross profit percentage is50% (gross profit of $250,000 contract priceof $500,000). He received $100,000 in 1999and included $50,000 in income for that year($100,000 0.50). Bob made no improve-ments to the property and sold it to AlfalfaInc., in 2000 for $600,000 after making thepayment for that year. The amount realizedfrom the second disposition is $600,000.Harvey figures his installment sale income for2000 as follows:

Harvey will not include in his installmentsale income any principal payments he re-ceives on the installment obligation for 2001,2002, and 2003 because he has already re-ported the total payments of $500,000 fromthe first disposition ($100,000 in 1999 and$400,000 in 2000).

Example 2. Assume the facts are thesame as Example 1 except that Bob sells theproperty for only $400,000. The gain for 2000is figured as follows:

Harvey receives a $100,000 payment in2001 and another in 2002. They are not taxedbecause he treated the $200,000 from thedisposition in 2000 as a payment receivedand paid tax on the gain. In 2003, he receivesthe final $100,000 payment. He figures thegain he must recognize in 2003 as follows:

Exceptions to Rule 2. These rules do notapply to a second disposition, and any latertransfer, if you can show, to the satisfactionof the IRS, that neither the first disposition (tothe related person) nor the second dispositionhad as one of its principal purposes theavoidance of federal income tax. Generally,an involuntary second disposition will qualifyunder the nontax avoidance exception, suchas when a creditor of the related personforecloses on the property or the related per-son declares bankruptcy.

The nontax avoidance exception also ap-plies to a second disposition that is also aninstallment sale if the terms of payment underthe installment resale are substantially equalto or longer than those for the first installmentsale. However, the exception does not applyif the resale terms permit significant deferralof recognition of gain from the first sale.

In addition, any sale or exchange of stockto the issuing corporation is not treated as afirst disposition. An involuntary conversion isnot treated as a second disposition if the firstdisposition occurred before the threat of con-version. A transfer after the death of the

person making the first disposition or the re-lated person's death, whichever is earlier, isnot treated as a second disposition.

Like-Kind ExchangeIf you trade business or investment propertysolely for the same kind of property, you canpostpone reporting the gain. These trades areknown as like-kind exchanges. The propertyyou receive in a like-kind exchange is treatedas if it were a continuation of the property yougave up.

You do not have to report any part of yourgain if you receive only like-kind property.However, if you also receive money or otherproperty in the exchange, you must report

your gain to the extent of the money and theFMV of the other property received.

For more information on like-kind ex-changes, see Like-Kind Exchangesin chapter1 of Publication 544.

Installment payments. If, in addition tolike-kind property, you receive an installmentobligation in the exchange, the following rulesapply.

1) The contract price is reduced by theFMV of the like-kind property received inthe trade.

2) The gross profit is reduced by any gainon the trade that can be postponed.

3) Like-kind property received in the tradeis not considered payment on the in-stallment obligation.

Example. In 2000, George Brown tradespersonal property with an installment salebasis of $400,000 for like-kind property hav-ing an FMV of $200,000. He also receives aninstallment note for $800,000 in the trade.Under the terms of the note, he is to receive$100,000 (plus interest) in 2001 and the bal-ance of $700,000 (plus interest) in 2002.

George's selling price is $1,000,000

($800,000 installment note + $200,000 FMVof like-kind property received). His gross profitis $600,000 ($1,000,000 $400,000 install-ment sale basis). The contract price is$800,000 ($1,000,000 $200,000). Thegross profit percentage is 75% ($600,000 $800,000). He reports no gain in 2000 be-cause the like-kind property he receives is nottreated as a payment for figuring gain. Hereports $75,000 gain for 2001 (75% of$100,000 payment received) and $525,000gain for 2002 (75% of $700,000 payment re-ceived).

Deferred exchanges. A deferred exchangeis one in which you transfer property and re-ceive like-kind property later. Under this type

of exchange, the person receiving your prop-erty may be required to place funds in anescrow account or trust. If certain rules aremet, these funds will not be considered apayment until you have the right to receive thefunds or, if earlier, the end of the exchangeperiod. See section 1.1031(k)1(j)(2) of theregulations for these rules.

Contingent Payment SaleFor installment sales, a contingent paymentsale is one whose total selling price cannotbe determined by the end of the tax year inwhich the sale takes place.

If the selling price cannot be determinedby the end of the tax year, the contract priceand the gross profit percentage cannot bedetermined (using the same rules that applyto an installment sale with a fixed sellingprice). This happens, for example, if you sellyour business and the selling price includesa percentage of its profits in future years.

For rules on using the installment methodfor a contingent payment sale or a contingentpayment sale with unstated interest, seesection 15A.4531(c) of the regulations.

Single Saleof Several AssetsIf you sell different types of assets in a singlesale, you must identify each asset to deter-mine whether you can use the installmentmethod to report the sale of that asset. Youalso have to allocate part of the selling priceto each asset. If you sell assets that constitutea trade or business, see Sale of a Business,next.

Unless an allocation of the selling pricehas been agreed to by both parties in anarm's-length transaction, you must allocatethe selling price to an asset based on its FMV.If the buyer assumes a debt, or takes theproperty subject to a debt, you must reducethe FMV of the property by the debt. Thisbecomes the net FMV.

A sale of separate and unrelated assetsof the same type under a single contract isreported as one transaction for the installmentmethod. However, if an asset is sold at a loss,

Total payments from the first dispositionreceived by the end of 2002 ................. $500,000

Minus the sum of:Payment from 1999 .......... $100,000Payment from 2000 .......... 100,000

Amount treated as re-ceived in 2000 .................. 200,000

Total on which gain was previouslyrecognized ............................................ 400,000Payment on which gain is recognizedfor 2003 ................................................. $100,000Multiply by gross profit % ........ ............. .50Installment sale income for 2003 ...... $ 50,000

Lesserof: 1) Amount realized on sec-ond disposition, or 2) Contract price onfirst disposition ....................................... $500,000Subtract: Sum of payments from Bob in1999 and 2000 ....................................... 200,000Amount treated as received because ofsecond disposition ................................. $300,000

Add: Payment from Bob in 2000 ........... + 100,000Total payments received and treated asreceived for 2000 ................................... $400,000

Multiply by gross profit % .............. ........ .50Installment sale income for 2000 ....... $200,000

Lesserof: 1) Amount realized on sec-ond disposition, or 2) Contract price onfirst disposition ....................................... $400,000Subtract: Sum of payments from Bob in1999 and 2000 ....................................... 200,000Amount treated as received because ofsecond disposition ................................. $200,000

Add: Payment from Bob in 2000 ........... + 100,000Total payments received and treated asreceived for 2000 ................................... $300,000

Multiply by gross profit % .............. ........ .50Installment sale income for 2000 ....... $150,000

Page 6


7/16

its disposition cannot be reported on the in-stallment method. It must be reported sepa-rately. The remaining assets sold at a gainare reported together.

Example. You sold three separate andunrelated parcels of real property (A, B, andC) under a single contract calling for a totalselling price of $130,000. The total sellingprice consisted of a cash payment of $20,000,the buyer's assumption of a $30,000 mort-gage on parcel B, and an installment obli-gation of $80,000 payable in eight annual in-stallments, plus interest at 8% a year.

Your installment sale basis for each parcelwas $15,000. Your net gain was $85,000($130,000 $45,000). You report the gain onthe installment method.

The sales contract did not allocate theselling price or the cash payment received inthe year of sale among the individual parcels.The FMV of parcels A, B, and C were$60,000, $60,000, and $10,000, respectively.

Since the installment sale basis for parcelC was more than its FMV, it was sold at a lossand must be treated separately. You mustallocate the total selling price and theamounts received in the year of sale betweenparcel C and the remaining parcels.

Of the total $130,000 selling price, you

must allocate $120,000 to parcels A and Btogether and $10,000 to parcel C. You shouldallocate the cash payment of $20,000 re-ceived in the year of sale and the notereceivable on the basis of the proportionatenet FMV. The allocation is figured as follows:

You cannot report the sale of parcel C onthe installment method because the sale re-sults in a loss. You report this loss of $5,000($10,000 selling price $15,000 installmentsale basis) in the year of sale. However, ifparcel C was held for personal use, the lossis not deductible.

You allocate the installment obligation of$80,000 to the properties sold based on theirproportionate net FMVs (90% to parcels Aand B, 10% to parcel C).

Sale of a BusinessThe installment sale of an entire business forone overall price under a single contract isnot the sale of a single asset.

Allocation of selling price. The selling pricemust be allocated among each asset class forthe following reasons.

1) The sale of a business generally in-cludes real and personal property thatcan be reported on the installmentmethod and inventory items that cannot.

2) Any depreciation recapture income fromthe sale of depreciable property cannotbe reported on the installment method.It is reported in full in the year of the sale.

3) Assets sold at a loss cannot be reportedon the installment method.

Inventory. The sale of inventory itemscannot be reported on the installment method.All gain or loss on their sale must be reportedin the year of sale, even if you are paid in lateryears.

If inventory items are included in an in-stallment sale, you may have an agreementstating which payments are for inventory andwhich are for the other assets being sold. Ifyou do not, each payment must be allocatedbetween the inventory and the other assetssold.

Report the amount you receive (or will re-ceive) on the sale of inventory items as ordi-nary business income. Use your basis in theitems to figure the cost of goods sold anddeduct the part of the selling expenses allo-cated to inventory as an ordinary businessexpense.

Residual method. Except for assets ex-changed under the like-kind exchange rules,both the buyer and seller of a business must

use the residual method to allocate the saleprice to each business asset sold. Thismethod determines gain or loss from thetransfer of each asset.

The residual method must be used for anytransfer of a group of assets that constitutesa trade or business and for which the buyer'sbasis is determined only by the amount paidfor the assets. This applies to both direct andindirect transfers, such as the sale of a busi-ness or the sale of a partnership interest inwhich the basis of the buyer's share of thepartnership assets is adjusted for the amountpaid. A group of assets constitutes a tradeor business if goodwill or going concern valuecould, under any circumstances, attach to theassets.

The residual method provides for the sale

price to first be reduced by cash, general de-posit accounts other than certificates of de-posit, and similar accounts transferred by theseller. The consideration remaining after thisreduction must be allocated among the vari-ous business assets in a certain order.

For asset acquisitions occurring afterJanuary 5, 2000, the allocation must bemade among the following assets in propor-tion to (but not more than) their fair marketvalue on the purchase date in the followingorder.

1) Certificates of deposit, U.S. Governmentsecurities, foreign currency, and activelytraded personal property, including stockand securities.

2) Accounts receivable, mortgages, andcredit card receivables that arose in theordinary course of business.

3) Property of a kind that would properlybe included in inventory if on hand at theend of the tax year and property held bythe taxpayer primarily for sale to cus-tomers in the ordinary course of busi-ness.

4) All other assets except section 197 in-tangibles, goodwill, and going concernvalue.

5) Section 197 intangibles except goodwilland going concern value.

6) Goodwill and going concern value(whether or not they qualify as section197 intangibles).

More information. For information on theallocation of assets acquired before January6, 2000, see Sale of a Business in chapter 2of Publication 544. For more information onsection 197 intangibles, see chapter 9 ofPublication 535.

How to report the sale of a business. Both

the seller and buyer must prepare and attachForm 8594, Asset Acquisition Statement Un-der Section 1060, to their income tax returnfor the year the sale occurs. If the amountallocated to any asset is increased or de-creased after Form 8594 is filed, a supple-mental statement in Part III of a new Form8594 must be completed.

Sale of partnership interest. A partner whosells a partnership interest at a gain may beable to report the sale on the installmentmethod. The sale of a partnership interest istreated as the sale of a single capital asset.However, the partner must allocate a portionof the proceeds to ordinary income if thepartnership's assets include unrealized

receivables and inventory items. (The termunrealized receivables includes depreciationrecapture income, discussed earlier.)

The gain allocated to the unrealizedreceivables and the inventory cannot be re-ported under the installment method. Thegain allocated to the other assets can be re-ported under the installment method.

For more information on the treatment ofunrealized receivables and inventory, seePublication 541.

ExampleOn March 4, 2000, you sold the machine shopyou had operated since 1990. You receiveda $100,000 down payment and the buyer's

note for $120,000. The note payments are$15,000 each, plus 10% interest, due everyJuly 1 and January 1, beginning in 2001. Thetotal selling price is $220,000. Your sellingexpenses are $11,000. The selling expensesare divided among all the assets sold, in-cluding inventory.

Your selling expense for each asset is 5%of the asset's selling price ($11,000 sellingexpense $220,000 total selling price).

The FMV, adjusted basis, and depreci-ation claimed on each asset sold are as fol-lows:

Under the residual method, you allocatethe selling price to each of the assets basedon their FMV ($201,500). The remainingamount is allocated to your section 197 in-tangible, goodwill ($18,500).

The assets included in the sale, their sell-ing prices based on their FMVs, the sellingexpense allocated to each asset, the adjustedbasis, and the gain for each asset are shownin the following chart.

ParcelsA and B Parcel C

FMV ..................................... $120,000 $10,000Minus: Mortgage assumed .. 30,000 -0-Net FMV .............................. $ 90,000 $10,000

Proportionate net FMV:Percentage of total .............. 90% 10%

Payments in year of sale:$20,000 90% .................... $18,000$20,000 10% .................... $2,000

Excess of parcel B mortgageover installment sale basis .. 15,000 -0-

Allocation of paymentsreceived (or consideredreceived) in year of sale .. $ 33,000 $ 2,000

Depre-ciation

Ad-justed

Asset FMV Claimed Basis

Inventory ... ... ... ... ... ... . $ 10,000 -0- $ 8,000Land .......................... 42,000 -0- 15,000Building ..................... 48,000 $ 9,000 36,000Machine A .. .. .. .. .. .. .. .. . 71,000 27,200 63,800Machine B .. .. .. .. .. .. .. .. . 24,000 12,960 22,040Truck ... ... ... ... ... ... ... ... . 6,500 18,624 5,376

$201,500 $67,784 $150,216

Page 7


8/16

The building was acquired in 1990, theyear the business began, and it is section1250 property. There is no depreciation re-

capture income because the building wasdepreciated using the straight line method.

All gain on the truck, machine A, and ma-chine B is depreciation recapture incomesince it is the lesser of the depreciationclaimed or the gain on the sale. Figure de-preciation recapture in Part III of Form 4797.

The total depreciation recapture incomereported in Part II of Form 4797 is $5,209.This consists of $3,650 on machine A, $799on the truck, and $760 on machine B (thegain on each item since it was less than thedepreciation claimed). These gains are re-ported in full in the year of sale and are notincluded in the installment sale computation.

Of the $220,000 total selling price, the$10,000 for inventory assets cannot be re-

ported on the installment method. The sellingprices of the truck and machines are also re-moved from the total selling price becausegain on these items is reported in full in theyear of sale.

The selling price equals the contract pricefor the installment sale ($108,500). The as-sets included in the installment sale, theirselling price, and their installment sale basesare shown in the following chart.

The gross profit percentage(gross profit contract price) for the installment sale is48% ($52,075 $108,500). The gross profitpercentage for each asset is figured as fol-lows:

Since the sale includes assets sold on theinstallment method and assets for which thegain is reported in full in the year of sale,payments must be allocated between the in-stallment part of the sale and the part re-ported in the year of sale. The selling pricefor the installment sale is $108,500. This is49.3% of the total selling price of $220,000($108,500 $220,000). The selling price ofassets not reported on the installment methodis $111,500. This is 50.7% ($111,500 $220,000) of the total selling price.

Multiply principal payments by 49.3% todetermine the part of the payment for the in-stallment sale. The balance, 50.7%, is for thepart reported in the year of the sale.

The gain on the sale of the inventory,machines, and truck is reported in full in theyear of sale. When you receive principalpayments in later years, no part of the pay-ment for the sale of these assets is included

SalePrice

SaleExp.

Adj.Basis Gain

in gross income. Only the part for the in-stallment sale (49.3%) is used in the install-ment sale computation.

The only payment received in 2000 is thedown payment of $100,000. The part of thepayment for the installment sale is $49,300($100,000 49.3%). This amount is used inthe installment sale computation.

Installment income for 2000. Your install-ment income for each asset is the gross profitpercentage for that asset times $49,300, the

installment income received in 2000.

Installment income after 2000. You figureinstallment income for years after 2000 byapplying the same gross profit percentagesto 49.3% of the total payments you receiveon the buyer's note during the year.

Unstated Interest andOriginal Issue DiscountNote: Section references are to the InternalRevenue Code and regulation references areto the Income Tax Regulations under theCode.

An installment sale contract generallyprovides that each deferred payment on thesale will include interest or there will be aninterest payment in addition to the principalpayment. Interest provided in the contract iscalled stated interest.

If an installment sale contract does notprovide for adequate stated interest, part ofthe stated principal amount of the contractmay be recharacterized as interest. If section483 applies to the contract, this interest iscalled unstated interest. If section 1274applies to the contract, this interest is called

original issue discount (OID).An installment sale contract does not pro-vide for adequate stated interest if the statedinterest rate is lower than the test rate (de-fined later).

Treatment of unstated interest and OID.Generally, the unstated interest rules do notapply to a debt given in consideration for asale or exchange of personal-use property.Personal-use property is any property inwhich substantially all of its use by the buyeris not in connection with a trade or businessor an investment activity.

Rules for the seller. If either section1274 or section 483 applies to the installmentsale contract, you must treat part of the in-stallment sale price as interest, even thoughinterest is not called for in the sales agree-ment. If either section applies, you must re-duce the stated selling price of the propertyand increase your interest income by this in-terest.

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

The OID includible in income each year isbased on the constant yield method describedin section 1272. (In some cases, the OID onan installment sale contract may also includeall or part of the stated interest, especially ifthe stated interest is not paid at least annu-ally.)

If you do not use the installment methodto report the sale, report the entire gain underyour method of accounting in the year of sale.Reduce the selling price by any stated prin-cipal treated as interest to determine the gain.

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

Rules for the buyer. Any part of the statedselling price of an installment sale contracttreated by the buyer as interest reduces thebuyer's basis in the property and increasesthe buyer's interest expense. These rules donot apply to personal-use property (for ex-ample, property not used in a trade or busi-ness).

Adequate stated interest. An installmentsale contract generally provides for adequatestated interest if the contract's stated principalamount is at least equal to the sum of thepresent values of all principal and interestpayments called for under the contract. Thepresent value of a payment is determinedbased on the test rate of interest, definednext. (If section 483 applies to the contract,payments due within six months after the saleare taken into account at face value.) In gen-eral, an installment sale contract provides foradequate stated interest if the stated interest

rate (based on an appropriate compoundingperiod) is at least equal to the test rate ofinterest.

Test rate of interest. The test rate ofinterest for a contract is the 3-month rate. The3-month rate is the lower of the followingapplicable federal rates (AFRs).

The lowest AFR (based on the appropri-ate compounding period) in effect duringthe 3-month period ending with the firstmonth in which there is a binding writtencontract that substantially provides theterms under which the sale or exchangeis ultimately completed.

The lowest AFR (based on the appropri-ate compounding period) in effect during

the 3-month period ending with the monthin which the sale or exchange occurs.

Applicable federal rate (AFR). The AFRdepends on the month the binding contract forthe sale or exchange of property is made andthe term of the instrument. For an installmentobligation, the term of the instrument is itsweighted average maturity, as defined insection 1.12731(e)(3) of the regulations. TheAFR for each term is shown below.

For a term of 3 years or less, the AFR isthe federal short-term rate.

For a term of over 3 years, but not over9 years, the AFR is the federal mid-termrate.

For a term of over 9 years, the AFR is thefederal long-term rate.

The applicable federal rates are pub-lished monthly in the Internal Reve-nue Bulletin (IRB). You can get this

information by contacting an IRS office. IRBsare also available on the IRS web site atwww.irs.gov.

Seller financed sales. For sales or ex-changes of property (other than new section38 property, which includes most tangiblepersonal property) involving seller financingof $3,960,100 or less, the test rate of interestcannot be more than 9%, compounded

Inventory ... .. $ 10,000 $ 500 $ 8,000 $ 1,500Land ........... 42,000 2,100 15,000 24,900Building ....... 48,000 2,400 36,000 9,600Mch. A ........ 71,000 3,550 63,800 3,650Mch. B ........ 24,000 1,200 22,040 760Truck .......... 6,500 325 5,376 799Goodwill ...... 18,500 925 -0- 17,575

$220,000 $11,000 $150,216 $58,784

Income

Land22.95% of $49,300 ......................... $11,314Building8.85% of $49,300 ...................... 4,363Goodwill16.2% of $49,300 ..................... 7,987Total installment income for 2000 ......... $23,664

SellingPrice

Install-mentSale

BasisGrossProfit

Land .......................... $ 42,000 $17,100 $24,900Build ing ... .. .. .. .. .. .. .. .. .. 48,000 38,400 9,600Goodwill . ................... 18,500 925 17,575

Total ......................... $108,500 $56,425 $52,075

Percentage

Land $24,900 $108,500 .......................... 22.95Building $9,600 $108,500 ....................... 8.85Goodwill $17,575 $108,500 .................... 16.20Total .............................................................. 48.00

Page 8


9/16

semiannually. For seller financing over$3,960,100 and for all sales or exchanges ofnew section 38 property, the test rate of in-terest is 100% of the AFR.

For information on new section 38 prop-erty, see section 48(b) of the Internal Reve-nue Code, as in effect before the enactmentof Public Law 101508.

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

Internal Revenue Code sections 1274 and483. If an installment sale contract does notprovide for adequate stated interest, generallyeither section 1274 or section 483 will applyto the contract. These sections recharacterizepart of the stated principal amount as interest.Whether either of these sections apply to aparticular installment sale contract dependson several factors, including the total sellingprice and the type of property sold.

Section 1274. Section 1274 applies to a debtinstrument issued for the sale or exchangeof property if any payment under the instru-ment is due more than 6 months after thedate of the sale or exchange and the instru-ment does not provide for adequate statedinterest. Section 1274, however, does notapply to an installment sale contract that is acash method debt instrument (defined next)or that arises from the following transactions.

A sale or exchange for which the totalpayments are $250,000 or less.

The sale or exchange of an individual'smain home.

The sale or exchange of a farm for$1,000,000 or less by an individual, anestate, a testamentary trust, small busi-ness corporation (defined in section1244(c)(3)), or a domestic partnershipthat meets requirements similar to those

of section 1244(c)(3). Certain land transfers between related

persons (described later).

Cash method debt instrument. This isany debt instrument given as payment for thesale or exchange of property (other than newsection 38 property) with a stated principal of$2,828,700 or less if the following items ap-ply.

1) The lender (holder) does not use an ac-crual method of accounting and is not adealer in the type of property sold orexchanged.

2) Both the borrower (issuer) and the lenderjointly elect to account for interest underthe cash method of accounting.

3) Section 1274 would apply except for theelection in (2) above.

Land transfers between related per-sons. The section 483 rules (discussed next)apply to debt instruments issued in a landsale between related persons to the extentthe sum of the following amounts does notexceed $500,000.

The stated principal of the debt instru-ment issued in the sale or exchange.

The total stated principal of any otherdebt instruments for prior land sales be-

tween these individuals during the calen-dar year.

The section 1274 rules, if otherwise ap-plicable, apply to debt instruments issued ina sale of land to the extent the stated principalamount exceeds $500,000, or if any party tothe sale is a nonresident alien.

Related persons include an individual andthe members of the individual's family andtheir spouses. Members of an individual'sfamily include the individual's spouse, brother

and sister (whole or half), ancestors, andlineal descendants.

Section 483. Section 483 generally appliesto an installment sale contract that does notprovide for adequate stated interest and is notcovered by section 1274. Section 483, how-ever, generally does not apply to an install-ment sale contract that arises from the fol-lowing transactions.

A sale or exchange for which no paymentis due more than one year after the dateof 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 thefollowing circumstances.

An assumption of a debt instrument inconnection with a sale or exchange or theacquisition of property subject to a debtinstrument, unless the terms or conditionsof the debt instrument are modified in amanner that would constitute a deemedexchange under section 1.1001-3 of theregulations.

A debt instrument issued in connectionwith a sale or exchange of property if ei-ther the debt instrument or the propertyis publicly traded.

A sale or exchange of all substantial

rights to a patent, or an undivided interestin property that includes part or all sub-stantial rights to a patent, if any amountis contingent on the productivity, use, ordisposition of the property transferred.See Publication 544 for more information.

An annuity contract issued in connectionwith a sale or exchange of property if thecontract is described in section1275(a)(1)(B) of the Code and section1.12751(j) of the regulations.

A transfer of property subject to section1041 of the Code (relating to transfers ofproperty between spouses or incident todivorce).

A demand loan that is a below-market

loan described in section 7872(c)(1) ofthe Code (for example, gift loans andcorporation-shareholder loans).

A below-market loan described in section7872(c)(1) of the Code issued in con-nection with the sale or exchange ofpersonal-use property. This rule appliesonly to the holder.

Determining whether section 1274 or sec-tion 483 applies. For purposes of determin-ing whether either section 1274 or section483 applies to an installment sale contract,all sales or exchanges that are part of thesame transaction (or related transactions) aretreated as a single sale or exchange and all

contracts arising from the same transaction(or a series of related transactions) aretreated as a single contract. Also, the totalconsideration due under an installment salecontract is determined at the time of the saleor exchange. Any payment (other than a debtinstrument) is taken into account at its FMV.

More information. For information on figur-ing unstated interest and OID and other spe-cial rules, see sections 1274 and 483 of theInternal Revenue Code and the related regu-lations. In the case of an installment salecontract that provides for contingent pay-ments, see sections 1.12754(c) and 1.4834of the regulations.

Disposition of anInstallment ObligationA disposition generally includes a sale, ex-change, 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 willmake future payments to you.

If you are using the installment methodand you dispose of the installment obligation,generally you will have a gain or loss to re-

port. It is considered gain or loss on the saleof the property for which you received the in-stallment obligation. If the original installmentsale produced ordinary income, the disposi-tion of the obligation will result in ordinary in-come or loss. If the original sale resulted ina capital gain, the disposition of the obligationwill result in a capital gain or loss.

Use the following rules to figure your gainor loss from the disposition of an installmentobligation.

1) If you sell or exchange the obligation,or you accept less than face value insatisfaction of the obligation, the gain orloss is the difference between your basisin the obligation and the amount you re-alize.

2) If you dispose of the obligation in anyother way, the gain or loss is the differ-ence between your basis in the obli-gation and its FMV at the time of thedisposition. This rule applies, for exam-ple, when you give the installment obli-gation to someone else or cancel thebuyer's debt to you.

Basis. Figure your basis in an installmentobligation by multiplying the unpaid balanceon the obligation by your gross profit per-centage. Subtract that amount from the un-paid balance. The result is your basis in theinstallment obligation.

Example. Several years ago, you soldproperty on the installment method. Thebuyer still owes you $10,000 of the sale price.This is the unpaid balance on the buyer's in-stallment obligation to you. Because yourgross profit percentage is 60%, $6,000 (60% $10,000) is the profit owed you on the obli-gation. The rest of the unpaid balance,$4,000, is your basis in the obligation.

Transfer between spouses or formerspouses. No gain or loss is recognized onthe transfer of an installment obligation be-tween a husband and wife or a former hus-band and wife if incident to a divorce. Atransfer is incident to a divorce if it occurswithin one year after the date on which the

Page 9


10/16

marriage ends or is related to the end of themarriage. The same tax treatment of thetransferred obligation applies to thetransferee spouse or former spouse as wouldhave applied to the transferor spouse or for-mer spouse. The basis of the obligation tothe transferee spouse (or former spouse) isthe adjusted basis of the transferor spouse.

The nonrecognition rule does not apply ifthe spouse or former spouse receiving theobligation is a nonresident alien.

Gift. A gift of an installment obligation is adisposition. The gain or loss is the differencebetween your basis in the obligation and itsFMV at the time you make the gift.

For gifts between spouses or formerspouses, see Transfers between spouses orformer spouses, earlier.

Cancellation. If an installment obligation iscanceled or otherwise becomes unenforce-able, it is treated as a disposition other thana sale or exchange. Your gain or loss is thedifference between your basis in the obli-gation and its FMV at the time you cancel it.If the parties are related, the FMV of the ob-ligation is considered to be no less than its full

face value.

Forgiving part of the buyer's debt. If youaccept part payment on the balance of thebuyer's installment debt to you and forgive therest of the debt, you treat the settlement asa disposition of the installment obligation. Thegain or loss is the difference between yourbasis in the obligation and the amount yourealize on the settlement.

If you reduce the selling price but do notcancel the rest of the buyer's debt to you, itis not considered a disposition of the install-ment obligation. You must refigure the grossprofit percentage and apply it to paymentsyou receive after the reduction. See Selling

price reducedunder General Rules, earlier.

Assumption. If the buyer of your propertysells it to someone else and you agree to letthe new buyer assume the original buyer'sinstallment obligation, you have not disposedof the installment obligation. It is not a dispo-sition even if the new buyer pays you a higherrate of interest than the original buyer.

Transfer due to death. The transfer of aninstallment obligation (other than to a buyer)as a result of the death of the seller is not adisposition. Any unreported gain from the in-stallment obligation is not treated as grossincome to the decedent. No income is re-

ported on the decedent's return due to thetransfer. Whoever receives the installmentobligation as a result of the seller's death istaxed on the installment payments the sameas the seller would have been had the sellerlived to receive the payments.

However, if an installment obligation iscanceled, becomes unenforceable, or istransferred to the buyer because of the deathof the holder of the obligation, it is a disposi-tion. The estate must figure its gain or losson the disposition. If the holder and the buyerwere related, the FMV of the installment obli-gation is considered to be no less than its fullface value.

RepossessionIf you repossess your property after makingan installment sale, you must figure the fol-lowing amounts.

1) Your gain (or loss) on the repossession.

2) Your basis in the repossessed property.

The rules for figuring these amounts de-pend on the kind of property you repossess.The rules for repossessions of personalproperty differ from those for real property.Special rules may apply if you repossessproperty that was your main home before thesale.

The repossession rules apply whether ornot title to the property was ever transferredto the buyer. It does not matter how you re-possess the property, whether you forecloseor the buyer voluntarily surrenders the prop-erty to you. However, it is not a repossessionif the buyer puts the property up for sale andyou repurchase it.

For the repossession rules to apply, therepossession must at least partially discharge(satisfy) the buyer's installment obligation toyou. The discharged obligation must be se-cured by the property you repossess. Thisrequirement is met if the property is auctioned

off after you foreclose and you apply the in-stallment obligation to your bid price at theauction.

Reporting the repossession. You reportgain or loss from a repossession on the sameform you used to report the original sale. Ifyou reported the sale on Form 4797, use it toreport the gain or loss on the repossession.

Personal PropertyIf you repossess personal property, you mayhave a gain or a loss on the repossession. Insome cases, you may also have a bad debt.

To figure your gain or loss, subtract thetotal of your basis in the installment obligationand any repossession expenses you havefrom the FMV of the property. If you receiveanything from the buyer besides the repos-sessed property, add its' value to the proper-ty's FMV before making this calculation.

How you figure your basis in the install-ment obligation depends on whether or notyou reported the original sale on the install-ment method. The method you used to reportthe original sale also affects the character ofyour gain or loss on the repossession.

For sales not reported on the installmentmethod: See Electing Out of the InstallmentMethod, earlier.

Basis in installment obligation. Your basisis 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 orloss in the year of sale. From this amount,subtract all payments of principal you havereceived on the obligation. The result isyour basis in the installment obligation. Ifonly part of the obligation is discharged bythe repossession, figure your basis in onlythat part.

Gain or loss. Add any repossession costs toyour basis in the obligation. If the FMV ofthe property you repossess is more thanthis total, you have a gain. Because it isgain on the installment obligation, it is allordinary income. If the FMV of the repos-sessed property is less than the total of

your basis plus repossession costs, youhave a loss. Because you included the fullgain in income in the year of sale, the lossis a bad debt. How you deduct the baddebt depends on whether you sold busi-ness or nonbusiness property in the ori-ginal sale. See Publication 550 for infor-mation on nonbusiness bad debts andchapter 11 of Publication 535 for informa-tion on business bad debts.

For sales reported on the installment

method:Basis in installment obligation. Multiply the

unpaid balance of your installment obli-gation by your gross profit percentage.Subtract that amount from the unpaid bal-ance. The result is your basis in the in-stallment obligation.

Gain or loss. If the FMV of the repossessedproperty is more than the total of your ba-sis in the obligation plus any repossessioncosts, you have a gain. If the FMV is less,you have a loss. Your gain or loss on therepossession is of the same character(capital or ordinary) as your gain on theoriginal sale.

Use the following worksheet to deter-mine the taxable gain or loss on arepossession of personal property re-

ported on the installment method.

Example. You sold your piano for $1,500

in December 1999 for $300 down and $100a month (plus interest). The payments beganin January 2000. Your gross profit percentageis 40%. You reported the sale on the install-ment method on your 1999 income tax return.After the fourth monthly payment, the buyerdefaulted on the contract (which has an un-paid balance of $800) and you are forced toforeclose on the piano. The FMV of the pianoon the date of repossession is $1,400. Thelegal costs of foreclosure and the expense ofmoving the piano back to your home total$75. You figure your gain on the repossessionas follows:

Basis in repossessed property. Your basisin repossessed personal property is its FMVat the time of the repossession.

Fair market value (FMV). The FMV of re-possessed property is a question of fact tobe established in each case. If you bid for theproperty at a lawful public auction or judicialsale, its FMV is presumed to be the price it

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) .......................................

1) FMV of property repossessed ................ $1,4002) Unpaid balance of installment

obligation .................................... $8003) Unrealized profit

(line 2 gross profit %) .............. 3204) Basis of obligation

(line 2 line 3) ........................... 4805) Plus: Repossession costs ... ... ... . 75 5556) Gain on repossession

(line 1 line 5) ....................................... $ 845

Page 10


11/16

sells for, unless there is clear and convincingevidence to the contrary.

Real PropertyThe rules for the repossession of real prop-erty allow you to keep essentially the sameadjusted basis in the repossessed propertyyou had before the original sale. You can re-cover this entire adjusted basis when you re-sell the property. This, in effect, cancels outthe tax treatment that applied to you on theoriginal 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 salemust be considered income to you. You re-port, as gain on the repossession, any partof the payments you have not yet included inincome. These payments are amounts youpreviously treated as a return of your adjustedbasis and excluded from income. However,the total gain you report is limited. See Limiton taxable gain, discussed later.

Mandatory rules. The rules concerning ba-sis and gain on repossessed real property aremandatory. You must use them to figure yourbasis in the repossessed real property andyour gain on the repossession. They apply

whether or not you reported the sale on theinstallment method. However, they apply onlyif allthe following conditions are met.

1) The repossession must be to protectyour security rights in the property.

2) The installment obligation satisfied bythe repossession must have been re-ceived in the original sale.

3) You cannot pay any additional consid-eration to the buyer to get your propertyback, unless either of the situationslisted below apply.

a) The reacquisition and payment ofthe additional consideration wereprovided for in the original contract

of sale.b) The buyer has defaulted, or default

is imminent.

Additional consideration includes moneyand other property you pay or transfer to thebuyer. For example, additional considerationis paid if you reacquire the property subjectto a debt that arose after the original sale.

Conditions not met. If any one of thesethree conditions is not met, use the rulesdiscussed under Personal Property, earlier,as if the property you repossess were per-sonal rather than real property. Do not use therules for real property.

Figuring gain on repossession. Your gain

on repossession is the difference between thefollowing amounts.

1) The total payments received, or consid-ered received, on the sale.

2) The total gain already reported as in-come.

See the earlier discussions under PaymentsReceived for items considered payment onthe sale.

Limit on taxable gain. Taxable gain islimited to your gross profit on the original saleminus the sum of the following amounts.

1) The gain on the sale you reported asincome before the repossession.

2) Your repossession costs.

This method of figuring taxable gain, in es-sence, treats all payments received on thesale as income, but limits your total taxablegain to the gross profit you originally expectedon the sale.

Indefinite selling price. The limit ontaxable gain does not apply if the selling priceis indefinite and cannot be determined at thetime of repossession. For example, a sellingprice stated as a percentage of the profits tobe realized from the buyer's development ofthe property is an indefinite selling price.

Character of gain. The taxable gain onrepossession is ordinary income or capitalgain, the same as the gain on the originalsale. However, if you did not report the saleon the installment method, the gain is ordi-nary income.

Repossession costs. Your repossessioncosts include money or property you pay toreacquire the real property. This includesamounts paid to the buyer of the property, aswell as amounts paid to others for such itemsas those listed below.

1) Court costs.

2) Legal fees.

3) Publishing, acquiring, filing, or recordingof title.

4) Lien clearance.

Repossession costs do not include theFMV of the buyer's obligations to you that aresecured by the real property.

Use the following worksheet to deter-mine the taxable gain on a repos-session of real property reported on

the installment method.

Example. You sold a tract of land inJanuary 1998 for $25,000. You accepted a$5,000 down payment, plus a $20,000 mort-gage secured by the property and payable atthe rate of $4,000 annually plus interest(9.5%). The payments began on January 1,1999. Your adjusted basis in the property was$19,000 and you reported the transaction asan installment sale. Your selling expenseswere $1,000. You figured your gross profit asfollows:

For this sale, the contract price equals theselling price. The gross profit percentage is20% ($5,000 gross profit $25,000 contractprice).

In 1998, you included $1,000 in income(20% $5,000 down payment). In 1999, youreported a profit of $800 (20% $4,000 an-nual installment). In 2000, the buyer de-faulted and you repossessed the property.You paid $500 in legal fees to get your prop-erty back. Your taxable gain on the repos-session is figured as follows:

Basis. Your basis in the repossessed prop-erty is determined as of the date of repos-session. It is the sum of the following

amounts.1) Your adjusted basis in the installment

obligation.

2) Your repossession costs.

3) Your taxable gain on the repossession.

To figure your adjusted basis in the install-ment obligation at the time of repossession,multiply the unpaid balance by the gross profitpercentage. Subtract that amount from theunpaid balance.

Use the following worksheet to deter-mine the basis of real property re-possessed.

Example. Assume the same facts as inthe preceding example. The unpaid balanceof the installment obligation (the $20,000note) is $16,000 at the time of repossessionbecause the buyer made a $4,000 payment.The gross profit percentage on the originalsale was 20%. Therefore, $3,200 (20% $16,000 still due on the note) is unrealizedprofit. You figure your basis in the repos-sessed property as follows:

Holding period for resales. If you resell therepossessed property, the resale may resultin a capital gain or loss. To figure whether thegain or loss is long-term or short-term, yourholding period includes the period you ownedthe property before the original sale plus theperiod after the repossession. It does not in-clude the period the buyer owned the prop-erty.

If the buyer made improvements to thereacquired property, the holding period forthese improvements begins on the day afterthe date of repossession.

Bad debt. If you repossess real propertyunder t

us internal revenue service: p537--2000

Documents