BY GEORGE G. JONES AND MARK A. LUSCOMBE
Using the installment
sales method to
create tax liquidity
In an economy still struggling on many fronts, installment sales offer a useful tool for many taxpayers to create liquidity to
buy and sell property in an other wise “
credit-sparse” environment. With correct planning,
the installment method can also defer taxable
gain on these sales and, therefore, provide
an additional reason to commit to an installment sales strategy.
INSTALLMENT METHOD BASICS
For tax purposes, an installment sale is a sale
of property for a gain, with at least one payment after the year of sale. An installment sale
for tax purposes allows gain to be deferred
under the installment method. The gain is
deferred in direct proportion to the payments
that are deferred. The installment method is
a method of accounting that can be used by
both cash and accrual-basis taxpayers.
The buyer’s obligation to make future payments generally takes the form of an installment note. Each installment payment under
the note generally will include a portion of:
return of adjusted basis, gain on the sale, and
interest (stated, unstated or original issue discount). With the AFR rates historically low,
sellers benefit from the interest calculation.
Excluded property. Some installment
sales are not allowed to use the installment
method to defer income. The installment sale
method is not available for the regular sale of
inventory of personal property. Dealer sales
are excluded from the installment method,
as are sales of stock or securities if traded on
an established securities market.
A notable exception to the general rule on
sales barred from the installment method is
property used or produced in farming. Dealers in time-share properties and residential
lots may also treat sales as installment sales,
provided they pay a deemed interest charge.
SOME RISK REQUIRED
The objective in using an installment sale is
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA,
is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
to lock in a sale while deferring recognition
of income. To defer income, however, the Tax
Code not only requires that receipt of the proceeds must be contractually postponed, but
also that receipt of the proceeds must not be
a “sure thing” until received. To defer gain
under an installment sale, a seller must take
some risk that the purchaser will default on
the installment obligation. In that respect, a
loan by the seller to the buyer to cover part
of the purchase price is an integral part of a
tax-qualified installment sale.
If the remaining installment payments
are paid from an irrevocable escrow account
(without “substantial restrictions”), sufficient
risk of nonpayment is no longer present and
the gain cannot be reported on the installment method. However, some risk protection
is allowed. For example, if the purchaser’s
debt is guaranteed by a third party, it is not
treated as an accelerated payment. The same
treatment applies to a letter of credit, even
one backed up by collateral. This opens up
an opportunity for the seller to defer tax while
receiving some protection that the buyer will
make future payments.
In reporting gain, two variables are key: basis
in the property and the sales price. The sales
price includes the total cost of the property,
which takes into account money and prop-
erty paid; any debt the buyer pays, assumes
or takes; and any selling expenses paid by the
buyer. The basis includes selling expenses and
A sale at a loss does not qualify for the installment method. However, a future default on
an installment obligation may produce an
additional loss at the time of the default.
If other gain property is also sold under
the same sales contract, the loss property
nonetheless must be separated in determining installment gain. Likewise, gain on the
sale of a business or partnership interest from
unrealized receivables or inventory items is
ordinary income that cannot be reported under the installment method.
One additional benefit gained from the installment sales method presents itself when
Section 1231 trade or business property is
sold and the taxpayer already has Section
1231 losses for the year. Those Section 1231
losses will be treated as ordinary losses that
offset ordinary income, but only if not otherwise offset by 1231 gains for the year. Use of
the installment method may help defer that
Section 1231 gain.
CHANGE IN TERMS
Especially in a challenging economy, an
installment agreement is not always kept.
A hard-pressed buyer may come back and
insist on some type of “workout,” either in
the form of a renegotiated purchase price or
a forgiveness of a portion of the installment
obligation. The seller, too, may want more of
the sales price sooner than anticipated, and
look to sell the note to a third party.
The seller’s disposition of the installment obligation may trigger income to the seller. A
disposition of an obligation that may trigger
income includes a sale, exchange, cancellation, gift or bequest, or distribution of the obligation. On a sale or exchange, the seller has
gain or loss equal to the difference between
the basis in the obligation and the amount
realized. On another type of disposition, the
gain or loss is the difference between the basis in the obligation and its fair market value.
If the parties are related, the obligation’s fair
market value must be at least its face value.
The character of the gain or loss on the
disposition of an installment obligation is
based on the underlying property. A sale for
less than the face value of the obligation creates a gain or loss measured by the difference
between the basis in the obligation and the
Basis in this case is determined by multiplying the unpaid balance by the gross profit
percentage and subtracting that amount for
the unpaid balance.
A cancellation or partial forgiveness of the
debt may also be considered a sale in which
gain or loss may be realized and recognized.
Gain or loss in that case is measured by the
See STRATEGY on