What Is It?
An installment sale, sometimes used when a small business or real estate is sold, is defined as a sale of property where at least one payment is to be received after the close of the tax year in which the sale occurs. In other words, rather than receiving the proceeds at the time of the sale, you typically receive a series of payments spread out over several years.
One advantage of the installment method is that you may defer the taxation of a portion of your capital gain to one or more later years. In addition, instead of recognizing the gain all at once, you may be able to spread out your income tax liability over a number of years. Installment sale treatment may not be available for certain types of assets including inventory and publicly traded securities. Both accrual basis taxpayers and cash basis taxpayers can qualify to use the installment method of reporting income.
Tip: A variation of the installment sale is the self-canceling installment note (SCIN). With a SCIN, the seller takes back a note, and the buyer makes a series of payments to the seller under that note. There is a provision in the note that upon the death of the seller, the remaining payments will be canceled. You should be aware, however, that a SCIN may cause adverse income and gift tax consequences for the seller. See Questions and Answers, below.
Caution: Comparisons are sometimes made to private annuities below. However, for private annuities issued after October 18, 2006, gain is generally recognized at the time property is exchanged for a private annuity; gain is not deferred until annuity payments are received.
When Can It Be Used?
One Payment Must Be Made In a Taxable Year After Year of Sale
To qualify for installment sale treatment, at least one of the payments of the installment sale must be made in a taxable year after the year of the sale. There is no requirement that there be a payment in the year of the sale. The seller of the asset has a great deal of flexibility in how and when the payments will be structured.
Installment Sale Treatment Is Automatic Unless You Elect Not to Have It Apply
Generally speaking, if you sell real or personal property, you must use the installment method to report gain if at least one payment is to be received after the close of the tax year in which the sale occurs, unless you affirmatively elect out of the installment method.
Certain Sales Do Not Qualify for Installment Sale Treatment
Installment sale treatment is not available for the sale of stocks or securities that are traded on established securities markets (New York Stock Exchange, American Stock Exchange, and the over-the-counter exchanges). Any installment payments received are considered to have been received in the year of the sale and will be taxed as such. Also, installment sale treatment is not available for:
- Sales of inventory
- Recapture income
- Sales of depreciable property to a related person
Tip: Special rules may apply if you're a dealer in real or personal property.
Shifts Income from High-Tax Years Into Low-Tax Years
An installment sale allows you to spread the taxable gain from the sale of an asset over the number of payment installments. This allows you to defer the taxable gain from years in which you may be in a higher tax bracket to years in which you may be in a lower bracket. You include a portion of the taxable gain in income each time that you receive a payment.
Example(s): You own a piece of undeveloped land with a basis of $20,000 that is currently worth $100,000. You are currently in a high tax bracket. You expect to retire in two years and anticipate that you will be in a lower tax bracket at that time. You would like to sell the land to your daughter this year, but you do not want to report the entire gain before you retire. One solution is to structure an installment sale. You can sell the land this year to your daughter, structuring the sale so that you will not receive most of the payment until three years after the sale, when you will be retired and in a lower tax bracket.
Tip: Long-term capital gains are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.
May Help Reduce Potential Estate Taxes
An installment sale transaction can be an effective estate freeze technique, especially when the sale is between family members and involves appreciating assets (such as real estate or a closely held business). When the asset is sold for full and fair value in an installment sale, only the present value of any unpaid installment payments may be includable in the seller's estate at the time of death; the value of the underlying asset is not included in the taxable estate of the seller. Therefore, any appreciation in the asset after the time of the installment sale is removed with neither gift tax nor estate tax consequences.
Tip: Another way to reduce the seller's estate even more is to have the seller gift back (gift tax free to the extent of the annual gift tax exclusion) part or all of the payments that he or she receives from the buyer.
May Create a Market for a Business
An installment sale may help a business owner sell his or her business more readily. An installment sale may allow a buyer who cannot afford to purchase the assets outright to spread the purchase price over a number of years.
Example(s): You own a closely held company and would like to retire. A friend works in the business and would like to buy the company. The company has a fair market value of $3 million. Your friend does not have enough capital to buy the company outright. One solution is to structure an installment sale of the business so that the purchase price can be spread out over a number of years. Your friend can then use the cash flow from the company to fund the payments.
Seller May Retain Security Interest In Property Without Jeopardizing Income Tax Benefits
Unlike a private annuity, the seller in an installment sale transaction may retain a security interest in the property without jeopardizing the beneficial income tax treatment. In a private annuity, if any security interest is retained by the seller, all of the gain is taxed at the time of the sale. However, in an installment sale, the seller may retain a security interest in the property and still spread the taxable gain over the term of the installment payments. In an installment sale transaction, the seller may also require that a third party (such as a bank issuing a standby letter of credit) guarantee payment if the buyer defaults.
Caution: The IRS and some courts have held that funds placed in an escrow account to secure the interest of the seller are considered to be constructively received and are currently taxable to the seller.
Caution: For private annuities issued after October 18, 2006, gain is generally recognized at the time property is exchanged for a private annuity; gain is not deferred until annuity payments are received.
Allows Flexibility and Certainty About Repayment Plan
The seller and buyer have substantial flexibility regarding the terms of the installment sale. As long as one of the payments is made in a taxable year after the year of the sale, you can generally structure the payments as you wish. Also, be aware that there is no minimum selling price required for installment sale treatment.
Example(s): You would like to sell a piece of artwork to your daughter this year for $4,000. You expect to be in a very high tax bracket for the next two years. For tax reasons, you would like to defer receiving any payments until at least year three. You can accomplish this goal with an installment sale. You can sell the painting this year and, in the installment sale agreement, specify that payments will not begin until the third year. Furthermore, your daughter will know at the time of the sale exactly how many payments she will have to make.
Tip: You may set up an installment sale for an asset even if the selling price is contingent on some other event at the time of the sale. For example, you may sell your business to your two children, and the final sale price will be contingent on how well the business does over the five years after the sale.
Buyer May Be Able to Deduct Interest Payments on Installment Sale Purchase
Unlike a private annuity (in which no part of the payment is deductible by the buyer), a buyer in an installment sale may be able to deduct interest payments made (or deemed made) in connection with an installment sale. Under Section 163(h) of the Internal Revenue Code, a deduction will be allowed for interest incurred in the purchase of a qualified residence, for investment interest to the extent of investment income, and for interest on purchases allocable to a trade or business. No interest deduction will be allowed if the interest is considered personal interest.
Buyer In Installment Sale Gets Stepped-Up Basis In Property
Unlike a gift, in which the donee takes the basis (generally, the property's cost) of the donor, the buyer's basis in an installment sale is the purchase price of the property. This may be especially advantageous when the seller has a very low basis in the property and the property has appreciated dramatically. The buyer can use the new stepped-up basis for depreciation (if it is depreciable property) or for income tax purposes on a sale (if the property is held for more than two years after the installment sale).
Example(s): You own a piece of land with a basis of $50,000. You sell the land for $150,000 to your daughter in an installment sale. Your daughter's basis in the land is now $150,000. She holds the land for more than two years and then sells it for $160,000. Her taxable gain is only $10,000. She does not have to pay the tax on the $100,000 gain that you would have been subject to if you had sold the land outright. The gain is further amplified if your daughter is in a lower tax bracket than you are. Your daughter is still obligated to make the remaining installment payments even if she sells the land to a third party.
Seller May Purchase and Be the Beneficiary of a Life Insurance Policy on the Buyer of the Property
A seller in an installment sale may own, pay the premiums on, and be the beneficiary of a life insurance policy on the buyer of the property. The seller can therefore protect against the potential cutoff of payments upon the premature death of the buyer. In fact, in many installment sale transactions, the amount of the payments is increased to allow the seller to purchase such a life insurance policy on the buyer.
Present Value of Unpaid Installments May Be Includable In the Estate of the Seller for Estate Tax Purposes
Installment sales may involve negative tax consequences when a seller dies shortly after the sale. If unpaid installments are still due at the death of the seller, the present value of those remaining installment payments may be includable in the seller's taxable estate if estate taxes are imposed in the year in which the seller dies. With a private annuity, on the other hand, the value of the property sold is not includable in the estate of the seller because the payments stop at the death of the seller.
Example(s): You sell your business to your son-in-law in an installment sale. Under the terms of the transaction, you will receive 10 payments of $200,000 each. You die two years later, after receiving 2 payments. The present value (according to IRS valuation tables) of the remaining 8 payments must be included in your estate for estate tax purposes. If, however, the transaction was structured as a private annuity, then the present value of the remaining annuity payments is not included in your estate.
A Sizable Portion of Each Payment May Be Treated As Interest Income to Seller
In many installment sale transactions, a portion of each installment payment will be considered interest. This interest income is fully taxable to the seller, so some of the income tax advantages of an installment sale transaction will be lost.
Federal Gift Tax May Be Due If Property Is Sold for Less Than Fair Market Value
If the fair market value (FMV) of the property exceeds the present value of the installment payments to be made, then the seller is considered to have made a gift to the buyer for the amount of the difference. Gift tax may be owed on this amount if the gift tax applicable exclusion amount (which shelters up to $11,580,000 of gifts in 2020, $11,400,000 in 2019) has been fully utilized. Gift tax may also be due if the interest rate on the installment note lies below the applicable federal interest rates. In such circumstances, the IRS considers the obligation to be worth less than its face value.
Is Not Allowed for Sale of Marketable Securities
The installment sale method does not apply to the sale of marketable securities. Under the Internal Revenue Code, marketable securities are defined as any stocks or securities that on the day of disposition are traded on an established securities market. All amounts received from the sale of listed securities are treated as received and taxable in the year of the sale. Installment sale treatment is also not available for sales of inventory and certain other sales.
Payments Under Installment Sale May End Before Death of Seller
Unlike a private annuity, there is no guarantee that the payments under an installment sale will continue until the death of the seller. If you are concerned about outliving the term of payments, then you should consider structuring the sale as a private annuity.
May Have Adverse Tax Consequences for Seller If Property Sold Is Subject to Mortgage
In an installment sale, when the buyer takes the property subject to a mortgage, the amount of the debt in excess of the seller's basis is considered a payment to the seller in the year of the sale and is fully taxable to the seller in that year.
Example(s): You sell a piece of property to your son. The property has an FMV of $100,000, and your basis in the property is $20,000. The property also has a mortgage of $40,000. Your son buys the property subject to the mortgage (meaning he is responsible for the mortgage payments in the future). You are considered to have received a payment of $20,000 in the year of the sale (in addition to any payments under the installment sale contract). This $20,000 payment is considered as realized in the year of the sale.
Special Rules for Disposition of Property Between Related Parties May Cause Adverse Tax Consequences for Seller
In an installment sale, there are special rules for the second disposition of property acquired in installment sales by parties related to the holder before the installment sale. Related parties include brothers and sisters, spouses, ancestors and lineal descendants, and other related entities. The rules are very complicated, and they may cause the original seller to have unintended income tax liabilities.
Under the second disposition rule, if a related party disposes of the property before the original seller receives all of the installment payments, then the original seller is considered to have received all of the proceeds from the second sale in connection with the original sale to the related party. The original seller then recognizes taxable gain in the amount of the excess of the second disposition original seller's basis in the property.
However, the gain is limited to the amount over the selling price between the related parties. Generally, the second disposition rule applies only if the second disposition takes place within two years of the first disposition. (The exception for second dispositions more than two years after your first disposition does not apply to marketable securities.)
Example(s): You sell property to your daughter for $100,000. Your basis in the property is $50,000. Your daughter sells the property one year later for $115,000. Under the second disposition rule, you are considered to have received the $115,000 in connection with the sale to your daughter. However, your reportable gain (for tax purposes) from this second disposition is limited to $15,000. Furthermore, under this rule, any payments that you receive from your daughter in the future will be tax free until they equal the $15,000 gain that you recognized under the second disposition rule.
Interest Charge May Apply
An interest charge may apply to the deferred gain from certain installment sales of property having a sales price over $150,000.
How to Do It
Hire a Competent and Experienced Attorney
A competent, experienced attorney should be hired to draft all the necessary legal documents to set up the installment sale. You may also want to have an experienced tax attorney or tax accountant review the transaction to make certain that you have complied with all of the relevant Internal Revenue Code sections. The code sections governing installment sale transactions are extremely complex, and you need to be certain to comply with all of the relevant provisions. Otherwise, there may be disastrous income, gift, and potential estate tax consequences.
For Certain Types of Property, an Appraiser Should Be Hired
If the fair market value (FMV) of the property selected for the installment sale cannot be readily determined, then an independent, third-party appraiser should be hired to do an appraisal on the property, especially in the case of sales between family members. The amount of the installment payments should be based on the FMV of the property sold. If the FMV is not used, there may be potential estate tax and gift tax problems (as well as possible income tax problems).
Buyer And Seller Need to Select Appropriate Property for Installment Sale
The buyer and seller need to decide what property they would like to select before undertaking the installment sale. If the sale is between family members, typically assets that have the potential to rapidly appreciate in the future will be selected. Such assets might include closely held stock, undeveloped real estate, commercial real estate, and other similar types of assets.
From an estate planning standpoint, it makes sense to select assets that you think will appreciate in the future, because once the installment sale has taken place, any appreciation in that asset in the future will be removed from the seller's estate. An installment sale is a very effective way to freeze the value of the seller's estate. However, remember that installment sale treatment is not available for sales of inventory or marketable securities.
Seller's Income Tax Liability on Gain May Be Spread Over Term of Installment Payments
One of the main tax benefits of an installment sale is that the seller may spread the taxable gain over the term of the installment payments. For income tax purposes, each payment will be broken down into three parts: (1) a tax-free return of capital, (2) taxable profit, and (3) taxable interest income. To determine what part of each payment will be a taxable gain, you must determine the gross profit ratio. The gross profit ratio is the proportion that the gross profit (selling price minus seller's adjusted basis) bears to the total contract price (amount to be received by seller). Any interest received is separated and taxed as ordinary income.
Example(s): You sell a piece of land to your daughter for $200,000. Your adjusted basis in the land is $100,000. You arrange an installment sale in which you will receive $20,000 per year for 10 years. The gross profit is $100,000 ($200,000 selling price minus $100,000 adjusted basis). The gross profit ratio is 50 percent ($100,000 gross profit divided by the $200,000 to be received over the life of the installment payments). Therefore, 50 percent of each payment will be a tax-free return of capital, and 50 percent will either be a capital gain or ordinary income (depending on whether the property sold was a capital asset). For the sake of simplicity, interest has been ignored in this example.
Tip: Long-term capital gains are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income.
Interest Portion of Each Payment, Whether Stated or Imputed, Will Be Taxed As Ordinary Income
The interest portion of each payment is segregated from the principal portion and then taxed as ordinary income. The selling price (used to calculate the gross profit ratio) does not include any interest, whether stated or imputed. Often, the installment sale agreement will not specify an interest charge or will have a very low interest charge. In this case, the IRS imputes interest to each payment using a statutory rate of interest and compounding the interest semiannually.
A portion of the payment will then be treated as interest by both the seller and buyer. The interest portion of each payment is taxed as ordinary income to the seller, and the buyer may be able to deduct the interest payments. The remaining portion of the payment is considered principal, and the gross profit ratio is applied to this portion of the payment to determine what percentage is a tax-free return of capital and what portion is either a capital gain or ordinary income.
Example(s): You sell land to your son for $100,000. Your adjusted basis in the land is $25,000. You set up an installment sale agreement whereby you will receive 10 annual payments of $10,000. There is no mention in the agreement about interest on the unpaid balance. The IRS will impute a statutory rate of interest to the balance and compound it twice a year. Let's assume that $1,000 of the $10,000 annual payment is determined by the IRS to be interest. The seller must then report this $1,000 each year as ordinary income. The gross profit ratio (75 percent in this instance — $75,000 divided by $100,000) is next applied to the remaining $9,000 principal payment. This 75 percent of $9,000 (or $6,750) is considered either a capital gain or ordinary income, and 25 percent (or $2,250) is considered a tax-free return of capital.
Buyer May Be Able to Deduct Interest Portion of Installment Payments
In general, the interest portion of the installment payment is not deductible by the buyer if the interest is considered personal. Interest is deductible by the buyer if the debt is properly allocated to (1) investment activities, but only to the extent of investment income; (2) the conduct of a trade or business; and (3) purchase of a qualified residence. A note of caution: Your tax advisor should be consulted before you deduct the interest payments on an installment sale. The rules allowing interest deductions are very complex.
Example(s): You buy your parents' house from them on an installment sale basis. You intend to use the house as your principal residence. The installment sale agreement sets an interest rate on the unpaid balance that is equal to the going market rate for fixed-rate mortgages. You will be able to deduct the interest portion (on up to $1 million of acquisition indebtedness) of each installment payment from your income.
If Sale Results In Loss, Installment Sale Treatment Does Not Apply
If the sale transaction results in a loss for the seller, then the seller cannot use the installment sale method to spread the loss over the term of the installment payments. This rule also applies to transactions between related parties. The full loss deduction must be taken in the year of the sale.
Example(s): You own a piece of land with a basis of $100,000. Land prices in the area have been falling in recent years. You sell the land for $60,000 in an installment sale for 10 annual payments of $6,000. You are not allowed to spread the $40,000 loss over the 10-year term of the installment sale. Rather, the entire $40,000 loss must be deducted in the year of the sale.
Installment Sale Treatment Does Not Apply to Sale of Marketable Securities
Installment sale treatment does not apply to the sale of securities that are traded on established securities markets (e.g., the New York Stock Exchange, the American Stock Exchange, the over-the-counter markets). The entire gain from the sale of the securities must be recognized in the year of the sale.
Example(s): You sell $100,000 worth of stock listed on the New York Stock Exchange to your grandson in an installment sale. Your basis is $30,000, and the $100,000 will be paid in 10 installments of $10,000 each. Your entire gain of $70,000 must be reported in the year of the sale. You are not allowed to spread the gain over the term of the installment payments.
Installment Sale Treatment Not Allowed for Depreciation Recapture of Real or Personal Property
If you sell any personal or real property that you have depreciated, recapture of that depreciation up to the amount of your gain must be recognized by you in the year of the sale, even if other gain on the sale is spread out over the term of the installment payments. The amount that is recaptured and reported as taxable income in the year of the sale may be added to the basis of the property. Thus, the gain that will have to be reported each year will be reduced.
Example(s): You sell a building to another person for $100,000, to be paid in four annual installments. Your original basis for the building was $120,000, but you have taken $40,000 in depreciation deductions over the years, bringing your adjusted basis down to $80,000. You have a gain of $20,000 ($100,000 selling price minus your adjusted basis of $80,000). You could normally spread this gain out over the 4 years of the installment payments. However, you must recapture your depreciation up to the amount of your gain. Therefore, the entire gain of $20,000 must be reported in the year of the sale. This reported gain of $20,000 may then be added to your adjusted basis of $80,000, bringing your basis up to $100,000. Because your new basis now equals the sale price, there is no remaining gain to report as you receive the four installment payments. If you had sold the property for $150,000, the entire depreciation recapture amount of $40,000 would have to be reported in the year of the sale. The remaining gain of $30,000 could then be spread out over the four installment payments.
Installment Sale Treatment Not Allowed for Sale of Depreciable Property to Certain Controlled Entities
Installment sale treatment is not allowed for the sale of depreciable property to a controlled entity. A controlled entity includes a partnership or corporation in which you have more than a 50 percent ownership position. A controlled entity also includes a trust in which you or your spouse is a beneficiary. All payments to be received (even if set up as an installment plan) are considered, for tax purposes, as received in the year of the sale. This tax result is true even if you have not depreciated the property. As long as the property is eligible to be depreciated, then the entire gain must be reported in the year of the sale.
Example(s): You sell tangible property that you personally own to a corporation in which you are an 80 percent owner. The sale price is $50,000, and your basis is $10,000. The property is eligible to be depreciated. The corporation buys the property on an installment plan, paying $10,000 a year for 5 years. For tax purposes, you have to report the entire $40,000 gain in the year of the sale. You have sold depreciable property to a controlled entity.
Present Value of Installment Payments Still Due May Be Includable In Estate of Deceased Seller for Estate Tax Purposes
Unlike a private annuity, the present value of any installments still outstanding upon the death of the seller of the property may be includable in the seller's taxable estate, if estate taxes are imposed in the year the seller dies. In an installment sale, the buyer must continue to make the payments even if the seller dies before the end of the installment payments.
The IRS may require that you include the present value of these post-mortem payments in your estate. However, the installment sale can still be a valuable estate freeze tool because the property itself and any future appreciation in the property are removed from the seller's estate.
Example(s): You have sold a piece of property to your daughter in an installment sale for $500,000. The original sale agreement calls for your daughter to make 10 annual principal payments of $50,000 each. After 5 payments have been made, you die. The present value of the 5 remaining payments is included in your estate and may be subject to estate taxes. Your daughter must continue to make the payments to either your estate or to your heirs. However, the value of the property and any appreciation in that property are not included in your estate. If the property was worth $700,000 at the time of your death, you have removed this $200,000 of appreciation from your estate. The installment sale can therefore be a very effective estate freeze technique. A further tip is that you can utilize the annual exclusion to return part of each payment back to your daughter, free from gift tax.
Upon Death of Seller, Remaining Payments Must Be Reported By Beneficiary As Income In Respect of a Decedent
Upon the death of the seller of the property, the beneficiary (or beneficiaries) of the seller must report the remaining payments in the same way that the seller would have had he or she lived. In other words, the beneficiary must divide each payment that is received into tax-free return of capital, gain, and taxable interest. The beneficiary (or beneficiaries) will be allowed an income tax deduction to the extent that the seller's estate was liable for any estate taxes that may be due on the unpaid installments.
Gift Tax Liability May Arise If Property Is Sold for Less Than Fair Market Value
When property is sold for less than its fair market value (FMV), the difference between the FMV and the consideration received may be a gift from the seller to the buyer. In an installment sale transaction, if the present value of the installment payments is less than the FMV of the property sold, then the seller is considered to have made a gift of the difference to the buyer.
Federal gift taxes may be owed on this difference if the gift tax applicable exclusion amount has been fully utilized. A note of caution: Because the FMV of the property should be the selling price, you should hire an experienced, objective appraiser to value any property forwhich there may be a question about the true value.
Example(s): You sell a piece of property with an FMV of $100,000 to your son in an installment sale. The present value of the installment payments that your son will make to you is only $70,000. You have made a gift to your son of the $30,000 difference.
Tip: Gifts may also be subject to state gift tax. Consult an experienced estate tax attorney.
Installment Payments With Low Interest Rates May Trigger Gift Tax Liability
If the installment payments carry a very low interest rate, this may trigger gift tax liability because the present value of the payments will be worth less than the face value of those payments. The IRS considers the difference to be a gift from the seller to the buyer (the buyer is paying less than what he or she would with a higher rate of interest). Unfortunately, it is not clear at the present time what interest rate should be charged to avoid gift tax consequences.
You could use the prevailing market rate, the applicable federal rate, the rate for sales of farmland under $500,000, or the IRS rates that are charged for income tax purposes on installment sales. There is a split between the IRS, the tax court, and some appellate courts as to which rates should be used. You should consult your tax advisor before you set up an installment sale. You should be aware, though, that if you use a very low interest rate, you might run into gift tax problems.
Example(s): You sell a commercial building to your daughter in an installment sale. The installment agreement states that the interest rate on the unpaid balance will be 2 percent. The prevailing market rate is 7 percent, and the applicable federal rate and other rates are all well above 2 percent. In this situation, the IRS may consider the installment sale to be a partial gift from you to your daughter because of the low interest rate. Consequently, you may owe federal gift taxes (and perhaps state gift tax) if your gift tax applicable exclusion amount has already been fully utilized.
Transaction Structured As Installment Sale May Be Disregarded By IRS and Treated As a Gift
The IRS may treat an installment sale as an outright gift if it believes that the transaction lacks substance. The IRS is especially suspicious of intrafamily transfers in which the seller takes back notes from the buyer (usually the child of the seller) but the seller has no intention of enforcing the notes. The IRS treats this type of transaction as an outright gift to the child, and the seller may owe a gift tax on the FMV of the property transferred. You should therefore be very careful to structure the sale with valid, enforceable, interest-bearing notes to avoid nullification by the IRS.
Questions & Answers
Are There Any Special Requirements for the Self-Canceling Installment Note?
A self-canceling installment note (SCIN) is simply a note that contains a provision that any payments remaining at the time of death are automatically canceled. All of the tax rules that apply to installment sales also apply to SCINs. However, there are additional tax considerations applicable to a SCIN.
Section 453B of the Internal Revenue Code holds that the cancellation of an installment note is considered a taxable disposition of the note. The gain would then have to be reported as income in respect of a decedent. For gift tax purposes, because of the possibility that the seller will die before all of the notes are due, the value of the notes to the seller is decreased (he or she may not receive all of the payments).
Therefore, if the selling price is not increased, the seller is considered to have made a gift to the buyer, and gift taxes may be due. If the selling price is increased to avoid the gift tax problem, then the seller will have to report a larger gain on the initial sale than if there were no self-canceling notes. One alternative is to use a higher interest rate on the notes, although this will increase the taxable interest income that the seller will have to report. Finally, because the balance of the note is canceled at the death of the seller, the tax court has held that there is nothing to include in the decedent's estate.
How Can Sellers Increase Their Security In an Installment Sale?
Unlike a private annuity, there are various ways for sellers in an installment sale to make sure that they will receive all of the payments due to them under the installment agreement without being taxed on the entire gain in the year of the sale.
First, a third party may guarantee that the payments will be made if the buyer defaults. The seller may have the buyer arrange a standby letter of credit from a bank to secure the installment payments.
Second, the seller may have the buyer place funds into an escrow account to secure the payments. If the parties set up an escrow account, they must be very careful regarding the way the account is structured. The IRS typically deems funds placed into an escrow account to be constructively received by the seller and thus fully taxable in the year of the sale.
The seller may succeed, though, if he or she can show that there is a legitimate business purpose to the escrow account and that he or she will continue to look to the contractual obligation of the buyer for payment. Also, the seller may purchase insurance on the life of the buyer to protect himself or herself against the premature death of the buyer.
Caution: For private annuities issued after October 18, 2006, gain is generally recognized at the time property is exchanged for a private annuity; gain is not deferred until annuity payments are received.
Can You Do an Installment Sale If The Selling Price Is Contingent on Some Future Event?
Yes, installment sale treatment is possible even if the selling price at the time of the sale is not precisely known. For example, you may sell a closely held corporation in an installment sale to one of your employees where the annual installment payments will be a percentage of the yearly profits of the company.
The formulas to determine what percent of each payment received by the seller should be a tax-free return of basis and what percent should be a taxable gain are fairly complicated. Under one method, you estimate the maximum potential gross profit from the sale and then divide that by the maximum potential total selling price.
This ratio is then multiplied by the installment payment to determine the percentage of each payment that will be treated as taxable gain. If it later appears that the maximum outcome will not occur, then adjustments can be made to the remaining payments to compensate for treating too much of the earlier payments as taxable gain. If the sale price cannot be determined but there is a fixed number of payments that can be made, the basis is spread ratably over the fixed number of payments.
Caution: Determining taxable gain in an installment sale where the sale price is contingent can be extremely complex. Therefore, your tax advisor and accountant should be consulted before you try to set up an installment sale transaction where the sale price is contingent on some future events.
What Are The Tax Consequences When The Seller Forgives the Buyer's Obligation to Make Payments?
The IRS treats the cancellation of the buyer's obligation to continue to make payments as a disposition, and the seller must report either a gain or a loss. The gain or loss is measured by the difference between the fair market value (FMV) of the obligation and the basis. The seller may also be liable for a gift tax on the transaction. If the transaction is between related parties, then the IRS considers the FMV of the obligation to be not less than the face value.
Example(s): You sell a piece of property to your son for $200,000 in an installment sale. The sale price will be paid in 10 installments of $20,000 each, plus interest. Your basis is $50,000. You immediately cancel your son's obligation to make payments. You must report a taxable gain of $150,000. In addition, you may have to pay federal gift taxes (and perhaps state gift tax) on the gift of the property. One way to avoid this result is to collect the installment payments from your son and then use the annual gift tax exclusion to gift back to him part of the installment payments.
When Would a Seller Want to Forgo the Installment Sale Method of Reporting a Gain for Tax Purposes, Even If the Sale Was Done on an Installment Basis?
There are times when it may make sense to report the entire gain from a sale in the year of the sale, even though the proceeds will be received over time through a series of installment payments. For example, if you have other unrelated losses in a particular year against which you can offset the gains, it may be smart tax-wise to take all (or disproportionately more) of the gain in that year. Also, if you have a year where your income is unusually low, you probably will be better off to take all of the gain from the installment sale in that year. Similarly, if you have a year in which you have unusually large deductions, you may want to offset the entire gain against those deductions.
Caution: For tax purposes, installment sale treatment is automatic (for a qualifying sale); if you want to report the entire gain in one year, you have to report the gain in your gross income for that year. Once you have decided to report all of the gain in one year, you can revoke this election only under very limited circumstances.
Does the Seller Have to Receive a Payment in the Year of the Sale to Qualify for Installment Sale Treatment?
No. The seller does not have to receive a payment in the year of the sale. The only requirement is that at least one payment be received in a taxable year other than the year of the sale. In fact, the buyer and seller have tremendous flexibility in how they structure the payment schedule. For example, they could wait for five years before the payments begin. Similarly, the buyer and seller have flexibility in determining the size of each payment (e.g., more money could be paid in one year than in another year).
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