Installment Sales Under Section 453: Gross Profit Percentage, Recapture and Electing Out

Business owners selling a building, a practice or equipment often take part of the price in a note. If at least one payment comes after year end, the installment method applies by default and defers part of the gain. The mechanics are simple, but recapture, the related-party rule and the election out catch clients who assume everything can be deferred.

The rule

Under section 453(a), income from an installment sale is taken into account under the installment method. Section 453(b)(1) defines an installment sale as a disposition of property where at least one payment is to be received after the close of the taxable year of the disposition. Section 453(b)(2) excludes dealer dispositions and dispositions of personal property of a kind required to be included in inventory if on hand at year end.

Section 453(c) defines the installment method: the income recognized for a year is the proportion of the payments received in that year that the gross profit (realized or to be realized when payment is completed) bears to the total contract price. Payment generally does not include the buyer's own evidences of indebtedness, but a bond or other evidence of indebtedness that is payable on demand or readily tradable is treated as payment received.

Worked example: gross profit percentage

A client sells land held for investment for $500,000. The adjusted basis is $200,000. The buyer pays $100,000 at closing and gives a note for $400,000, payable $100,000 a year over four years, plus interest.

• Gross profit: $500,000 minus $200,000, or $300,000.
• Contract price: $500,000.
• Gross profit percentage: $300,000 divided by $500,000, or 60 percent.
• Income in the year of sale: 60 percent of the $100,000 down payment, or $60,000.
• Income in each of the next four years: 60 percent of $100,000, or $60,000.
• Total gain recognized: five years times $60,000, or $300,000, which equals the gross profit.

Interest on the note is ordinary interest income and is not part of the gain computation. Each payment received is split into interest, a tax-free return of basis and gain, and the gross profit percentage applies to the payment excluding interest.

Second example: the buyer assumes a mortgage

The same land sells for $500,000 with a $200,000 basis. The buyer assumes a $250,000 mortgage, pays $50,000 in cash and gives a $200,000 note payable $50,000 a year over four years.

• Contract price: selling price of $500,000, minus the $250,000 mortgage, plus the $50,000 by which the mortgage exceeds basis, or $300,000.
• Gross profit: $300,000. Gross profit percentage: $300,000 divided by $300,000, or 100 percent.
• Payments in the year of sale: $50,000 cash plus the $50,000 excess of the mortgage over basis, or $100,000. Income in the year of sale: 100 percent of $100,000, or $100,000.
• Income in each of the next four years: 100 percent of $50,000, or $50,000, for $200,000.
• Total: $300,000, which equals gross profit.

Publication 537 states the rule: when an assumed mortgage is equal to or more than the installment sale basis, the gross profit percentage is 100 percent and the excess is treated as a payment in the year of sale.

Recapture is taxed up front

Section 453(i) says that recapture income is recognized in the year of the disposition, whether or not a payment is received, and only the gain in excess of recapture income is reported under the installment method. Recapture income is the amount that would be ordinary income under section 1245 or 1250 (or section 751 as it relates to them) if all payments were received in the year of disposition. The depreciation analysis is in sections 1245 and 1250.

Example. A client sells equipment with a $150,000 original cost and $120,000 of depreciation taken, so adjusted basis is $30,000. The price is $100,000, with $20,000 down and $20,000 a year for four years.

• Total gain: $100,000 minus $30,000, or $70,000.
• Recapture income: the lower of recomputed basis ($150,000) or the amount realized ($100,000), minus adjusted basis ($30,000), which is $70,000.
• Income in the year of sale: $70,000, even though only $20,000 was received.
• Installment gain in later years: none, because the entire gain was recapture.

The client has a $70,000 tax bill in year one against $20,000 of cash. Plan for the cash.

Electing out

Under section 453(d), a taxpayer can elect not to apply the installment method to a disposition. The election must be made on or before the due date, including extensions, of the return for the year of the disposition, and it is revocable only with the Secretary's consent. To elect out, the client does not report the sale on Form 6252 and reports it instead on Form 8949, Form 4797 or both. Publication 537 says a late election can be made by amended return within 6 months of the due date of the return, excluding extensions. A client with capital loss carryforwards or a low-rate year may prefer to recognize all the gain at once.

Sales that cannot use the installment method

• A sale at a loss. Publication 537 states that property sold at a loss cannot use the method.
• Dealer dispositions and personal property of a kind includible in inventory, under section 453(b)(2).
• Stock or securities traded on an established securities market, under section 453(k). All payments are treated as received in the year of the sale.
• Personal property sold under a revolving credit plan, also under section 453(k).
• Depreciable property sold to a related person that is a controlled entity, under section 453(g), unless tax avoidance was not a principal purpose. All payments are treated as received in the year of sale.

Related-party second dispositions

Under section 453(e), if a person sells property to a related person and the related person disposes of it before the first seller has received all payments, the amount realized on the second disposition is treated as received by the first seller at that time. The two-year cutoff in section 453(e)(2) applies to property other than marketable securities, and the period is suspended while the related person's risk of loss is substantially diminished, for example by a put or a short sale. The amount treated as received is capped at the total contract price less payments already received. A family sale of a building followed by a quick resale by the relative can accelerate the seller's deferred gain.

File checklist

• Sales contract, closing statement and note terms, including whether the note is payable on demand or readily tradable.
• Basis and depreciation schedule for each asset sold, with allocation of price by asset class.
• Gross profit percentage worksheet and a year-by-year recognition schedule.
• Form 6252 for the year of sale and each later year.
• Related-party analysis and a record of the election decision.
• Stated interest on the note compared to the test rate. Publication 537 says a contract without adequate stated interest can have part of the principal recharacterized as unstated interest.

Gains from these sales also feed section 1231 netting.

Sources

• Legal Information Institute, 26 U.S.C. 453, Installment method: https://www.law.cornell.edu/uscode/text/26/453
• Internal Revenue Service, Publication 537, Installment Sales: https://www.irs.gov/publications/p537

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