• Home
• Federal Income Taxes
• State Tax Laws
• Estate Planning
• Publications
  • Ag. Handbook #731
  • Internal Revenue service
  • Tax Articles
  • Historical Documents
  • Forest Service Publications
• Professional Research
• Tax Workshops/Education
• Tax Policy
• Links

Chapter 11 Installment Contracts

General Provisions

If certain conditions are met, the gain recognized on an installment sale of real property can be spread over the duration of the contract for income tax purposes (Internal Revenue Code (IRC) section 453). An outright sale, on the other hand, triggers immediate recognition of all gain in the year of sale. Although using the installment sale method determines when gain from the sale is reported, it does not affect characterization of the gain as a capital gain or ordinary income. The correct category depends on the nature of the asset sold.

Dealers in real and personal property are prohibited from using the installment sale method of reporting. There is, however, a specific exemption to this rule for sales of property used or produced in the trade or business of farming as defined in sections 2032A(e)(4) and (5) of the IRC (see chapter 12). This definition of farming includes timber growing. The use of the installment sales method thus is permitted for taxpayers whose timber ownership qualifies as a farm business under IRC section 2032A; however, a lump-sum (timber deed) sales contract must be used in this case. If a pay-as-cut contract wherein the seller retains an economic interest is used, the proceeds cannot be reported under the installment sales method. Lump-sum sales by timber investors also qualify for installment sales treatment.

In addition to the income tax advantages, installment sales can be a good estate planning tool, as discussed below. Their use has become much more prevalent in recent years for facilitating the lifetime transfer of farm and forest property to succeeding generations while deferring recognition of gain to future years.

Basic Requirements

The installment method of reporting gain can be used when at least one payment will be received after the close of the taxable year in which the sale occurs. No payment is required in the year of sale, although one or more can be made. The installment method is available only for reporting gains; losses cannot be deferred but must be recognized in the taxable year of the sale.

Payments in the year of sale—Payments in the year of sale include down payments made in a prior year as well as payments received in the year that the benefits and burdens of ownership pass to the buyer. This usually is the year of transfer of possession, or the year of title passage, whichever occurs first.

Example 11.1. A forest landowner agrees to sell his tree farm for $150,000 and receives a down payment of $2,000 on September 15, 2008. The first installment payment of $25,000 is received on April 1, 2009, and possession is given to the buyer at that time. A total payment of $27,000 ($2,000 + $25,000) is reportable by the seller in 2009.

Restrictions

Certain restrictions on the use of installment sales should be noted. For example, a sale of depreciable property between related persons, as defined in IRC section 1239(b), cannot be reported by the installment method unless it is established that the transaction did not have as one of its principal purposes the avoidance of taxation.

Another restriction [IRC section 453(g)] governs the sale of nondepreciable property between related parties followed by a resale by the purchaser. If the purchaser sells the property before the installment payments are made in full, the amount realized from the second sale is treated as being received at that time by the initial seller. In other words, the first seller’s gain is accelerated to the extent of the payment received by the second seller. In most cases, however, because of the specific provisions governing the resale rule, the related party restrictions will not apply if the second sale takes place more than 2 years after the first. A related person includes a spouse, child, grandchild, parent, grandparent, brother or sister, as well as corporations, partnerships and estates that are 50 percent or more owned, either directly or indirectly, by such persons.

Mechanics of the Election

If the eligibility requirements discussed above are met, the installment method of reporting income is automatic for sales of real property and casual sales of personal property unless the taxpayer elects out in writing of such a reporting method. This “negative election” recognizes that almost all taxpayers prefer the installment method of reporting when possible. The negative election must be made on or before the due date, including extensions, for filing the taxpayer’s return for the tax year in which the installment sale occurs.

The Interest Portion of Installment Income

Any stated interest included in a payment is reported separately as ordinary income. If the contract provides for no interest on the deferred payments, or provides for inadequate interest as defined in the Internal Revenue Service (IRS) regulations, the taxpayer is required to impute interest. Imputed interest is reported in the same manner

as stated interest. Generally, an installment sale contract provides for adequate stated interest if it calls for interest at a rate no lower than the “test rate;” the test rate applicable to a particular sale can be obtained from the IRS.

The imputed interest rules apply only if some or all of the scheduled payments are due more than 6 months after the date of the sale and at least one payment is due more than 1 year after the date of the sale. The rules do not apply if the sales price does not exceed $3,000, regardless of the number of payments.

Computing the Gain

In order to compute the portion of each installment payment to be reported as gain, the selling price, gross profit, and contract price must be determined. The selling price includes the amount of the down payment, the face amount (excluding interest) of the installment obligations, and the amount of any liability or indebtedness that the purchaser assumes. Tentative gross profit is the difference between the selling price and the seller’s basis in the property; realized gross profit is tentative gross profit, minus expenses of the sale. The contract price is the selling price, less any amount of liability or indebtedness assumed by the purchaser. If, however, the liability or indebtedness exceeds the seller’s basis, the excess is not subtracted from the selling price to determine the contract price. Once the realized gross profit and contract price have been calculated, the percentage of each payment to be reported as gain is determined by dividing the realized gross profit by the contract price. The following example illustrates the computation procedure:

Example 11.2. A forest landowner decides to sell 150 acres on the installment method and enters into an agreement providing for a $20,000 down payment, annual installments of $7,300 ($7,000 principal, plus $300 interest) each over a period of 10 years, a final balloon payment of $37,500 ($25,000 principal, plus $12,500 interest), and assumption by the purchaser of a $65,000 mortgage. The taxpayer’s basis in the property is $50,000 and sale expenses are $5,000. The calculations are as follows:

The percentage gain on each payment is: $125,000 ÷ $130,000 = 96.2 percent.

That portion received each year of the total $15,500 [(10 x $300) + $12,500)] in interest is reported in the year received as ordinary income.

Estate Planning Considerations

Advantages

An installment sale contract may be an ideal tool for parents to begin lifetime transfers of forest land to their children. Such contracts could be particularly attractive to a surviving spouse wanting to avoid heavy involvement in management of a tree farm. The following can be accomplished with an installment sale: (1) an interest in the property as security can be retained by keeping the title, (2) a steady annual income can be received for the duration of the contract, with the receipts not subject to the social security tax or reducing social security benefits, (3) management responsibility can be transferred to the children, (4) an opportunity can be provided for the children to acquire an interest in the property with a low down payment, (5) the size of the estate can be reduced by consuming or making gifts of the installment payments received, and (6) because the contract value is fixed, further increases in value after the contract is signed will not increase the size of the estate.

Disadvantages

There also may be certain disadvantages associated with an installment sale from parents to children that should be considered. For example, the parents may outlive the term of the contract and then have to depend on other sources of income, or inflation may elevate the parents’ cost of living to a point where they have difficulty living on the fixed-contract payments. Although an installment contract reduces the uncertainty of available annual income, it increases the uncertainty of outliving one’s assets.

Other Considerations

Careful consideration must be given to establishing the price and terms of an installment sale in order to further the objectives of moving future appreciation out of the parent’s estate and to facilitate transfer of ownership and management control from one generation to the next. If the price is too high or the terms too inflexible, the purchaser may be unable to meet the payments.

If parents are concerned that the child (children) purchasing the tree farm will have difficulty generating sufficient cash flow to finance the purchase, they may wish to establish a selling price below market value. The danger of this, however, is that transfers for inadequate consideration will be treated as gifts to the extent that the fair market value of the property exceeds the sale price. The transaction then will be subject to gift tax as well as income tax. If audited by the IRS, transfers of property between family members will be scrutinized carefully to determine whether a gift has occurred. Unless a gift is intended, the parties should structure the sale to ensure that it has the characteristics of an arms-length business transaction.

Although many court decisions suggest that the sale need not be at the top of the market in order to avoid characterization as a gift, the parties should proceed with

caution. Because the gift tax statute of limitations does not begin to run until a gift tax return is filed, there always is the danger that the IRS will examine the transaction many years later, perhaps during an estate tax audit, and contend that the sale was in fact a gift. For that reason, if the sale is substantially below market, it might be advisable to file a gift tax return at the time of transfer even though one may not be required and no gift tax due.

Use of Installment Sales to Facilitate Gifts

On the other hand, an installment sale may facilitate the gifting of forest property by making it possible for both parents together to convey the forest land to their children and avoid the gift tax by keeping annual gifts to each child within the $24,000 (2008, as indexed; see chapter 8) annual exclusion amount for split gifts. For example, if the parents already have used their gift tax lifetime exclusions and wish to give the tree farm to their children, the value of the gift in excess of $24,000 per child would be subject to gift tax. If the parents wished to stay within the $24,000 limit, they would have to convey the property a few acres at a time or give small fractional interests, neither of which are very suitable alternatives. An installment sale, however, can provide a vehicle for immediate transfer of the forest land to the children while making it possible for the parents to stay within the annual exclusion amount for each child.

For example, assume forest land property is conveyed in exchange for $150,000 principal amount, with interest bearing notes, payable semiannually for a term of years. If the parents wish to make gifts to the acquiring children, they may forgive one or more of the notes as they become due. Caution must be exercised, however, so that the IRS will not contend that a gift of the entire value of the property occurred in the year of sale. There should be no problem if the notes are legally enforceable and subject to assignment or sale to third parties, if the property is subject to foreclosure in the event of default, and if the parents have no legal obligation to make annual gifts to the children (see Estate of Kelley, J.W., 63 TC 321 (1974), and Hudspeth v. Commissioner, 31 TCM 1254, TC Memo. 1972-253; affirmed and reversed 509 F2d 1224 (CA-9), 75-1 USTC¶9224).

Installment Obligation Dispositions at Death

Income Tax Basis

Generally, upon the death of a property owner, the property receives a new income tax basis (the so-called “stepped-up basis”), and the potential gain or loss is eliminated. But

on the death of a seller within the term of an installment sale transaction, the installment obligation as an asset of the estate does not receive a new basis. Payments received after death are reported in the same manner, for income tax purposes, as the seller would have done if living. There is, however, a deduction for the estate tax—if any—attributable to the obligation. This feature may pose an income tax disadvantage compared with retention of the property until death. The disadvantage is greatest for property that has appreciated substantially in value.

Transfer to the Obligor

Previously unreported gain from an installment sale will be recognized immediately by (become part of) a deceased seller’s estate, if the installment obligation is transferred by bequest or inheritance from the decedent to the obligor (purchaser) or is cancelled by the seller’s executor. For example, suppose a father sold 100 acres of forest land to his only son John in 2000 for $126,000 using an installment sale with annual payments. After receiving the first six payments, the father died with the contract passing to John by inheritance. All unreported gain in the installment obligation would be taxable to the father’s estate.

In order to avoid this result, installment obligations could be bequeathed to family members other than the obligor. This would mean that family members would own each other’s installment obligations, not their own, and that payments would have to continue to be made. Another possible method of avoiding acceleration of income to the estate as a result of a disposition of an installment obligation to the obligor might be to provide that the obligation be transmitted to an irrevocable trust in which the obligor is a beneficiary. The obligor would have to continue to make payments that would constitute income to the trust, but the estate could argue that no taxable obligation had occurred because the trust is treated as a separate taxpayer.

Installment Sales by the Estate

A different rule applies if the estate is the seller under an installment obligation. In that case, distribution of the obligation to the heirs or legatees causes immediate taxation of the gain. For some assets with a new income tax basis received at death, the amount of gain may be little or nothing. But if the sale involves forested property that was valued under special use valuation (see chapter 12), the amount of gain could be substantial. The new basis at death in this case is the special use value, not the fair market value.