5.22 Figuring the Taxable Part of Installment Payments

On the installment method, a portion of each payment other than interest represents part of your gain and is taxable. This taxable gain amount is based on the gross profit percentage or ratio, which is figured by dividing gross profit by the contract price. The contract price is the same as the selling price unless an adjustment is made for an existing mortgage assumed or “taken subject to” by the buyer. The term contract price is used in the computation to describe only payments that the seller receives or is considered to have received. Thus, it does not include the buyer’s assumption of an existing mortgage; see below for the mortgage adjustment to contract price. By following the line-by-line instructions to Form 6252, you get the gross profit percentage. Selling price, gross profit, and contract price are explained in the following paragraphs.

Interest equal to the applicable federal rate must generally be charged on a deferred payment sale. Otherwise, the IRS treats part of the sale price as interest (4.32).

EXAMPLE
On December 14, 2012, you sell unmortgaged real estate for $100,000. The property had an adjusted basis of $56,000. Selling expenses are $4,000. You are to receive installment payments of $25,000 in 2012, 2013, 2014, and 2015 plus interest at 5%, compounded semiannually. The gross profit percentage of 40% is figured as follows:

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In 2012, you report a profit of $10,000 (40% of $25,000 payment) on Form 6252. Interest received is separately reported as income on your Form 1040. Similarly, in each of the following three years, a profit of $10,000 is reported so that by the end of four years, the entire $40,000 profit will have been reported.

Selling price.

Include cash, fair market value of property received from the buyer, the buyer’s notes (at face value), and any outstanding mortgage on the property that the buyer assumes or takes subject to. If, under the contract of sale, the buyer pays off an existing mortgage or assumes liability for any other liens on the property, such as taxes you owe, or pays the sales commissions, such payments are also included in the selling price.

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Foreclosures
If your property is foreclosed, the amount of the mortgage is treated as sales proceeds even if you do not receive anything on the sale.
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Interest, including minimum interest imputed under the rules in 4.32, is not included in the selling price.

Notes of a third party given to you by the buyer are valued at fair market value.

Gross profit and gross profit percentage.

Gross profit is the selling price less what the IRS calls installment sale basis, which is the total of adjusted basis of the property (5.20), selling expenses, such as brokers’ commissions and legal fees, and recaptured depreciation income, if any (44.1).

Divide the gross profit by the contract price to get the gross profit percentage. Each year, you multiply this percentage by your payments to determine the taxable amount under the installment method.

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Recapture of Depreciation or First-Year Expensing Deduction
The entire recaptured amount (44.1–44.3) is reported in the year of sale on Form 4797, even though you report the sale on the installment basis. An installment sale does not defer the reporting of the recaptured deduction. You also add the recaptured amount to the basis of the sold asset on Line 12 of Form 6252 to compute the amount of the remaining gain to be reported on each installment. See the instructions to Form 6252.
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Contract price where the buyer takes subject to or assumes an existing mortgage.

To figure the gross profit percentage first reduce the selling price by the amount of your existing mortgages that the buyer assumes or takes the property subject to. The reduced amount is the contract price. You then divide your gross profit by the contract price to get the gross profit percentage.

If the mortgage exceeds your installment sale basis (total of adjusted basis of the property, selling expenses, and depreciation recapture), you are required to report the excess as a payment received in the year of sale and also increase the contract price by that excess amount. Where the mortgage equals or exceeds your installment sale basis, the gross profit percentage will be 100%; see Example 3 below.

EXAMPLES
1. You sell a building for $300,000. The building was secured by an existing mortgage of $50,000 that you pay off at the sale closing from the buyer’s initial payment. The contract price is $300,000.
2. Same facts as in Example 1, but the buyer assumes the mortgage of $50,000. The contract price is $250,000 ($300,000 − $50,000).
3. You sell a building for $90,000. The buyer will pay you $10,000 annually for three years and assume an existing mortgage of $60,000. The adjusted basis of the property is $45,000. Selling expenses are $5,000. The total installment sale basis is $50,000 ($45,000 plus $5,000). The mortgage exceeds this basis by $10,000 ($60,000 − $50,000). This $10,000 excess is included in the contract price and treated as a payment made in the year of sale. The contract price is $40,000:
Selling price (including mortgage) $90,000
Less: Mortgage   60,000
$30,000
Add: Excess of mortgage ($60,000) over installment sale basis ($50,000)   10,000
Contract price $40,000
Selling price $90,000
Less: Installment sale basis   50,000
Gross profit $40,000
Gross profit percentage ($40,000 gross profit÷ $40,000 contract price)     100%
4. Abel sells real property, encumbered by a mortgage of $900,000, for $2 million. Installment sale basis (adjusted basis plus selling costs) is $700,000. The buyer pays $200,000 cash and gives an interest-bearing wraparound mortgage note for $1.8 million. Abel remains obligated to pay off the $900,000 mortgage. The gross profit ratio is 65% ($1,300,000 gross profit÷ $2,000,000 contract price). In the year of sale, Abel reports the $200,000 cash, of which 65%, or $130,000, is taxable income.

In a wraparound mortgage transaction, the buyer does not assume the seller’s mortgage or take the property subject to it, but instead makes payments that cover the seller’s outstanding mortgage liability. At one time, the IRS treated a wraparound mortgage transaction as an assumption of a mortgage by the buyer and required a reduction of the selling price by the mortgage to compute the contract price. The Tax Court rejected the IRS position, and the IRS acquiesced in the decision. Currently, the IRS does not require a reduction of selling price for a wraparound mortgage in the Form 6252 instructions or in Publication 537; see Example 4 above.

Change of selling price.

If the selling price is changed during the period payments are outstanding, the gross profit percentage is refigured on the new selling price. The adjusted profit ratio is then applied to payments received after the adjustment.

EXAMPLE
Jones sold real estate in 2010 for $100,000. His basis, including selling expenses, was $40,000, so his gross profit was $60,000. The buyer agreed to pay, starting in 2010, five annual installments of $20,000 plus 10% interest. As the gross profit percentage was 60% ($60,000÷ $100,000), Jones reported profit of $12,000 (60% of $20,000) on the installments received in 2010 and 2011.
In 2012, the parties renegotiated the sales price, reducing it from $100,000 to $85,000, and reducing payments for 2012, 2013, and 2014 to $15,000. Jones’s original profit of $60,000 is reduced to $45,000 ($85,000 revised sales price less $40,000 basis). Of the $45,000 profit, $12,000 was reported in 2010 and an additional $12,000 in 2011. To get the revised profit percentage, Jones must divide the $21,000 of profit not yet received by the remaining sales price of $45,000 ($85,000 less $40,000 in total installments in 2010 and 2011). The revised profit percentage is 46.67% ($21,000÷ $45,000). In 2012, 2013, and 2014, Jones reports profit of $7,000 on each $15,000 installment (46.67% of $15,000).

Payments received during the year.

Payments include cash, the fair market value of property or services received, and payments on the buyer’s notes. Payments do not include receipt of the buyer’s notes or other evidence of indebtedness, unless payable on demand or readily tradable. “Readily tradable” means registered bonds, bonds with coupons attached, debentures, and other evidences of indebtedness of the buyer that are readily tradable in an established securities market. This rule is directed mainly at corporate acquisitions. A third-party guarantee (including a standby letter of credit) is not treated as a payment received on an installment obligation.

If the buyer has assumed or taken property subject to a mortgage that exceeds your installment sale basis (adjusted basis plus selling expenses plus depreciation recapture, if any), you include as a payment in the year of the sale the excess of the mortgage over the installment basis; see the Johnson Example below.

EXAMPLE
Johnson sells a building for $160,000, subject to a mortgage of $60,000. Installments plus interest are to be paid over five years. His adjusted basis in the building was $30,000 and his selling expenses were $10,000, so his installment sale basis is $40,000 and his gross profit is $120,000 ($160,000 − $40,000). The contract price is also $120,000, the selling price of $160,000 less $40,000, the part of the mortgage that did not exceed the installment sale basis.
The $20,000 excess of the $60,000 mortgage over the installment sale basis of $40,000 is part of the contract price and is also treated as a payment received in the year of sale. Since the mortgage exceeds Johnson’s installment sale basis, he is treated as having recovered his entire basis in the year of sale, and all installment payments will be taxable, as his gross profit ratio is 100%: gross profit of $120,000÷ contract price of $120,000. In the year of sale, Johnson must report as taxable gain 100% of the installment payment received, plus the $20,000 difference between the mortgage and his installment sale basis.
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Extension of Pledge Rule
If a loan arrangement gives you the right to repay the debt by transferring an installment obligation, you are treated as if you had directly pledged the obligation as security for the debt. As a result, the loan proceeds are treated as a payment on the installment obligation, which will increase installment income for the year of the “deemed pledge.”
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Pledging installment obligation as security.

If, as security for a loan, you pledge an installment obligation from a sale of property of more than $150,000 (excluding farm property, personal-use property and timeshares and residential lots), the net loan proceeds must be treated as a payment on the installment obligation. The net loan proceeds are treated as received on the later of the date the loan is secured and the date you receive the loan proceeds. These pledging rules do not apply if the debt refinances a debt that was outstanding on December 17, 1987, and secured by the installment obligation until the refinancing. If the refinancing exceeds the loan principal owed immediately before the refinancing, the excess is treated as a payment on the installment obligation. See the Form 6252 instructions.

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3.143.4.117