5.24 Restriction on Installment Sales to Relatives
The installment sale method is not allowed where you sell depreciable property to a controlled business, or to a trust in which you or your spouse is a beneficiary. All payments to be received over the installment period are considered received in the year of sale.
Further, if you sell property to a relative on the installment basis, and the relative later resells the property, you could lose the benefit of installment reporting. Generally, you are taxed on your relative’s sale if it is within two years of the original sale.
Caution
Two-year resale rule for property.
If you make an installment sale of property to a related party, you are taxed on a second sale by the related party only if it occurs within two years of the initial installment sale and before all payments from the first installment sale are made. However, the two-year limitation does not apply if the property is marketable securities.
Related parties include a spouse, child, grandchild, parent, grandparent, brother or sister, controlled corporation (50% or more direct or indirect ownership), any S corporation in which you own stock or partnership in which you are a partner, a trust in which you are a beneficiary, or a grantor trust of which you are treated as the owner. You are treated as owning stock held by your spouse, brothers, sisters, children, grandchildren, parents, and grandparents.
You must report as additional installment sale income: (1) the proceeds from the related party’s sale or the contract price from the initial installment sale, whichever is less, minus (2) installment payments received from the related party as of the end of the year. The computation is made in Part III of Form 6252.
The two-year period is extended during any period in which the buyer’s risk is lessened by a put on the property, an option by another person to acquire the property, or a short sale or other transaction lessening the risk of loss.
Caution
Exceptions to related-party rule.
There are exceptions to the related-party rule. Second dispositions resulting from an involuntary conversion of the property will not be subject to the related-party rule so long as the first disposition occurred before the threat or imminence of conversion. Similarly, transfers after the death of the person making the first disposition or the death of the related person (who acquired the property in the first disposition) are not treated as second dispositions. Also, a sale or exchange of stock to the issuing corporation is not treated as a first disposition. Finally, you may avoid tax on a related party’s second sale by satisfying the IRS that neither the initial nor the second sale was made for tax avoidance purposes. The non-tax-avoidance exception is considered met if the second disposition by the related party is an installment sale with payment terms that are substantially equal to or longer than those for the original installment sale; there must not be significant deferral of gain from the original sale.
Sales of depreciable property to related party.
Installment reporting is not allowed for sales of depreciable property made to a controlled corporation or partnership (50% control by seller) and between such controlled corporations and partnerships. In figuring control of a corporation, you are considered to own stock held by your spouse, children, grandchildren, brothers or sisters, parents, and grandparents. Installment reporting is also disallowed on a sale to a trust in which you or a spouse is a beneficiary unless your interest is considered a remote contingent interest whose actuarial value is 5% or less of the trust property’s value. On these related-party sales, the entire gain is reported in the year of sale, unless the seller convinces the IRS that the transfer was not motivated by tax avoidance purposes.
On a sale of depreciable property to a related party, if the amounts of payments are contingent (for example, payments are tied to profits), the seller must make a special calculation. He or she must treat as received in the year of sale all noncontingent payments plus the fair market value of the contingent payments if such value may be reasonably ascertained. If the fair market value of the contingent payments may not be reasonably calculated, the seller recovers basis ratably. The purchaser’s basis for the acquired property includes only amounts that the seller has included in income under the basis recovery rule. Thus, the purchaser’s basis is increased annually as the seller recovers basis.