5.28 Dispositions of Installment Notes
A sale, a gift, an exchange or other transfer or cancellation of mortgage notes or other obligations received in an installment sale has tax consequences. If you sell or exchange the notes or if you accept less than face value in satisfaction of the obligation, gain or loss results to the extent of the difference between the basis of the notes and the amount realized. For example, if in satisfaction of an installment note, the buyer gives you other property worth less than the face value of the note, you have gain (or loss) to the extent your amount realized exceeds (or is less than) your basis in the installment note. The basis of an installment note or obligation is the face value of the note less the income that would be reported if the obligation were paid in full; see Example 2 below.
| Selling price of property | $200,000 |
| Cost of property | 100,000 |
| Total profit | $100,000 |
| Profit percentage, or proportion of each payment returnable as income, is 50% ($100,000 total profit÷ $200,000 contract price) | |
| Unpaid balance of notes | $150,000 |
| Amount of income reportable if notes were paid in full (50% of $150,000) | 75,000 |
| Adjusted basis of the notes | $75,000 |
| Amount realized ($50,000 for each parcel) |
$100,000 |
| Face value of note | 180,000 |
| Less: Amount of income reportable if note was paid in full given 40% profit percentage (40% of $180,000 = $72,000) |
72,000 |
| Basis in installment note | $108,000 |
Gain or loss is long term if the original sale was entitled to long-term capital gain treatment. This is true even if the notes were held short term. If the original sale resulted in short-term gain or ordinary income, the sale of the notes gives short-term gain or ordinary income, regardless of the holding period of the notes.
Suppose you make an installment sale of your real estate, taking back a land contract. Later a mortgage is substituted for the unpaid balance of the land contract. The IRS has ruled that the substitution is not the same as a disposition of the unpaid installment obligations. There is no tax on the substitution.
Filing Tip
Gift of installment obligation.
If the installment obligations are disposed of other than by sale or exchange, such as when you make a gift of the installment obligations to someone else, gain or loss is the difference between the basis of the obligations and their fair market value at the time of the disposition. If an installment obligation is cancelled or otherwise becomes unenforceable, the same rule for determining gain or loss applies. However, no gain or loss is recognized on a gift to a spouse (6.7).
A gift of installment obligations to a person other than a spouse or to a charitable organization is treated as a taxable disposition. Gain or loss is the difference between the basis of the obligations and their fair market value at the time of the gift. If the notes are donated to a qualified charity, you may claim a contribution deduction for the fair market value of the obligations at the time of the gift.
Transfer at death.
A transfer of installment obligations at the death of the holder of the obligation is not taxed as a disposition. As the notes are paid, the estate or beneficiaries report income in the same proportion as the decedent would have, had he or she lived. A transfer of installment obligations to a revocable trust is also not taxed. However, the estate is subject to tax if the obligation is cancelled, becomes unenforceable, or is transferred to the buyer because of the death of the obligation holder.