March 20, 2013
© 2013 by Michael C. Gray, CPA
Planning benefits of installment sales
Installment sales are a powerful tool in the real estate tax planning arsenal. Here are four ways that installment sales can be used to your advantage: (1) a seller postpones paying tax on a portion of the taxable gain from selling property until cash is collected, roughly matching the requirement to pay income taxes with the receipt of cash; (2) interest income can be collected on amounts that otherwise would have been paid as taxes; (3) an installment sale to a family member is an effective way to “freeze” the value of an asset for estate planning and income-shifting; (4) income from a qualifying sale can be spread over many years to avoid exceeding income thresholds for higher income tax rates, the Medicare surtax and phaseouts of deductions and credits.
Starting in 2013, the 3.8% Medicare surtax applies to investment income when married persons filing joint returns have adjusted gross income exceeding $250,000 and singles have adjusted gross income exceeding $200,000.
Under the American Taxpayer Relief Act of 2012, also known as the “fiscal cliff” tax legislation, the maximum 39.6% federal income tax rate for ordinary income applies when married persons who file joint income tax returns have taxable income exceeding $450,000, heads of household have taxable income exceeding $425,000, and other single taxpayers have taxable income exceeding $400,000. The same thresholds apply for an increase in the maximum federal income tax rate for qualified dividends and long-term capital gains from 15% to 20%. Phaseouts also apply to personal exemptions and itemized deductions for married persons filing joint income tax returns with adjusted gross income exceeding $300,000, $275,000 for heads of households and $250,000 for other singles.
These additional income taxes at various thresholds will provide an incentive for taxpayers to seek to defer income to avoid reaching the thresholds.
What is an installment sale?
An installment sale is a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.
Certain items treated as cash received in the year of sale
Notes payable on demand and bonds that are readily tradable on a securities market that are received as consideration for a sale of real estate are treated as cash when received.1
What property isn’t eligible for installment sale reporting?
Inventoriable personal property isn’t eligible for installment sale reporting. This applies to businesses that sell products. For example, a department store can’t report merchandise sales for which it carries open accounts receivable from customers using the installment method.
Sales of marketable securities aren’t eligible for installment sale reporting.
More pertinent to real estate sales, “dealer dispositions” don’t qualify. A dealer disposition of real property is any disposition of real property which is held by the taxpayer for sale to customers in the ordinary course of the taxpayer’s trade or business. For example, sales of homes in a housing development don’t qualify for installment sale reporting. If a taxpayer regularly buys “fixer upper” homes, rehabilitates them and sells them without renting them for a period of time, he or she probably has a trade or business of rehabilitating homes and will not be eligible for installment sale reporting.
There are exceptions to “dealer disposition” sales for property used or produced in the trade or business of farming and for timeshares and residential lots. There is an interest charge paid to the IRS for these sales.2 The interest is shown as an additional tax on the income tax return, but may be eligible for a tax deduction as interest expense.3
How is the election made?
If real estate or a casual sale of personal property is made with a payment received after the year of sale, installment sale reporting applies by default. A taxpayer may elect not to report an installment sale using the installment method. The election out is made by reporting the full amount of the selling price, including the face amount of the installment obligation, on the tax return filed for the taxable year in which the installment sale occurs filed on or before the due date, including extensions, of the taxpayer’s tax return for that taxable year.
Late elections or revocations of elections are only permitted with the consent of the IRS.
Installment sales are reported on Federal Form 6252. You can get a copy at www.irs.gov.
Why elect to not use the installment method?
A good reason to elect out of installment sale reporting is when you have capital losses to partially or completely eliminate the capital gain.
Ordinary income from depreciation recapture isn’t eligible for installment sale reporting
Ordinary income from depreciation recapture, principally under Internal Revenue Code Section 1245, is not eligible for installment sale reporting.4 This income is taxable in the year of sale. It is entered at line 12 on 2012 Form 6252 (Installment Sale Income). Any additional section 1231 gain or capital gain is eligible for installment sale reporting.
Income subject to highest rate is taxed first
Section 1231 gains and losses from installment sales of business or rental property are netted on 2012 Form 4797, line 4. If a net gain results and any nonrecaptured Section 1231 losses from prior years at line 8 don’t recharacterize the balance of the gain to ordinary income, the balance is carried forward (for individuals) to line 11 on 2012 Schedule D.
A computation is made on the Unrecaptured Section 1250 Gain Worksheet in the instructions for 2012 Schedule D to determine if any of the gain is subject to the special 25% tax rate for long-term capital gains.5 This computation will result in the long-term capital gain subject to the 25% special tax rate being taxed first. The amount subject to the special rate from the Worksheet is carried to line 19 of Schedule D.6
How the taxable gain is computed each year
In order to determine the amount of gain to report each year, a ratio is computed, called the gross profit percentage. The gross profit percentage is the gross profit (gain eligible for installment sale reporting) divided by the contract price.
The contract price is the sales price (line 5 of 2012 Form 6252) minus the mortgages and liabilities of the seller that the buyer has either assumed or taken the property subject to under the terms of the sale (line 6 of 2012 Form 6252), plus the excess of those mortgages and liabilities over the adjusted basis of the property, including the depreciation recapture taxed in the year of sale and the expenses of the sale (line 13 of 2012 Form 6252). The excess is indicated at line 17 of 2012 Form 6252. The contract price is indicated at line 18 of (2012) Form 6252 for the year of sale.
The excess of the mortgages and debts assumed in excess of basis, etc. (line 17 of 2012 Form 6252) is treated as a payment received in the year of the sale (line 20 of 2012 Form 6252.)
This gross profit ratio is applied as payments are received each year for the installment sale to determine the amount of gain reported each year.
Wrap around mortgages
A way to further postpone the tax on an installment sale is to have a wrap around mortgage. The buyer does not assume the mortgage balance and debts of the seller or take the property “subject to” those debts. The buyer gives the seller cash plus a mortgage for the entire selling price, and the seller remains personally liable for and responsible for making the payments for the previously-existing mortgage and debts. Therefore, the excess of the mortgage and liabilities over the tax basis plus ordinary income plus selling expenses will not be treated as a payment in the year of sale.
Most lenders prohibit wrap-around mortgages in their mortgage terms, and can accelerate the payoff of the mortgage if this requirement is violated.
The Tax Court has ruled that a purchaser is deemed to assume the seller’s debt and a wrap around may fail when the purchaser is directly obligated to the mortgagee as a guarantor of payment and could have had an action brought directly against him by the mortgagee without any prior efforts at collection from the seller.7
The IRS doesn’t like wrap around mortgages, but lost a case, Professional Equities, Inc. v. Commissioner (89 T.C. 165, July 23, 1987) and has acquiesced to that decision. It has not updated its regulations for this change.
Example with and without a wrap around mortgage
Without - Jane Seller sold a commercial building in 20X1 for $3,000,000. The buyer assumed the $2,000,000 mortgage, paid $100,000 cash down and gave Jane a second mortgage of $900,000 for the balance of the purchase price. Jane bought the building in 1990 for $2,000,000 and has claimed accumulated (straight-line) depreciation of $900,000. Selling expenses are $120,000. In 20X2, Jane received a $100,000 principal payment on the second mortgage. This is Jane’s only sale of business property for 20X1 and 20X2.
With – Same facts as “without,” except the buyer did not assume the $2,000,000 mortgage. Jane remains responsible for making the mortgage payments on the $2,000,000 mortgage. Jane receives $100,000 cash down plus a second mortgage of $2,900,000 for the purchase price. In 20X2, Jane received a $300,000 principal payment on the second mortgage.
Taxable income for 20X1
|Cost (tax basis)||2,000,000|
|Excess of mortgage assumed over adjusted tax basis plus depreciation recapture plus selling expenses||$ 780,000|
|Less mortgage assumed||-2,000,000|
|Plus excess of mortgage assumed treated as payment in year of sale||780,000||_________|
|Gross profit percentage
(gross profit / contract price)
|Unrecaptured Section 1250 gain – lesser of gross profit or accumulated depreciation||$900,000||$900,000|
|Taxable income for 20X1|
|Excess mortgage assumed||$780,000|
|Cash down payment||100,000||$100,000|
|Total payments received||880,000||100,000|
|Gross profit percentage||X 100.00%||X 59.33%|
|Taxable Section 1231 gain||$880,000||$59,333|
Since the gain is less than the unrecaptured Section 1250 gain, it is taxable as a long-term capital gain at a 25% maximum federal tax rate.
Taxable income for 20X2
|Cash payments received||$100,000||$300,000|
|Gross profit percentage||X 100.000%||X 59.333%|
|Taxable Section 1231 gain||$100,000||$177,999|
|Total unrecaptured Section 1250 gain||$900,000||$900,000|
|Less amount taxed in 20X1||-880,000||-59,333||Untaxed balance at beginning of 20X2||$20,000||$840,667|
|Long-term capital gain taxable at 25% maximum federal tax rate (lesser of untaxed balance of unrecaptured Section 1250 gain and taxable Section 1231 gain)||$20,000||$177,999|
|Long-term capital gain taxable at 20% maximum federal tax rate (balance)||$80,000||$0|
Some like-kind exchanges may have taxable income because unlike property, or “boot,” is received as part of the consideration in the exchange. If part of the boot is an installment note, the taxable gain may be reported using the installment sale method.8
The gross profit for the exchange is determined based on the rules for like-kind exchanges, so taxable income will be the lesser of the realized gain or the “boot” received. The deferred gain is excluded from the gross profit. Boot will usually be cash plus notes. There may be other “unlike” property involved if there is a cost segregation study.
Like-kind property received is excluded from the contract price.
For example, Jane Taxpayer exchanges her building during 20X1 for land worth $800,000: $200,000 cash plus a $500,000 installment note. There is no debt balance for the building. She bought the building in 1999 for $800,000, and has accumulated depreciation of $200,000. Jane has no other gains and losses for 20X1.
|Cost basis||$ 800,000|
|Adjusted tax basis||600,000|
|Realized gain||$ 900,000|
|Total boot||$ 700,000|
|Recognized gain/gross profit||$ 700,000|
|Amount received||$1,500,000||Less like-kind property||-800,000|
|Contract price||$ 700,000|
|Gross profit percentage –|
|Gross profit / Contract price||100.000%|
|Cash received in year of sale, 20X1||$200,000|
|X Gross profit percentage||X 100.000%|
|Taxable Section 1231 gain for 20X1||$200,000|
|Unrecaptured Section 1250 gain||$200,000|
|Long-term capital gain taxable at 25% (lesser of taxable 1231 gain and Unrecaptured Section 1250 gain)||$200,000|
(As note payments are received in future years, they will be 100% taxable at the tax rates for the years of collection.)
Sale of principal residence
In some cases, the gain from the sale of a principal residence may exceed the exclusion amount.
If the seller takes a note back as part of the sales proceeds, the taxable income may be reported on the installment method.
We may see more of these “creative financing” transactions with tightening credit markets.
Mixed property sales
A single sale of mixed property under one contract is a sale of the individual assets and must be broken down to separate components. For example, a sale of business assets may include a sale of depreciable equipment, inventory and a commercial building. The separate items must be identified and the sales price must be prorated based on the values of the various assets.9
Some of the items might qualify for installment sale reporting (land and structural components of the commercial building) and others might not (inventory, depreciable equipment if all of the gain is depreciation recapture.)
Insufficient or unstated interest for installment sale note
Interest income is taxed as ordinary income at regular federal income tax rates up to 39.6%, and long-term capital gains are taxed at more favorable tax rates, 25% for “unrecaptured Section 1250 gain” and 20% for other long-term capital gains. A 3.8% Medicare surtax also applies to both interest income and long-term capital gains for certain high-income taxpayers.
Sellers may try to reduce their income tax bills by increasing the sale price and having reduced or no interest on the installment sale note.
Congress has insured that at least a minimum amount of the loan proceeds are taxed as interest by creating imputed interest rules.10
To determine if there is unstated interest, a computation is made to discount payments over the term of the contract at “applicable federal rates,”11 which are published by the IRS each month. If the discounted amount is less than the stated sales price, part of the sales price is recharacterized as interest. For a sale or exchange, the applicable federal rate is the lowest of the rates published for the three-calendar-month period ending with the calendar month in which there is a binding contract in writing for the sale or exchange. If the seller is carrying a mortgage with an interest rate below the applicable federal rate, you should probably consult with a tax advisor who is familiar with these rules to make the discount computations.
The maximum interest rate for this computation for a sale of land with a sale price up to $500,000 to certain related parties is 6%, compounded semiannually.
Rather than go through the gyrations of making these computations, I recommend that you be sure there is adequate stated interest on your contract by consulting with a tax advisor or looking up the applicable federal rates at the IRS web site, www.irs.gov.
Interest charge due to IRS for some installment sales
Congress recognized that installment sales represented a type of interest-free loan from the U.S. government to taxpayers in the form of postponed payment of income taxes. As part of its budget-balancing process, it adopted an interest charge for deferred taxes on certain non-dealer installment sales.12 (See below for an interest charge for dealers.)
The interest charge only applies when the sales price of the property exceeds $150,000. In addition, the interest charge will only apply when the face amount of all installment sale notes for the year of sale and outstanding at the end of a taxable year exceed $5,000,000.
In applying this test, all persons treated as a single employer are treated as one person. This would usually apply to groups of controlled corporations.
In addition, installment sales of personal use property for the seller (like a personal residence or a second home) or of property used or produced in the trade or business of farming are not subject to the interest charge.
The interest for a taxable year is computed by multiplying the interest rate for underpayments of income tax as of the end of the tax year (3% for 2012) times the portion of the deferred tax attributable for installment sale obligations over $5,000,000.
For example, Jane Taxpayer had a $6,000,000 balance receivable for an installment sale of land formerly held for investment as of the end of 2012. The gross profit percentage was 16.66667%.
Her interest charge for 2012 was:
Balance of installment sale obligations
$6,000,000 Gross profit percentage 16.66667% Total deferred income $1,000,002 Excess of balance over $5,000,000 $1,000,000 Divided by total balance / $6,000,000 Percentage excess 16.666% Deferred income for excess of installment sale obligations receivable over $5,000,000 166,660 Maximum tax rate for long- term capital gains (for 2012) 15% Tax on applicable deferred income 24,999 Underpayment penalty rate 3% Interest charge $ 750
The interest charge may be deductible as interest expense for interest paid or accrued during a taxable year.
The gain or loss recognized when a property is repossessed for which the gain is being reported as an installment sale is the amount of money and fair market value of any property other than the debt of the purchaser received as payment on the property before the repossession minus the gain previously reported as income.13
The gain from repossessing the property is limited to the untaxed installment sale gain less costs of repossession. The character of the gain is the same as for the installment sale.
The tax basis of the repossessed property is the tax basis of the installment note plus any taxable gain relating to the repossession and costs of repossession.
For example, John Taxpayer sold a commercial building for $2,000,000 during 20X1. He received $200,000 cash and a note for $1,800,000. The gain for the sale was $500,000. After 20X1, he received $200,000 of principal payments, leaving a principal balance of $1,600,000. During 20X4, he repossessed the building, incurring $40,000 of costs for the repossession.
The gross profit percentage is $500,000 / $2,000,000 = 25%.
The untaxed gain is: Total gain $500,000 Cash down payment $200,000 Principal payments received 200,000 Total cash received 400,000 Gross profit percentage 25% Taxed gain 100,000 Untaxed gain $400,000 Total cash received before repossession $400,000 Less gain previously taxed -100,000 Potential gain from repossession $300,000 Limitation Untaxed installment sale gain $400,000 Less costs of repossession -40,000 Limitation $360,000 Taxable gain – lesser of potential gain or limitation $300,000 Tax basis of repossessed property: Balance of installment sale note at repossession $1,600,000 Untaxed gain balance
$400,000 Taxed gain at repossession -300,000 Minus untaxed gain -100,000 Add costs of repossession 40,000 Tax basis of repossessed property $1,540,000
Sales to related persons who resell the property
If an installment sale is made to a “related person” and that person resells the property within two years after the close of the sale and the installment sale hasn’t already been paid off, then the balance of the installment sale loan is deemed to be paid off and any previously untaxed gain becomes currently taxable.14
If there is an offsetting option or short sale for the related person that reduces the risk of ownership, the two-year holding period is suspended, and the time a resale will trigger the remaining gain is extended.
Related persons include partnerships, corporations and S corporations controlled directly or indirectly by the seller, estates and trusts for the benefit of the seller, and most family members, except cousins, uncles and aunts. If there will be a resale of the property within two years of an installment sale, the seller should review this issue with his or her tax advisor.
For example, John Taxpayer sells land to his son, James Taxpayer in 20X1. The sale is reported as an installment sale. James resells the property during 20X2 to Jane Smith, an unrelated person, when John has previously unreported capital gains of $200,000. Jane assumes the note payable to John for the purchase of the property. John will have to report the $200,000 as taxable income for 20X2, even though James hasn’t paid off the note payable to John for the purchase of the property.
There are exceptions to this rule when there is an involuntary conversion of the real estate (usually as a result of a casualty or condemnation) or when the property is sold after the death of the seller or the buyer in the installment sale. There is another exception to the rule when the taxpayers can establish to the satisfaction of the IRS that tax avoidance was not a principal purpose of the first or second sale, which would require requesting a ruling from the IRS.
Sale of depreciable property to a related person
Installment sale reporting is generally disallowed when depreciable property is sold to a related person.15 In addition, any gain for the sale of depreciable property is taxable as ordinary income.16
By segregating the amounts for (non-depreciable) land and depreciable improvements, it may be established that most, if not all, of the gain is for the land and qualifies for installment sale reporting despite this rule.
Related persons include corporations, S corporations and partnerships that are controlled, directly or indirectly by the seller, a taxpayer and a trust with the taxpayer or his or her spouse is a beneficiary, and the executor and a beneficiary of an estate, unless the sale is in satisfaction of a pecuniary bequest.
Note that family members aren’t considered “related persons” for this rule.
There is an exception when the taxpayer can establish to the satisfaction of the IRS that the disposition did not have as one of its principal purposes the avoidance of Federal income tax. To satisfy this requirement, the seller would have to apply for a ruling from the IRS.
Borrowing with installment sale note used as security
If a taxpayer who isn’t a dealer borrows money and pledges an installment note as security for the loan, the lesser of the balance of the installment sale note or the amount of cash received from the loan will be treated as a payment for the installment sale. The amount is considered received on the later of the time the loan becomes a secured indebtedness or the time the proceeds of the loan are received by the seller.17
A payment is treated as secured by an interest in the installment sale note to the extent the arrangement allows the seller to satisfy all or a portion of the indebtedness with the installment sale note.
Contingent payment sales
Some sales are structured so the total selling price can’t be determined at the close of the taxable year of sale. Such sales can be reported using the installment sale method. In some cases, the arrangement may be considered as retaining a partnership or joint venture interest in the property sold, or as the uncertain amount being classified as interest income. Sales contracts stated in foreign currency are also considered to be contingent payment sales.18
These transactions require recomputations of gain and interest during the term of the contract. The details of the tax rules for these transactions are beyond the scope of this discussion. Consult with a tax advisor.
Interest charge for sales by dealers of timeshares and residential lots
The only sales by dealers that qualify for installment sale reporting are sales of timeshares, residential lots, and farm property. Since these are dealer sales, the income reported will be ordinary income. When dealers elect to report sales of timeshares and residential lots using the installment method, they agree to pay an interest charge for the deferred tax.19
The timeshare rights are for use of residential real property for not more than six weeks per year, or a right to use specified campgrounds for recreational purposes. Family rights of spouses, children, grandchildren and parents are aggregated for this test.
The interest charge is paid to the IRS as the payments are received. The tax attributable to the installment sale payments received is computed, and interest is computed based on the period from the date of sale to the date the payment is received. The interest rate is the applicable federal rate (AFR) under Internal Revenue Code Section 1274 for the date of sale, compounded semiannually. The IRS publishes these applicable federal rates each month. Only the rate for the month of sale applies; a special rule that would otherwise allow the lowest rate for the 3-month period ending with the month of the contract doesn’t apply.
No interest applies for payments received in the year of sale.
For example, XYZ Land Company (a C corporation) sells residential lots. XYZ Land had taxable income of $100,000 for principal payments received on November 1, 2012 for installment sales of land on November 1, 2004. The installment notes were for 10 years.
The tax for the collections was $100,000 X 35% tax rate $35,000 Long-term AFR November 2004 Semiannual compounding 4.65% Compounding periods 8 years X 2 8 Formula $35,000 X (1 + (4.65% /2))16 Amount $50,556 Less tax -35,000 Interest $15,556
This interest is shown as an additional tax on the income tax return, but may be deducted as a business expense for the dealer. The amount is included at line 60 of Form 1040, with the notation “Section 453(l)(3) interest.”
Suspended passive activity losses and installment sales
Operating losses from “passive activities” may be limited to the amount of income from passive activities for a tax year and suspended until additional passive activity income is generated or until the entire interest in the passive activity is disposed.20
When the disposition of the entire interest is done using an installment sale, the suspended losses are allowed based on a ratio of the gain recognized for a tax year to the total gross profit from the sale.21
For example, Jane Taxpayer made an installment sale of her entire interest in a commercial building during 20X1. She had $500,000 of suspended passive activity losses for the building. Her gross profit for the sale was $1,000,000. $500,000 of the profit was taxable for 20X1.
Here are suspended passive activity losses she may deduct for 20X1.
Gross profit taxable for 20X1 $ 500,000 Divided by total gross profit / 1,000,000 Ratio of taxable gross profit to total 0.50 Times suspended passive activity losses 500,000 Deduction allowed for passive activity Losses for 20X1 $ 250,000
A corporate tax trap – the alternative minimum tax
Regular “C” corporations may be subject to the alternative minimum tax. Small corporations that have average annual gross receipts of no more than $7,500,000 for the 3 taxable years before the current taxable year are exempt from the AMT. The first taxable year of a corporation is exempt, and a $5,000,000 average gross receipts test applies for the second and third year of existence.22
If the alternative minimum tax does apply, there is a tax trap for installment sales. Alternative minimum taxable income includes an adjustment for “adjusted current earnings” or ACE.23 The adjustment is an addition of 75% of the excess of ACE over the alternative minimum taxable income before the ACE adjustment.24
Real estate investment trusts (REITs) and S corporations are not subject to the adjustment for ACE.25
When computing ACE, installment sale reporting isn’t allowed.26Therefore, larger corporations may not receive the benefits of an installment sale that they otherwise might expect.
As the installment sale income is reported for the regular tax, negative ACE adjustments may be allowed to help recover minimum tax credits.27
Income with respect of a decedent
The federal estate tax still exists after the American Taxpayer Relief Act of 2012, but will apply to only a few of us.
The federal estate and gift tax exemption and generation-skipping tax exemption for 2013 is $5,250,000, and will continue to be indexed for inflation in the future. Effective January 1, 2013, the federal estate and gift tax rate for estates exceeding the exemption amount is 40%.
When the estate tax is attributable to an item that will be taxable income to the estate, trust or heirs of the decedent, a tax deduction is allowed to reduce the impact of double taxation.28 Items that are subject to both income tax after death and estate tax are called “income with respect of a decedent” (IRD). One item of income with respect of a decedent is untaxed income for an installment sale.
There are also deductions that are allowable for both income tax reporting and estate tax reporting. A real estate-related item is property tax that was assessed before death but wasn’t paid yet.
Deductions with respect of a decedent (DRD) are subtracted from income with respect of a decedent to arrive at a net income with respect of a decedent amount. The federal estate tax is computed on a “with” and “without” basis to determine the estate tax attributable to income with respect of a decedent. As the income is collected, the deduction for estate tax is determined based on the ratio of income received for the tax year to the total income with respect of a decedent.
A similar computation applies to generation-skipping taxes.
The tax deduction for estate tax attributable to capital gains is reported on the related part of Schedule D.29 The tax deduction for other income is reported on Schedule A as a miscellaneous itemized deduction.
For example, Jane Taxpayer was deceased on December 31, 2012. She had a taxable estate of $10,000,000. None of her beneficiaries were skip persons and generation-skipping tax did not apply to her estate. Her estate included an installment sale with $200,000 of untaxed income. She had no other income with respect of a decedent, but had deductions with respect of a decedent of $5,000 of property taxes unpaid at her death. Her estate had taxable installment sale income of $20,000 for 2013.
Taxable estate before IRD
$10,000,000 IRD – installment sale $200,000 DRD – property taxes -5,000 Net IRD -195,000 Taxable estate “without” IRD $ 9,805,000 Estate tax with IRD $1,708,000 Estate tax without IRD 1,639,750 Estate tax on IRD $ 68,250 Installment sale income for 2012 $20,000 Divided by total IRD / 200,000 Fraction collected 0.10 Times Estate tax on IRD X 68,250 Deduction for Estate Tax on IRD for 2012 $ 6,825
This deduction will be reported on Part II of Schedule D to offset the long-term capital gain from the installment sale.
The Eighth Circuit Court of Appeals has ruled that income had to be reported for previously untaxed installment sale income when the note provided that all future payments would be cancelled on the death of the payee/buyer, who was related to the obligor/seller.30
“Cutting Edge” estate planning strategy – installment sale to a “defective” grantor trust
How can you “freeze” the estate and gift tax value of real estate that you expect to rapidly appreciate while keeping control of the asset and avoiding an income tax consequence from a sale to an estate planning trust?
An estate planning strategy that is currently “hot” is to take advantage of differences between the income tax rules and the estate tax rules that apply to trusts. A taxpayer can create a trust that is treated as owned by the taxpayer and so disregarded for income tax reporting, but is treated as not owned by the taxpayer for estate tax reporting. When such a trust is created intentionally, it is called an “intentionally defective grantor trust” or IDGT.
The trust is made defective by giving the creator or grantor of the trust (who is also the seller of the property) certain “prohibited” powers, such as the power to substitute assets of equal value in a nonfiduciary capacity or the power of a nonadverse party to add beneficiaries. (This is not a complete list.)
An installment sale to an IDGT can be used to “freeze” the value of the sold asset for estate and gift reporting, without an income tax consequence. No gain or loss is reported by the selling taxpayer. You can’t sell an asset to yourself for a taxable gain. No interest is reported for interest payments for the installment note. The grantor/seller reports any income earned from the property by the trust on his or her individual income tax return. Since the income tax is the obligation of the grantor/seller, there is no gift subject to federal gift tax for payment of the income tax by the grantor/seller.
Since the trust is respected for estate and gift tax reporting, transfers of assets to the trust are subject to gift tax.
It’s uncertain whether the balance of the deferred gain is taxable when the grantor/seller dies before the note is paid off.
Restating the mechanics of the strategy, cash for the down payment is contributed to an irrevocable trust that is “disregarded” for income tax reporting. This cash transfer is reported on a gift tax return as a taxable gift. An installment sale of real estate is made by the “seller/grantor” to the trust. The trust accumulates rental income minus operating expenses minus payments on the installment sale note. The only “income” the seller/grantor receives is the interest on the note. There is additional cash flow to the seller from the principal payments. The interest rate may be a low “applicable federal rate” to shift as much of the income from the property as possible to beneficiaries of the trust free of additional estate and gift tax. The seller/grantor reports the rental income and expenses from the property on his or her income tax return and pays the income taxes personally. The payment of income taxes is not subject to gift tax. No gain is reported for the sale of the property and the interest for the installment note is ignored as income and a deduction on the income tax return of the seller/grantor.
This is only an introduction to this strategy as an item for your checklist of planning ideas for real estate. You should only implement this strategy under the guidance of qualified legal counsel.
Installment sales remain one of the most powerful tools in the tax planning arsenal for real estate. They are useful for stretching additional interest income from deferred taxes, managing cash flow by matching the payment of income taxes with cash collections, potentially avoiding high income tax rates, and for estate planning by “freezing” the value of the property sold in the seller’s estate.
For more information on installment sales, see IRS Publication 537.
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1 IRC § 453(f)(4) RETURN
2 IRC § 453(1)(3) RETURN
3 IRC § 453(1)(3)(C) RETURN
4 IRC § 453(i) RETURN
5 2012 Schedule D instructions, page D-12 RETURN
6 Treasury Regulations § 1.453-12(a) RETURN
7 F.J. Voight, 68 TC 99 Affirmed CA-5, 80-1 USTC ¶ 9310, 614 F2d 94 RETURN
8 IRC § 453(f)(6) RETURN
9 Revenue Ruling 55-79 RETURN
10 IRC § 483 RETURN
11 IRC § 1274(d) RETURN
12 IRC § 453(a)(1) RETURN
13 IRC § 1038 RETURN
14 IRC § 453(e) RETURN
15 IRC § 453(g) RETURN
16 IRC § 1239(a) RETURN
17 IRC § 453A(d) RETURN
18 Treasury Regulations § 15A.453-1(c) RETURN
19 IRC § 453(1)(3) RETURN
20 IRC § 469 RETURN
21 IRC § 469(g)(3) RETURN
22 IRC § 55(e) RETURN
23 IRC § 56(c)(1) RETURN
24 IRC § 56(g)(1) RETURN
25 Treasury Regulations § 1.56(g)-1(a)(4) RETURN
26 IRC § 56(g)(4)(D)(iv) RETURN
27 IRC § 56(g)(2) RETURN
28 IRC § 691 RETURN
29 IRC § 691(c)(4) RETURN
30 J.M. Frane, 93-2 USTC ¶ 50,386 RETURN