Congress periodically has provided taxpayers with relief from the burden of current income tax liabilities generated in qualified transactions. Internal Revenue Code Section 1031, which governs like-kind exchanges, is a familiar example of such a provision that allows taxpayers to defer the payment of income taxes on any gain realized from the exchange of a like-kind property until a future point in time when the taxpayer disposes of the exchanged property. This genre of tax-deferred transaction historically has provided taxpayer-friendly mechanisms for taxpayers to manage their overall effective tax rate.
However, as Congress engages in its infamous “open a door and shut a window” approach to financing new tax cuts, the installment method of recognizing gain on the disposition of property for accrual-basis taxpayers has fallen victim to the political chopping block. On Dec. 17, 1999, President Clinton signed into law H.R. 1180, the Ticket to Work Incentives Improvement Act, which officially renewed a number of expired business tax breaks and eliminated others -- specifically the use of the installment method for most accrual-basis taxpayers. Moreover, Congress added insult to injury by making the act applicable immediately, casting its net over all property sales after the date of its enactment, rather than allowing a grace period for taxpayers to adjust.
Installment-Method Background
The Revenue Act of 1926 first allowed installment-method reporting of gains on sales of property with deferred payments. It primarily was designed to provide deferral of income-tax liability on profits from a sale until the deferred payments for the property that was sold actually were received. The rules governing installment sales that developed since then were found in IRC Section 453.
Before the Ticket to Work Act was signed, IRC Section 453 provided that if a property disposition qualified as an installment sale, accrual-method taxpayers could defer recognition of a proportional amount of the profit on the sale until they actually received payments.
Accordingly, any installment-sale gain could be spread over the period during which the payments were received, rather than being taxed in the year of sale.
Sales that qualified for installment-method treatment generally were property dispositions for which at least one payment was received after the close of the taxable year in which the sale occurred. However, qualifying sales did not include sales of personal property held as inventory or most dispositions by “dealers.”
Under IRC Section 453, the recognized reportable gain was calculated when each installment was received, and each payment represented two components. The first part was the nontaxable recovery amount of a portion of the seller's tax basis or net investment in the property, and the second part was the taxable realization of a portion of the seller's gain. Accordingly, the taxpayer was taxed only on the part of the payment that represented the gain on the sale. This amount, which was reported as income, was calculated by multiplying the total amount of payments received during the year by the ratio of the gross profit to the total contract price -- the gross profit percentage.
The following example illustrates the basic mechanics of an installment sale under IRC Section 453. Taxpayer A sells real estate with an adjusted tax basis of $250 to taxpayer B for $500, which is payable to A in five annual installments of $100 (plus annual market-rate interest). A's gross profit on the sale is $250 ($500 sales price less $250 basis). The gross profit percentage is 50 percent ($250 gross profit divided by $500 total contract price). Accordingly, the amount of each payment received by A that would have been reported as gain is $50 (50 percent multiplied by $100 payment). The remaining $50 of each payment is a nontaxable recovery of basis. Interest included in each payment would be reported separately by A as ordinary income.
Real Estate Implications
The act's repeal of the use of the installment method for accrual-basis taxpayers as outlined by IRC Section 453 has sweeping implications for most taxpayers, including those in the real estate industry. Because most business taxpayers are accrual-method taxpayers for federal income-tax purposes, many businesses or joint ventures that hold real estate will lose any deferral benefit provided by the use of the installment method. Instead, accrual-method taxpayers will be relegated to calculating their realized taxable gain using the general rules of IRC Section 1001. This section allows taxpayers to recognize a gain, if any, equal to the difference between the fair-market value of the property and its adjusted basis in the year of sale.
The lost deferred tax benefit easily is identified when applied to the example outlined above. Assuming that taypayer A cannot use the installment method to recognize the gain on the sale, A's recognized gain on the sale of the real estate in the year of disposition is the full $250 (fair-market value less adjusted bases as required by IRC Section 1001). Granted, A eventually would have had to recognize the same $250 using the installment method instead of the accrual method. However, A would have been able to pay the tax liability associated with that gain over a five-year period rather than in the year of the sale.
Although the total dollar amount of the tax liability is the same, the time value of money makes paying the full $250 currently more expensive than having to pay it in the future. Moreover, because A receives proceeds from the sale over a five-year period, the current income-tax recognition may place a strain on cash flow because A must come up with the cash to pay the income-tax liability from sources other than proceeds from the property sale.
Planning Considerations
Depending on the facts and circumstances of any particular case, accrual-basis taxpayers that would have received income-tax deferral under the installment method may be able to dispose of property and still receive income-tax deferral. This can be achieved by using IRC Section 1031 transactions qualifying for federal income tax treatment as like-kind exchanges. However, such dispositions may not be able to clear the high hurdles of Section 1031 or may not meet present business objectives. As always, consult your tax adviser when planning for any transaction.