IRS Guides Taxpayers on Repeal of Installment-Sales Repeal
The Internal Revenue Service has clarified the implications of Congress' recent change of heart about repealing the installment-sales method for accrual-basis taxpayers.
Signed in December 2000, the Installment Tax Correction Act repeals former Internal Revenue Code Section 453(a)(2), which prohibited most accrual-basis taxpayers from using the installment method of reporting sales of property occurring on or after Dec. 17, 1999 (see “Accrual-Basis Taxpayers Lose the Use of Installment-Sales Tax Break,” CIRE, March/April 2000).
The lack of installment reporting had not been well received by the real estate industry and small-business owners. And, after much criticism and an intense lobbying effort, Congress agreed to repeal retroactively Section 453(a)(2) back to the date of the enactment. Thus, accrual-basis taxpayers again are eligible to report income with the installment-sales method.
Overview of Installment Sales
An installment sale generally is defined in Section 453(b) as a disposition of property in which at least one payment is to be received after the close of the taxable year in which the sale occurs. Section 453(a) states that the seller must recognize income from an installment sale ratably upon receipt.
If a property sale qualifies as an installment sale, an accrual-basis taxpayer can defer recognition of gain or profit on the sale until he actually receives the money. Accordingly, any gain on an installment sale could be spread over the entire period during which the payments are received, rather than being taxed entirely in the year of the sale.
Under Section 453, the reportable gain recognized by the accrual-basis taxpayer is calculated when each installment is received. Therefore, each payment that the selling taxpayer receives represents two components: The first includes the amount of the gain that the seller realizes, and the second consists of the nontaxable recovery of a portion of the seller's tax basis or investment in the property. The taxpayer is taxed only on the piece of the payment that represents his gain on the sale. This amount reported as income each year is calculated by multiplying the amount of the payment received by the gross profit percentage (calculated as the total selling price of the property less the adjusted tax basis).
The 1999 Repeal
On Dec. 17, 1999, President Clinton signed into law the Ticket to Work Incentives Improvement Act, which repealed the use of the installment method for most accrual-basis taxpayers, eliminating any tax-deferral benefits. Therefore, taxpayers were required to report the entire gain on the sale of property in the year of sale, while receiving the cash proceeds over the course of several years. This provided a possible substantial economic disadvantage for taxpayers.
Any business or joint venture that held real estate lost the deferral benefit that the installment method provided. Instead, these accrual-basis taxpayers temporarily were relegated to calculating their realized taxable gain using the general rules of Section 1001, recognizing a gain, if any, equal to the difference between the fair-market value of the property and its adjusted basis in the year of the sale.
Repeal of the Repeal
After heavy criticism from the real estate industry and small-business owners, President Clinton signed the Installment Tax Correction Act in December 2000. The act retroactively applies the repeal of Section 453(a)(2) with respect to sales and other dispositions occurring on or after Dec. 17, 1999. The act provides that the IRC should be applied and administered as if Section 453(a)(2) never was enacted in the Ticket to Work Incentives Improvement Act.
Guidance for Taxpayers
In February, the IRS issued Notice 2001-22, which provides guidance on the application of the Installment Tax Correction Act of 2000 for accrual-basis taxpayers who disposed of property in installment sales on or after Dec. 17, 1999, and filed federal income tax returns reporting the gain on the sale using an accrual method of accounting rather than the installment method.
Taxpayers can revoke their effective election out of the installment method, provided that they file, within the applicable period of limitations, amended federal income tax returns for the taxable years in which the installment sales occurred — and for any other affected taxable year — reporting the gain on the installment method. However, taxpayers may not revoke their effective election out of the installment method if the taxable year in which any payment on the installment obligation was received has closed.
For example, assume an accrual-basis taxpayer enters into an installment-sale transaction on real property for a sale price of $1 million and a basis of $500,000 (not taking into account any depreciation recapture). The taxpayer will receive the proceeds over five years, or $200,000 per year.
Assuming the sale occurred on Jan. 1, 2000, with a taxable year-end of June 30, 2000, the taxpayer would have reported the entire gain of $500,000 on the June 30 tax return according to former Section 453(a)(2). By reporting the entire gain in year one, the taxpayer made an affirmative election out of the installment-sales method.
The taxpayer now can file an amended tax return revoking his election out of the installment method and file a refund claim and report the true installment sale gain of $100,000, which is the $200,000 cash received multiplied by the gross profit of 50 percent.
Granted, the taxpayer eventually will have to recognize the same $500,000 using the installment method. However, he will be able to pay the tax liability associated with that gain over a five-year period rather than in one year. Although the total dollar amount of the tax liability is the same, the time value of money makes paying the tax on the full $500,000 currently more expensive than having to pay it sometime in the future. Moreover, since the taxpayer is receiving the sale proceeds over a five-year period, the current income tax recognition may place a strain on cash flow, as he will have to come up with the cash to pay the income tax liability from sources other than proceeds from the property disposition.
As always, contact your tax adviser for more specific information.