Installment sale

Can an installment sale with payment spread over just two calendar years be set up solely for the tax benefit of the seller? Will it pass muster with the code and regs?

My client and another individual (unrelated) each have a 50% interest (as tenants in common) of a 6-unit residential building. Income and expenses have been reported 50/50 on each individual's Sch E/1040. My client plans to sell his interest to the other owner and would like to receive half the sale proceeds in 2018 and the balance in early 2019. Can the transaction be treated as an installment sale? (I'm not sure whether there will be any bank financing.)

Sure, why not? "Generally, an installment sale is a disposition of property where at least one payment is received after the end of the tax year in which the disposition occurs." Nothing special about two years.

Sure, why not? "Generally, an installment sale is a disposition of property where at least one payment is received after the end of the tax year in which the disposition occurs." Nothing special about two years.

Exactly. In fact, the section 453 installment method would generally be required -- unless for example the taxpayer were to decide for some reason to "elect out" of that method under section 453(d).

(I'm not sure whether there will be any bank financing.). That certainly might matter.

Don't forget that any gain attributable to depreciation taken on 1245 or 1250 property has to be picked up in the year of sale, regardless of any payments being made in the year of sale.

If this is a significant issue, you want to make sure some payment is made to the seller to at least cover the tax to the seller in the year of recapture. You can see how this can get complicated. An allocation of purchase price is critical here.

Any depreciation recapture is added to the basis of the property to determine the portion of the gain taxed as capital gain, and that determines the gross profit percentage.

So if you are not selling the property for any more than was originally paid for the property, all the gain is due to 1245 or 1250 recapture, and the installment method isn't deferring anything. There won't be any net 1231 gain to defer.

As long as S/L depreciation was used, the 1250 property is eligible for installment reporting. Must be reported first before any 1231 gain is reported.

It is a nice way to spread out the income.... Also, if the seller is interested in holding the mortgage on the property, a good source of higher % interest income.

A vital distinction should be made in this situation: There's a type of gain that's known as "Section 1250 recapture," and there's another type of gain, that's known as "Unrecaptured section 1250 gain." Not only are these two types of gain taxed differently, but they are also recognized differently - at different times - under the rules of the installment method [IRC Section 453].

It's a brutally difficult topic to explain, accurately and completely, and that's why I'm choosing not to explain it right here, right now.

It looks like some of us might be well served to read up on it.

It's a brutally difficult topic to explain

Not really. However, I assume you made the comment because some previous comments in this thread demonstrate a lack of understanding of the issue, or at least sloppy terminology.

Here's how some CE material I have describes it:

"A gain on the disposition of §1250 property is treated as ordinary income to the extent of additional depreciation (that is, accelerated depreciation over straight line depreciation) allowed or allowable on the property. Because straight-line depreciation is generally used for real property, it is unusual to have §1250 recapture issues. However, it is common to have unrecaptured §1250 gain. This is the part of any long-term capital gain on §1250 property (real property) that is due to depreciation allowed or allowable after May 6, 1997. [...] Unrecaptured §1250 gain, computed on Schedule D, is equal to the smaller of the following:
• Gain on disposition of a §1250 asset
• Depreciation claimed on the asset, reduced by depreciation recaptured under §1250"

...and this CE material doesn't even mention the special rule for recognition of Section 1250 recapture found in Section 453(i) of the installment sale rules.

...and this CE material doesn't even mention the special rule for recognition of Section 1250 recapture found in Section 453(i) of the installment sale rules.

Oh, I see now you were referring to the brutal difficulty of explaining the installment sale treatment of sec 1250 items. I thought you were simply referring to the explanation of sec 1250 recapture and gain itself.

But, to give credit where due, the CE material I quoted from does include such info elsewhere, and I still don't see where exactly it is "brutal". Plus, good tax software would be expected to handle most if not all of this.

"When a sale of business-use property is reported under the installment method, any depreciation recapture required under §§1245 or 1250 is taxable as ordinary income in the year of sale–even when no payments are received in the year of sale. If the total gain is more than the amount recaptured, the remaining gain is reported using the installment rules."

But of course, Sec 1250 depreciation recapture is very uncommon, so who cares?

It also goes on to explain,

"Payments received under an installment arrangement are taxed based on the rates in place on the date of receipt. A maximum rate of 25% is applied to unrecaptured §1250 gain. If the capital gain from an installment sale consists of both unrecaptured §1250 gain and “regular” §1231 gain, the unrecaptured §1250 gain must be recovered first as installment payments are received. If there is non-recaptured §1231 gain loss to be offset, any installment gain recaptured as ordinary income is still treated as a recovery of unrecaptured §1250 gain." [edit - corrected original material, use "loss" instead of "gain"]

Don't forget that any gain attributable to depreciation taken on 1245 or 1250 property has to be picked up in the year of sale, regardless of any payments being made in the year of sale. [...]
So if you are not selling the property for any more than was originally paid for the property, all the gain is due to 1245 or 1250 recapture, and the installment method isn't deferring anything. There won't be any net 1231 gain to defer.

So, in light of the explanations I posted, we see that these statements are incorrect.

(I'm not sure whether there will be any bank financing.). That certainly might matter.

Trying to see how. I thought all that mattered was the year in which payments were received, not the source of funds for making the payments.

I'm pretty sure that your CE's reference to "non-recaptured §1231 gain" [in the last paragraph of #11, above] might more correctly have been a reference to "non-recaptured §1231 loss," instead. Whaddyathink? Brutal, isn't it?

Trying to see how. I thought all that mattered was the year in which payments were received, not the source of funds for making the payments.. I was referring to assumption of existing debt, which is what I thought you were not sure there will be, I guess I misunderstood you.

more correctly have been a reference to "non-recaptured §1231 loss," instead. Whaddyathink?

Perhaps. I think it could be read either way and still be accurate, but I agree it is not a complete explanation. Again, there is another section in the text that explains "NONRECAPTURED NET §1231 LOSSES" more clearly, so not the fault of the text. But it does show that it's going to take 4-5 paragraphs minimum to explain it.

"Plus, good tax software would be expected to handle most if not all of this."
But I don't have good tax software.

Trying to see how. I thought all that mattered was the year in which payments were received, not the source of funds for making the payments.. I was referring to assumption of existing debt, which is what I thought you were not sure there will be, I guess I misunderstood you.

I suspect the OP is saying, the buying partner may need to take a loan on the property in order to pay the selling partner (his client). I thought you were saying there is a scenario where all the payment is considered to be received in the year of disposition (not an installment sale). There might be such a scenario, I wouldn't know. This is why I don't like partnerships -- too complicated.

No more Mister Nice Guy. The reference in the CE material quoted above [last paragraph in #11] to "non-recaptured §1231 gain" is incorrect. There's no such thing as "non-recaptured §1231 gain."

If the property is sold at a loss (i.e. discussion of Section 1231 loss vs gain terminology) you aren't eligible to use installment sale.