Selling expenses - Installment Sale vs 1031 Exchange

I have a client grumbling about paying tax in Year #1 on an installment sale because they received no money. Here are the facts:

Sales price $1,600,000
Selling expenses $165,000
Seller carryback $1,435,000

Gain on sale:
Sales price $1,600,000
Selling expenses $165,000
Basis $135,000
Net gain $1,300,000
Gross profit 81.25%

Year 1 taxable gain: $165,000 x 81.25% = $134,000

My client *thinks* the $165,000 coming out on the sale should be 100% reduced by the $165,000 of selling expenses. That is not my understanding of how the installment sale formula works. Am I mistaken?

However, it did make me wonder why you get to do this in a 1031 exchange? When you realize boot in an exchange, you are allowed to take the selling expenses directly against that boot. For example, if my client was conducting an exchange and transferred the $1,435,000 to the QI, they would have no gain on the $165,000 of boot because it was used to pay $165,000 of selling expenses.

Could a taxpayer avoid tax on the payment of these selling expenses by planning a failed exchange that converts to an installment sale?

Whose selling expenses were they and who paid them?

From Pub 537



Selling price.

The selling price is the total cost of the property to the buyer and includes any of the following.

Any money you are to receive.

The FMV of any property you are to receive (FMV is discussed under General Rules, earlier.).

Any existing mortgage or other debt the buyer pays, assumes, or takes (a note, mortgage, or any other liability, such as a lien, accrued interest, or taxes you owe on the property).

Any of your selling expenses the buyer pays.



Don’t include stated interest, unstated interest, any amount refigured or recharacterized as interest, or OID.

Adjusted basis for installment sale purposes.

Your adjusted basis is the total of the following three items.

Adjusted basis.

Selling expenses.

Depreciation recapture.

Whose selling expenses were they and who paid them?

They are the seller's selling expenses, including normal costs like commissions to the broker and escrow charges. It also includes significant fees to set up the installment sale.

All of these costs were paid out of the sale proceeds.

If this were a 1031 exchange, we can reduce the boot by these costs. This has the effect of treating the selling expenses as a reduction to the sales price. The seller receives no cash in their pocket and therefore avoids any gain recognition.

In an installment sale, it's different. You treat the selling expenses as additional basis in the property being sold. This forces the seller to recognize gain even though they received no cash in their pocket.

All of these costs were paid out of the sale proceeds.

Yeah, effectively by the buyer. If your guy sold for $1.6m, came out of pocket $0, and the buyer only owes him $1.435m, this means the buyer effectively paid the selling expenses…it’s treated as a $165k cash down payment to your seller client who was deemed to receive those funds and then pay the selling expenses. If instead, your client came to the table with $165k in cash and paid those expenses immediately before closing, for example, the closing statement would show a $1.6m sale and the buyer would owe him the full $1.6m.

In essence, you can’t say that the seller paid the $165k with his own funds. And if you would try to say that, we’d say, “Well, where did he get the money from if he didn’t come out of pocket?” Answer is: From the buyer.

However, it did make me wonder why you get to do this in a 1031 exchange?

Because it’s a deferred exchange. In your example, there’s a $1.3m gain, taxable if it’s a taxable sale. If it’s a 1031, he ends up with a property having an FMV of $1.435m and a basis of $135k, resulting in a $1.3m tax-deferred gain.

Could a taxpayer avoid tax on the payment of these selling expenses by planning a failed exchange that converts to an installment sale?

I don’t see how. If it turns out to be a taxable installment sale, then it’s a taxable installment sale. No longer are we receiving boot in a 1031 exchange and then offsetting that boot. There is no boot, because there is no 1031 exchange. What you’d have is a $165k down payment by the buyer.

Year 1 taxable gain: $165,000 x 81.25% = $134,000

Right, in your example, except it’s $134,063. And $1.435m x 81.25% = $1,165,937. And those two numbers added up equal $1.3m, proving things out.

Now, if your client came to the table with $165k and with those funds, paid the selling expenses immediately prior to closing, for example, we’d end up with the same $1.3m gain. We would have no down payment at closing. Buyer’s note would be the full $1.6m. And that times 81.25% is the $1.3m gain. Thus, your guy could have deferred the gain on the $165k by coming to the table with $165k, but he didn’t.

As Pitch says in Post #2, “Any of your selling expenses the buyer pays.” See Reg. Sec. 15A.453-1(b)(2)(iii).