IRS Tax Treatment of Installment Sales


Installment Sales (See footnote 1.)

IRC Section 453 defines the appropriate accounting method for reporting income from an “installment sale.” (See footnote 2.) An installment sale is generally defined as a sale of property at a profit for which the seller will receive one or more payments of the purchase price after the close of the taxable year in which the sale occurs. (See footnote 3.) The Regulations (See footnote 4) require the taxpayer in this context to account for such income under the” installment method;” that is, the income must be accounted for as payments are received. (See footnote 5.) For sales of real property, the seller may account for receipt of the purchase price on the installment method even when s/he does not receive any payment during the taxable year of sale. (See footnote 6.)

The installment method of accounting is easily viewed as an exception to the general rule requiring taxpayers to recognize income (and pay the resulting tax over to the government) in the taxable year in which they receive cash (or its equivalent). Therefore, the installment method allows a taxpayer to defer recognition of the income from the sale to a future taxable year or years. In the case of appreciated real property sold on an installment contract, the taxpayer must only report as income the gain s/he receives in any taxable year. (See footnote 7.)

The installment method can also apply to a Section 1031 tax-deferred exchange whenever the sale of the relinquished property occurs in one taxable year but the exchange fails in a subsequent taxable year. (See footnote 8.) Here, the safe harbors (i.e., qualified escrow account, qualified trust and qualified intermediary) (See footnote 9) are disregarded for purposes of Section 453 but only until the earlier of the time the taxpayer has the right to receive the sales proceeds prior to the expiration of the exchange period (See footnote 10) or 180 days following the sale of the relinquished property. Specifically, if the taxpayer does not identify replacement property, the identification period must end in the next taxable year or, if the taxpayer properly identifies replacement property, the exchange period must expire in the next taxable year. Taxpayers who use the safe harbors and whose exchange period crosses the end of the taxable year are entitled to report income recognized on the deferred exchange using the installment method. (See footnote 11.)

[1] This discussion is largely sourced from (a) Section 453 of the Internal Revenue Code, (b) the Regulations to Section 453, (c) Tax Topic 705 – Installment Sales of the Internal Revenue Service and (d) Internal Revenue Service Publication 537, Installment Sales.

[2] 26 U.S.C. §453(a) et seq.

[3] 26 U.S.C. §453(b)(1).

[4] Treas. Reg. §15A.453-1 et seq.

[5] 26 U.S.C. §453(a).

[6] Technically, receipt of an installment note or similar contract (what the Regulations to Section 453 term “an evidence of indebtedness”) under which cash or its equivalent will be made to its holder constitutes the receipt of a payment itself. Treas. Reg. §15a.453-1(b)(3)(i). However, if the terms of the installment note impose “substantial restriction or condition” on the holder’s ability to obtain funds thereunder, then the note is not currently taxable under the “economic benefit” theory. See, e.g., PLR 150148-04 (citing Rev.Rul. 77-294 and Stiles v. Commissioner, 69 T.C. 558, 569 (1978)). The Section 1031 safe harbors provide ample restriction on the taxpayer’s right to receive funds during the exchange, thereby nullifying constructive receipt of the note and allowing the taxpayer to use the installment method.

[7] Plainly, “gain” is the difference between the purchase price and the adjusted basis in the property.

[8] Treas. Reg. §1.1031(k)-(1)(j)(2). Generally, a 1031 Exchange fails whenever the taxpayer either (1) elects not to identify replacement property within 45 days of the relinquished property sale date or (2) cannot close on the purchase of properly identified replacement property within 180 days of the relinquished property sale date.

[9] Treas. Reg. §1.1031(k)-(1)(g)(2)-(5).

[10] Treas. Reg. §1.1031(k)-1(g)(6) sets forth the restrictions on the taxpayer’s right to, among other things, receive an early release of exchange funds. These restrictions allow the taxpayer to immediately receive the sales proceeds following expiration of the identification period if s/he does not make replacement property identifications, or after the taxpayer has acquired all of the properly identified replacement property or after the identification period has expired but before the expiration of the exchange period for a “material or substantial contingency” that makes acquisition of replacement property near impossible, or at the end of the exchange period.

[11] See PLR 200813019 (in this ruling, a partnership, using the qualified intermediary safe harbor of Section 1031, sold its relinquished property in tax year 1 but was unable to acquire replacement property. In tax year 2, the intermediary gave the sales proceeds to the partnership). Section 15A.453-1(d)(3) provides that a taxpayer who reports an amount realized equal to the selling price, including the full face amount of an installment obligation, on a timely filed tax return for the taxable year in which the installment sale occurs is considered to have elected out of the installment method. This “opt-out” is not fatal, however. The IRS will in some limited circumstances allow a taxpayer to file an amended return to report the installment obligation in the subsequent tax year as indicated in this PLR.