Seller notes and interest in an installment sale

Your usual installment receipts combine three categories: interest earnings, recovery of the property's adjusted basis and sale profit. You must report the interest as ordinary income. Interest is generally not included in your down payment.

You calculate the installment sale income portion after subtracting interest from the payment. You then apply your gross profit percentage to the remaining amount. Your gross profit percentage is your gross profit from the sale divided by your contract price. That percentage generally remains the same for each payment you receive, but if your selling price is later reduced, you must refigure gross profit using Worksheet B, recalculate the percentage for remaining payments and spread any remaining gain over future installments.

Your gross profit percentage therefore applies to the payment after interest has been removed. The interest portion remains ordinary income. With each receipt, you typically earn interest, recoup your property's adjusted basis and realize a profit.

You count a buyer's demand note or readily tradable note toward payments for its receipt year. This rule can affect whether your sale qualifies as an installment sale.

For example, treating your note as a current payment may leave you with no other payments to receive after the close of the taxable year in which the sale occurs. If that treatment causes your sale not to be an installment sale, you determine the amount realized under Regulations section 1.1001-1(g).

If you finance the buyer's purchase of your home by holding a note, mortgage or other financial agreement, you probably have an installment sale. You may be able to report any nonexcludable gain on an installment basis. Generally, however, you must report all recognized recapturable depreciation gain for the year of the installment sale.

For a sale or exchange involving seller financing of $7,296,700 or less, your test rate of interest cannot exceed 9%, compounded semiannually. This limit excludes new section 38 property, which includes most tangible personal property subject to depreciation.

Generally, you must pay interest on deferred tax related to an installment obligation arising during a tax year when both thresholds apply. Your property's sales price must exceed $150,000. The total balance of your nondealer installment obligations arising during that year and outstanding at its close must exceed $5 million.

For the statutory sales price test, you treat all sales or exchanges that are part of the same transaction or a series of related transactions as one sale or exchange. For the interest payment test, your obligation must remain outstanding at the close of the taxable year in which it arose. To meet this test, you must hold more than $5 million in aggregate face value from that year's obligations still outstanding at year end.

Except as regulations provide, persons treated as a single employer under section 52(a) or (b) are treated as one person for this threshold and the applicable percentage calculation. Your statutory aggregation test therefore includes that rule when it applies.

Your obligation is excluded from section 453A's covered obligations if it arises from your disposition, as an individual, of personal use property within section 1275(b)(3). An obligation arising from your disposition of property used or produced in the trade or business of farming is also excluded, within the meaning of section 2032A(e)(4) or (5).

Your obligation is also excluded from those covered obligations if it arises from a disposition described in section 453(l)(2)(B). The separate interest payment provisions for timeshares and residential lots in section 453(l)(3) still apply to that obligation.

For your section 453A interest calculation, the statute also requires implementing regulations addressing contingent payments, short taxable years and pass through entities.

If your covered obligation remains outstanding at the close of a taxable year, your tax for that year increases by the interest calculated under section 453A(c). You multiply the applicable percentage of your deferred tax liability by the section 6621(a)(2) underpayment rate for the month with or within which your taxable year ends.

Your deferred tax liability equals the gain on the obligation that remains unrecognized at the close of that year, multiplied by the appropriate maximum tax rate under section 1 or section 11 for that year. For gain that will be treated as long term capital gain when recognized, you take into account the maximum rate on net capital gain under section 1(h).

Your applicable percentage is determined for obligations arising in a particular taxable year. You divide the portion of their aggregate face amount outstanding at that year's close that exceeds $5 million by their aggregate face amount outstanding at that year's close.

You take the amount payable under this subsection into account when computing any allowable deduction for interest paid or accrued during the taxable year.

You enter the section 453A interest as additional tax on your tax return. If you file as an individual, you report the amount on Schedule 2 of Form 1040, line 15.

If you file for a U.S. corporation, you report the interest on Form 1120, Schedule J, line 9f. If you file for a foreign corporation using Form 1120 F, you include the interest on the other taxes line of Schedule J, line 8f.

If indebtedness is secured by an installment obligation to which section 453A applies, you treat the net proceeds of that indebtedness as a payment on your installment obligation. The deemed payment occurs at the later of two times: when the indebtedness becomes secured by the obligation or when you receive the borrowing proceeds.

The amount you treat as received cannot exceed your total contract price minus the portion of that price received before that later time. This subtraction includes amounts previously treated as received under the pledging rule. It excludes amounts disregarded under the rule for subsequent payments.

After you have treated an amount as received under the pledging rule, you disregard subsequent payments on that obligation for section 453 purposes to the extent their aggregate does not exceed the aggregate amount already treated as received.

Your indebtedness is secured by an installment obligation to the extent payment of principal or interest is directly secured by an interest in that obligation. The terms of your indebtedness and any underlying arrangements count. If your borrowing arrangement permits repayment with some or all of the installment obligation, the corresponding debt payment qualifies as directly secured.

In the potentially abusive transactions described by the IRS, promoters find taxpayers seeking to defer gain on appreciated property. For a fee, they facilitate a purported monetized installment sale. If you are the seller in that arrangement, an intermediary purchases your appreciated property in exchange for an installment note.

In these arrangements, your note typically provides for interest payments only, with principal paid at the end of the term. You receive the lion's share of the proceeds but improperly delay recognizing gain on the appreciated property until the final installment note payment, often years later.