FEDERAL TAXATION

March 2000

FINAL REGULATIONS ON UNRECAPTURED IRC SECTION 1250 GAIN REPORTED ON THE INSTALLMENT METHOD

By Steven Blumenthal, CPA,Wiss & Company, LLP

On August 20, 1999, Treasury Decision 8836 made official the final regulations relating to the taxation of capital gains on installment sales of depreciable real property. These regulations are effective for installment payments after August 23, 1999. Proposed regulations were issued on January 22, 1999.

This regulation considers installment sales and the interplay of unrecaptured IRC section 1250 gain [IRC section 1(h)(7)], adjusted net capital gain [IRC section 1(h)(4)], installment payments from sales before May 7, 1997, and IRC section 1231(c) recapture. The unrecaptured IRC section 1250 gain is taxed at 25%, the adjusted net capital gain is taxed at the 20/10% tax rate, the pre-May 7, 1997, tax rate is 28%, and the IRC section 1231(c) recapture is taxed at ordinary income tax rates. This regulation designates the order of income recognition.

The general rule, Treasury Regulations section 1.453-12(a), states that a gain attributable to the unrecaptured IRC section 1250 gain (25% tax rate) is recognized before the adjusted net capital gain (20/10% tax rate) is recognized.

Treasury Regulations section 1.453-12(b) deals with installment payments received after May 6, 1997, on sales that took place before May 7, 1997. In determining the amount of unrecaptured IRC section 1250 gain remaining after May 6, 1997, payments received prior to May 7, 1997, are deemed unrecaptured IRC section 1250 gain. After the unrecaptured IRC section 1250 gain is recognized, the balance is applied against adjusted net capital gain.

Treasury Regulations section 1.453-12(c) addresses installment payments received after May 6, 1997, and on or before August 23, 1999, the effective date of the final regulations. The regulation states:

If the amount of unrecaptured IRC section 1250 gain in an installment payment that is properly taken into account after May 6, 1997, and on or before August 23, 1999, is less than the amount that would have been taken into account under this IRC section, the lesser amount is used to determine the amount of unrecaptured IRC section 1250 gain that remains to be taken into account.

The regulation goes further by including examples under Treasury Regulations section 1.453-12(d). The first two examples address Treasury Regulations sections 1.453-12(a) and (b). The third considers IRC section 1231(c) recapture; the fourth illustrates the effect of an IRC section 1231 loss.

The examples that follow assume an individual utilizing a calendar year and the installment method of accounting. The property sold is real property used in a trade or business that qualifies as both IRC section 1231 and 1250 property. The marginal tax rate on ordinary income is 28%.

Example 1 illustrates the rule under Treasury Regulations section 1.453-12(a): In 1999, A sells property for $10,000, to be paid in 10 equal annual installments beginning on December 1, 1999. A originally purchased the property for $5,000, held the property for several years, and took straight-line depreciation deductions in the amount of $3,000. In each of the years 1999­2008, A has no other capital or IRC section 1231 gains or losses.

A's adjusted basis at the time of the sale is $2,000. Of A's $8,000 of IRC section 1231 gain on the sale of the property, $3,000 is attributable to prior straight-line depreciation deductions and is unrecaptured IRC section 1250 gain. The gain on each installment payment is $800.

A takes into account the unrecaptured IRC section 1250 gain first. Therefore, gain on A's first three payments, received in 1999, 2000, and 2001, is taxed at 25%. Of the $800 of gain on the fourth payment, received in 2002, $600 is taxed at 25% and the remaining $200 is taxed at 20%. The gain on A's remaining six installment payments is taxed at 20%.

Example 2 illustrates the rule under Treasury Regulations section 1.453-12(b), installment payments from sales prior to May 7, 1997. The facts are the same as in Example 1, except that A sold the property in 1994, received the first of the 10 annual installment payments on December 1, 1994, and had no other capital or IRC section 1231 gains or losses in the years 1994­2003.

As in Example 1, $3,000 of A's $8,000 gain on the sale of the property was attributable to prior straight-line depreciation deductions and is unrecaptured IRC section 1250 gain.

A's first three payments, in 1994, 1995, and 1996, were received before May 7, 1997, and taxed at 28%. Under the rule described in paragraph 1.453-12(b), A determines the allocation of unrecaptured IRC section 1250 gain for each installment payment after May 6, 1997, by taking unrecaptured IRC section 1250 gain into account first, as if the general rule of paragraph 1.453-12(a) applied since the time the property was sold in 1994.

Consequently, of the $800 of gain on the fourth payment received in 1997, $600 is taxed at 25% and the remaining $200 is taxed at 20%. The gain on A's remaining six installment payments is taxed at 20%.

Example 3 illustrates the rule where there are nonrecaptured net IRC section 1231(c)(2) losses from prior years. The facts are the same as in Example 1, except that in 1999, A has nonrecaptured net IRC section 1231 losses of $1,000 from the previous four years.

In 1999, all of A's $800 installment gain is recaptured as ordinary income under IRC section 1231(c). Under the rule described in Treasury Regulations section 1.453-12(a), for purposes of determining the amount of unrecaptured IRC section 1250 gain remaining to be taken into account, the $800 recaptured as ordinary income under IRC section 1231(c) is treated as reducing unrecaptured IRC section 1250 gain, rather than adjusted net capital gain. Therefore, A has $2,200 of unrecaptured IRC section 1250 gain remaining to be taken into account.

In 2000, A's installment gain is taxed at two rates. First, $200 is recaptured as ordinary income under IRC section 1231(c). Second, the remaining $600 of gain on A's 2000 installment payment is taxed at 25%. Because the full $800 of gain reduces unrecaptured IRC section 1250 gain, A has $1,400 of unrecaptured IRC section 1250 gain remaining to be taken into account.

The gain on A's installment payment received in 2001 is taxed at 25%. Of the $800 of gain on the fourth payment, received in 2002, $600 is taxed at 25% and the remaining $200 is taxed at 20%. The gain on A's remaining six installment payments is taxed at 20%.

Example 4 considers the application of Treasury Regulations section 1.453-12(a) when there is a net IRC section 1231 loss. The facts are the same as in Example 1 except that A has IRC section 1231 losses of $1,000 in 1999.

In 1999, A's IRC section 1231 installment gain of $800 does not exceed A's IRC section 1231 losses of $1,000. Therefore, A has a net IRC section 1231 loss of $200. As a result, under IRC section 1231(a) all of A's IRC section 1231 gains and losses are treated as ordinary gains and losses. A's entire $800 of installment gain is ordinary gain. Under the rule described in Treasury Regulations section 1.453-12(a), A's $800 of ordinary IRC section 1231 installment gain in 1999 is treated as reducing unrecaptured IRC section 1250 gain. Therefore, A has $2,200 of unrecaptured IRC section 1250 gain remaining to be taken into account.

In 2000, A has $800 of IRC section 1231 installment gain, resulting in a net IRC section 1231 gain of $800. A also has $200 of nonrecaptured net IRC section 1231 losses. The $800 gain is taxed at two rates. First, $200 is taxed at ordinary rates under IRC section 1231(c), recapturing the $200 net IRC section 1231 loss sustained in 1999. The remaining $600 of gain on A's 2000 installment payment is taxed at 25%. As in Example 3, the $200 of IRC section 1231(c) gain is treated as reducing unrecaptured IRC section 1250 gain, rather than adjusted net capital gain. Therefore, A has $1,400 of unrecaptured IRC section 1250 gain remaining to be taken into account.

The gain on A's installment payment received in 2001 is taxed at 25%, reducing the remaining unrecaptured IRC section 1250 gain to $600. Of the $800 of gain on the fourth payment, received in 2002, $600 is taxed at 25% and the remaining $200 is taxed at 20%. The gain on A's remaining six installment payments is taxed at 20%.

Comment: The IRS needs to carefully and quickly modify the related tax forms (in particular, Form 4797 and 6252) to reflect these changes. Practitioners should carefully review tax forms and related schedules generated by computer software programs to ensure the proper handling of these complex computations. *