Installment sales of real estate by nondealers.by Groton, Anne S.
TRA 86 dramatically changed the method of taxing installment sales of real estate by adding Sec. 453C. Before the ink was dry and before any regulations could be finalized, Congress passed RA 87, which repealed Sec. 453C effective after December 31, 1987, and added a new Sex. 453A.
Adding to the complexity of these new and repealed sections, the taxpayer may elect to use the interest rules of the 1987 Act for transactions incurred after August 16, 1986. If this election is made, then the proportionate disallowance rule will not apply. The new Act allows the installment method to be used in determining alternate minimum taxable income for nondealer dispositions effective for taxable years after December 31, 1986.
This article will first describe RA 87 and continue with a discussion of TRA 86 as it pertains to nondealer installment sales of real estate.
RA 87--Nondealer Installment Sales of Real Estate
The installment sales of real estate for nondealers, after December 31, 1987, are subject to a new set of rules recited in Sec. 453A.
The Code provides for:
. The repeal of the proportionate disallowance rule (Sec. 453C) for installment sales enacted in TRA 86;
. An interest charge on the deferred tax included in the outstanding installment obligations at the end of each year, subject to certain limitations;
. To the extent that an installment obligation secures indebtedness, the proceeds of the indebtedness will be considered as payment received on the installment obligation, at the later of a) the time the indebtedness is secured or b) the proceeds of such indebtedness are received by the taxpayer; and,
. For alternative minimum tax purposes the installment method may be used in determining AMT income.
For the purpose of calculating the interest charge, the maximum tax rate in effect for the year is applied to the applicable percentage of the deferred tax. The result is multiplied by the underpayment rate in effect under Sec. 6621(a) (2) for the month in which the taxable year ends.
The interest charge is to be treated as an addition to the tax for the year. The addition to the tax, however, is to be taken into account in computing the amount of any deduction allowable to the taxpayer as interest paid during such taxable year.
The applicable percentage with respect to installment obligations arising in a taxable year is determined by dividing the portion of outstanding installment obligations in excess of $5 million by the face amount of all outstanding installment obligations. For example, if at the end of the year, the outstanding installment obligation is $15 million, then the applicable percentage is 66 2/3% $15 million--$5 million / $15 million. The effect of this provision is to exclude from the interest charge transactions of less than $5 million and to increase disproportionately the charge as the obligations exceed the $5 million base. The applicable percentage does not change in subsequent years as payments are made, or deemed made under the pledge rules.
Congress has authorized the Treasury to write regulations relating to short taxable years, installment obligations with contingent payments, and pass-through entities. Congress anticipates that regulations relating to pass-through entities will treat installment obligations of partnerships as owned directly by the partners in proportion of each partner's share in the partnership. Sec. 453A does not apply to property for personal use and farm property used in a trade or business. There are special rules for timeshares and residential lots.
When installment obligations that were considered as received because the instrument has been pledged, are actually received, they will not be included in determining income subject to tax in the year received. Subsequent payments are not taken into account until they exceed the amounts treated as received due to pledging.
TRA 86--Nondealer Installment Sales of Real Estate
Limitations have been placed on the use of the installment method of accounting with respect to certain installment receivables. The limitation requires the taxpayer to treat installments as having been received even though no payments have been made. The amount is based on the taxpayer's outstanding indebtedness at the end of the taxable year. Sec. 453(C) provides that where there is a disposition of real property after August 16, 1986, which property was used in the taxpayer's trade or business, or if the property was held for the production of rental income, and the sales price exceeds $150,000, then such disposition, if financed by the seller would be subject to the proportional disallowance rule.
Specifically, the limitation is applied by determining the amount of the taxpayer's "allocable installment indebtedness" (AII). The AII for any taxable year is determined by 1) Dividing the face amount of the taxpayer's applicable installment obligations that are outstanding at the end of the year, by the sum of a) the face amount of all installment obligations and b) the adjusted bases of all other assets of the taxpayer; and 2) multiplying the resulting quotient by the taxpayer's indebtedness at the end of the taxable year; and 3) subtracting any AII that it is attributable to applicable installment obligations arising in previous years that are outstanding at the end of the year. The amounts so determined will be treated as a payment of the installment obligation immediately before the close of the taxable year. When the taxpayer actually receives payment on the installment obligation in later years he or she need not recognize any gain until the payments exceed the AII in previous years. In defining the amount of the installment obligation, such amount will be determined by the application of the imputed interest rules under Sec. 1274(c) (3) (A) (ii). Also, the basis of the taxpayer's other assets may be adjusted using the deduction for depreciation under Sec. 312(k), which allows for the computation of basis using straight line depreciation if the taxpayer's current basis has been determined by the use of accelerated depreciation.
Regulations have yet to be written to define outstanding indebtedness. The Committee reports make clear that liabilities to be included are accounts payable, accrued expenses as well as bank loans and indebtedness arising from the issuance of bonds in connection with the purchase of property. The Committee reports also state that year-end clearing of indebtedness for the purpose of reducing indebtedness, just to avoid the proportionate disallowance rules, will be disregarded.
There is still another TRA 86 provision which affects seller financed real estate. The entire deferred gain on any installment sale is an adjustment for alternative minimum tax purposes. To the extent that there is AII or receipt of payments in future years there will be a credit in those years to the extent that there has been a payment of the AMT on these amounts. This provision has been repealed for transactions after December 31, 1986.
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