Previous Page: Publication 537 - Installment Sales - General Rules Next Page: Publication 537 - Installment Sales - Reporting an Installment Sale Use   to find additional occurrences of topic items.

taxmap/pubs/p537-002.htm#TXMP446cf739 Other Rules(p4)

The rules discussed in this part of the publication apply only in certain circumstances or to certain types of property. The following topics are discussed.

• Electing out of the installment method.
• Payments received or considered received.
• Escrow account.
• Depreciation recapture income.
• Sale to a related person.
• Like-kind exchange.
• Contingent payment sale.
• Single sale of several assets.
• Sale of a business.
• Unstated interest and original issue discount.
• Disposition of an installment obligation.
• Repossession.
• Interest on deferred tax.

taxmap/pubs/p537-002.htm#TXMP6c3763b2 Electing Out of the  Installment Method(p4)

Electing Out of the Installment Method

If you elect not to use the installment method, you generally report the entire gain in the year of sale, even though you do not receive all the sale proceeds in that year.

To figure the amount of gain to report, use the fair market value (FMV) of the buyer's installment obligation that represents the buyer's debt to you. Notes, mortgages, and land contracts are examples of obligations that are included at FMV.

You must figure the FMV of the buyer's installment obligation, whether or not you would actually be able to sell it. If you use the cash method of accounting, the FMV of the obligation will never be considered to be less than the FMV of the property sold (minus any other consideration received).

taxmap/pubs/p537-002.htm#TXMP4baa3c91
Example.(p4)

You sold a parcel of land for $50,000. You received a $10,000 down payment and will receive the balance over the next 10 years at $4,000 a year, plus 8% interest. The buyer gave you a note for $40,000. The note had an FMV of $40,000. You paid a commission of 6%, or $3,000, to a broker for negotiating the sale. The land cost $25,000 and you owned it for more than one year. You decide to elect out of the installment method and report the entire gain in the year of sale.

Gain realized:
Selling price			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain realized			$22,000
Gain recognized in year of sale:
Cash			$10,000
Market value of note			40,000
Total realized in year of sale			$50,000
Minus:	Property's adj. basis	$25,000
	Commission	3,000	28,000
Gain recognized			$22,000

The recognized gain of $22,000 is long-term capital gain. You include the entire gain in income in the year of sale, so you do not include in income any principal payments you receive in later tax years. The interest on the note is ordinary income and is reported as interest income each year.

taxmap/pubs/p537-002.htm#TXMP2b05d8be How to elect out.(p4)

To make this election, do not report your sale on Form 6252. Instead, report it on Schedule D (Form 1040) or Form 4797, whichever applies.

taxmap/pubs/p537-002.htm#TXMP58c32007 When to elect out.(p4)

Make this election by the due date, including extensions, for filing your tax return for the year the sale takes place.

taxmap/pubs/p537-002.htm#TXMP62993dc1 Automatic six-month extension.(p4)

If you timely file your tax return without making the election, you still can make the election by filing an amended return within 6 months of the due date of your return (excluding extensions). Write "Filed pursuant to section 301.9100-2" at the top of the amended return and file it where the original return was filed.

taxmap/pubs/p537-002.htm#TXMP7f9e3ed1 Revoking the election.(p4)

Once made, the election can be revoked only with IRS approval. A revocation is retroactive. You will not be allowed to revoke the election if either of the following applies.

• One of the purposes is to avoid federal income tax.
• The tax year in which any payment was received has closed.

taxmap/pubs/p537-002.htm#TXMP05fff125 Payments Received or Considered Received(p4)

Payments Received or Considered Received

You must figure your gain each year on the payments you receive, or are treated as receiving, from an installment sale.

In certain situations, you are considered to have received a payment, even though the buyer does not pay you directly. These situations occur when the buyer assumes or pays any of your debts, such as a loan, or pays any of your expenses, such as a sales commission. However, as discussed later, the buyer's assumption of your debt is treated as a recovery of your basis rather than as a payment in many cases.

taxmap/pubs/p537-002.htm#TXMP7d1f95e2 Buyer Pays Seller's Expenses(p4)

Buyer Pays Seller's Expenses

If the buyer pays any of your expenses related to the sale of your property, it is considered a payment to you in the year of sale. Include these expenses in the selling and contract prices when figuring the gross profit percentage.

taxmap/pubs/p537-002.htm#TXMP7a4ee09e Buyer Assumes Mortgage(p5)

Buyer Assumes Mortgage

If the buyer assumes or pays off your mortgage, or otherwise takes the property subject to the mortgage, the following rules apply.

taxmap/pubs/p537-002.htm#TXMP4ca1f6ab Mortgage less than basis.(p5)

If the buyer assumes a mortgage that is not more than your installment sale basis in the property, it is not considered a payment to you. It is considered a recovery of your basis. The contract price is the selling price minus the mortgage.

taxmap/pubs/p537-002.htm#TXMP03dfd1a5
Example.(p5)

You sell property with an adjusted basis of $19,000. You have selling expenses of $1,000. The buyer assumes your existing mortgage of $15,000 and agrees to pay you $10,000 (a cash down payment of $2,000 and $2,000 (plus 12% interest) in each of the next 4 years).

The selling price is $25,000 ($15,000 + $10,000). Your gross profit is $5,000 ($25,000 − $20,000 installment sale basis). The contract price is $10,000 ($25,000 − $15,000 mortgage). Your gross profit percentage is 50% ($5,000 ÷ $10,000). You report half of each $2,000 payment received as gain from the sale. You also report all interest you receive as ordinary income.

taxmap/pubs/p537-002.htm#TXMP0c2b825d Mortgage more than basis.(p5)

If the buyer assumes a mortgage that is more than your installment sale basis in the property, you recover your entire basis. The part of the mortgage greater than your basis is treated as a payment received in the year of sale.

To figure the contract price, subtract the mortgage from the selling price. This is the total amount you will receive directly from the buyer. Add to this amount the payment you are considered to have received (the difference between the mortgage and your installment sale basis). The contract price is then the same as your gross profit from the sale.

If the mortgage the buyer assumes is equal to or more than your installment sale basis, the gross profit percentage always will be 100%.

taxmap/pubs/p537-002.htm#TXMP3cb91ee4
Example.(p5)

The selling price for your property is $9,000. The buyer will pay you $1,000 annually (plus 8% interest) over the next 3 years and assume an existing mortgage of $6,000. Your adjusted basis in the property is $4,400. You have selling expenses of $600, for a total installment sale basis of $5,000. The part of the mortgage that is more than your installment sale basis is $1,000 ($6,000 − $5,000). This amount is included in the contract price and treated as a payment received in the year of sale. The contract price is $4,000:

Selling price		$9,000
Minus: Mortgage		(6,000)
Amount actually received		$3,000
Add difference:
Mortgage	$6,000
Minus: Installment sale basis	n5,000	1,000
Contract price		$4,000

Your gross profit on the sale is also $4,000:

Selling price	$9,000
Minus: Installment sale basis	(5,000)
Gross profit	$4,000

Your gross profit percentage is 100%. Report 100% of each payment (less interest) as gain from the sale. Treat the $1,000 difference between the mortgage and your installment sale basis as a payment and report 100% of it as gain in the year of sale.

taxmap/pubs/p537-002.htm#TXMP59a0a1d1 Mortgage Canceled(p5)

Mortgage Canceled

If the buyer of your property is the person who holds the mortgage on it, your debt is canceled, not assumed. You are considered to receive a payment equal to the outstanding canceled debt.

taxmap/pubs/p537-002.htm#TXMP769654c1
Example.(p5)

Mary Jones loaned you $45,000 in 2003 in exchange for a note mortgaging a tract of land you owned. On April 4, 2007, she bought the land for $70,000. At that time, $30,000 of her loan to you was outstanding. She agreed to forgive this $30,000 debt and to pay you $20,000 (plus interest) on August 1, 2007, and $20,000 on August 1, 2008. She did not assume an existing mortgage. She canceled the $30,000 debt you owed her. You are considered to have received a $30,000 payment at the time of the sale.

taxmap/pubs/p537-002.htm#TXMP77845523 Buyer Assumes Other Debts(p5)

Buyer Assumes Other Debts

If the buyer assumes any other debts, such as a loan or back taxes, it may be considered a payment to you in the year of sale.

If the buyer assumes the debt instead of paying it off, only part of it may have to be treated as a payment. Compare the debt to your installment sale basis in the property being sold. If the debt is less than your installment sale basis, none of it is treated as a payment. If it is more, only the difference is treated as a payment. If the buyer assumes more than one debt, any part of the total that is more than your installment sale basis is considered a payment. These rules are the same as the rules discussed earlier under Buyer Assumes Mortgage. However, they apply only to the following types of debt the buyer assumes.

• Those acquired from ownership of the property you are selling, such as a mortgage, lien, overdue interest, or back taxes.
• Those acquired in the ordinary course of your business, such as a balance due for inventory you purchased.

If the buyer assumes any other type of debt, such as a personal loan or your legal fees relating to the sale, it is treated as if the buyer had paid off the debt at the time of the sale. The value of the assumed debt is then considered a payment to you in the year of sale.

taxmap/pubs/p537-002.htm#TXMP0ed88b55 Property Used As a Payment(p5)

Property Used As a Payment

If you receive property rather than money from the buyer, it is still considered a payment in the year received. However, see Like-Kind Exchange, later.

Generally, the amount of the payment is the property's FMV on the date you receive it.

taxmap/pubs/p537-002.htm#TXMP171f4dde Exception.(p5)

If the property the buyer gives you is payable on demand or readily tradable, the amount you should consider as payment in the year received is:

• The FMV of the property on the date you receive it if you use the cash receipts and disbursements method of accounting,
• The face amount of the obligation on the date you receive it if you use the accrual method of accounting, or
• The stated redemption price at maturity less any original issue discount (OID) or, if there is no OID, the stated redemption price at maturity appropriately discounted to reflect total unstated interest. See Unstated Interest and Original Issue Discount (OID), later.

taxmap/pubs/p537-002.htm#TXMP35a4a771 Debt not payable on demand.(p5)

Any evidence of debt you receive from the buyer that is not payable on demand is not considered a payment. This is true even if the debt is guaranteed by a third party, including a government agency.

taxmap/pubs/p537-002.htm#TXMP31cd1e2f Fair market value (FMV).(p5)

This is the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having a reasonable knowledge of all the necessary facts.

taxmap/pubs/p537-002.htm#TXMP17b1253e Third-party note.(p5)

If the property the buyer gives you is a third-party note (or other obligation of a third party), you are considered to have received a payment equal to the note's FMV. Because the FMV of the note is itself a payment on your installment sale, any payments you later receive from the third party are not considered payments on the sale. The excess of the note's face value over its FMV is interest. Exclude this interest in determining the selling price of the property. However, see Exception under Property Used As a Payment, earlier.

taxmap/pubs/p537-002.htm#TXMP01576f5e
Example.(p5)

You sold real estate in an installment sale. As part of the down payment, the buyer assigned to you a $50,000, 8% interest third-party note. The FMV of the third-party note at the time of the sale was $30,000. This amount, not $50,000, is a payment to you in the year of sale. The third-party note had an FMV equal to 60% of its face value ($30,000 ÷ $50,000), so 60% of each principal payment you receive on this note is a nontaxable return of capital. The remaining 40% is interest taxed as ordinary income.

taxmap/pubs/p537-002.htm#TXMP71b230bb Bond.(p5)

A bond or other evidence of debt you receive from the buyer that is payable on demand or readily tradable in an established securities market is treated as a payment in the year you receive it. For more information on the amount you should treat as a payment, see Exception under Property Used As a Payment, earlier.

If you receive a government or corporate bond for a sale before October 22, 2004, and the bond has interest coupons attached or can be readily traded in an established securities market, you are considered to have received payment equal to the bond's FMV. However, see Exception, earlier.

taxmap/pubs/p537-002.htm#TXMP34571e55 Buyer's note.(p6)

The buyer's note (unless payable on demand) is not considered payment on the sale. However, its full face value is included when figuring the selling price and the contract price. Payments you receive on the note are used to figure your gain in the year received.

taxmap/pubs/p537-002.htm#TXMP6dc67947 Installment Obligation Used  as Security (Pledge Rule)(p6)

Installment Obligation Used as Security (Pledge Rule)

If you use an installment obligation to secure any debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is known as the pledge rule and it applies if the selling price of the property is over $150,000. It does not apply to the following dispositions.

• Sales of property used or produced in farming.
• Sales of personal-use property.
• Qualifying sales of time-shares and residential lots.

The net debt proceeds are the gross debt minus the direct expenses of getting the debt. The amount treated as a payment is considered received on the later of the following dates.

• The date the debt becomes secured.
• The date you receive the debt proceeds.

A debt is secured by an installment obligation to the extent that payment of principal or interest on the debt is directly secured (under the terms of the loan or any underlying arrangement) by any interest in the installment obligation. For sales after December 16, 1999, payment on a debt is treated as directly secured by an interest in an installment obligation to the extent an arrangement allows you to satisfy all or part of the debt with the installment obligation.

taxmap/pubs/p537-002.htm#TXMP429ad83b Limit.(p6)

The net debt proceeds treated as a payment on the pledged installment obligation cannot be more than the excess of item (1) over item (2), below.

1. The total contract price on the installment sale.
2. Any payments received on the installment obligation before the date the net debt proceeds are treated as a payment.

taxmap/pubs/p537-002.htm#TXMP39d47487 Installment payments.(p6)

The pledge rule accelerates the reporting of the installment obligation payments. Do not report payments received on the obligation after it has been pledged until the payments received exceed the amount reported under the pledge rule.

taxmap/pubs/p537-002.htm#TXMP679acdf7 Exception.(p6)

The pledge rule does not apply to pledges made after December 17, 1987, to refinance a debt under the following circumstances.

• The debt was outstanding on December 17, 1987.
• The debt was secured by that installment sale obligation on that date and at all times thereafter until the refinancing occurred.

A refinancing as a result of the creditor's calling of the debt is treated as a continuation of the original debt so long as a person other than the creditor or a person related to the creditor provides the refinancing.

This exception applies only to refinancing that does not exceed the principal of the original debt immediately before the refinancing. Any excess is treated as a payment on the installment obligation.

taxmap/pubs/p537-002.htm#TXMP7ed6336b Escrow Account(p6)

Escrow Account

In some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These sales cannot be reported on the installment method. The buyer's obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, you no longer rely on the buyer for the rest of the payments, but on the escrow arrangement.

taxmap/pubs/p537-002.htm#TXMP1415785b
Example.(p6)

You sell property for $100,000. The sales agreement calls for a down payment of $10,000 and payment of $15,000 in each of the next 6 years to be made from an irrevocable escrow account containing the balance of the purchase price plus interest. You cannot report the sale on the installment method because the full purchase price is considered received in the year of sale. You report the entire gain in the year of sale.

taxmap/pubs/p537-002.htm#TXMP659c0aa8 Escrow established in a later year.(p6)

If you make an installment sale and in a later year an irrevocable escrow account is established to pay the remaining installments plus interest, the amount placed in the escrow account represents payment of the balance of the installment obligation.

taxmap/pubs/p537-002.htm#TXMP749dbb7a Substantial restriction.(p6)

If an escrow arrangement imposes a substantial restriction on your right to receive the sale proceeds, the sale can be reported on the installment method, provided it otherwise qualifies. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer, that is, a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer.

taxmap/pubs/p537-002.htm#TXMP5d8e85d5 Depreciation Recapture Income(p6)

Depreciation, Recapture

If you sell property for which you claimed or could have claimed a depreciation deduction, you must report any depreciation recapture income in the year of sale, whether or not an installment payment was received that year. Figure your depreciation recapture income (including the section 179 deduction and the section 179A deduction recapture) in Part III of Form 4797. Report the recapture income in Part II of Form 4797 as ordinary income in the year of sale. The recapture income is also included in Part I of Form 6252. However, the gain equal to the recapture income is reported in full in the year of the sale. Only the gain greater than the recapture income is reported on the installment method. For more information on depreciation recapture, see chapter 3 in Publication 544.

The recapture income reported in the year of sale is included in your installment sale basis in determining your gross profit on the installment sale. Determining gross profit is discussed under General Rules, earlier.

taxmap/pubs/p537-002.htm#TXMP19d0069f Sale to a Related Person(p6)

Sale to a Related Person

If you sell depreciable property to a related person and the sale is an installment sale, you may not be able to report the sale using the installment method. If you sell property to a related person and the related person disposes of the property before you receive all payments with respect to the sale, you may have to treat the amount realized by the related person as received by you when the related person disposes of the property. These rules are explained next under Sale of Depreciable Property and later under Sale and Later Disposition.

taxmap/pubs/p537-002.htm#TXMP6716671c Sale of Depreciable Property(p6)

Sale of Depreciable Property

If you sell depreciable property to certain related persons, you generally cannot report the sale using the installment method. Instead, all payments to be received are considered received in the year of sale. However, see Exception, later. Depreciable property for this rule is any property the purchaser can depreciate.

Payments to be received include the total of all noncontingent payments and the FMV of any payments contingent as to amount.

In the case of contingent payments for which the FMV cannot be reasonably determined, your basis in the property is recovered proportionately. The purchaser cannot increase the basis of the property acquired in the sale before the seller includes a like amount in income.

taxmap/pubs/p537-002.htm#TXMP2e94c6e8 Exception.(p6)

You can use the installment method to report a sale of depreciable property to a related person if no significant tax deferral benefit will be derived from the sale. You must show to the satisfaction of the IRS that avoidance of federal income tax was not one of the principal purposes of the sale.

taxmap/pubs/p537-002.htm#TXMP54f65532 Related person.(p6)

Related persons include the following.

• A person and all entities that are controlled entities with respect to such person.
• A taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary, unless such beneficiary's interest in the trust is a remote contingent interest.
• Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.
• Two or more partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or the profits interests.

For information about which entities are controlled entities, see section 1239(c) of the Internal Revenue Code.

taxmap/pubs/p537-002.htm#TXMP27d0aa9d Sale and Later Disposition(p7)

Sale and Later Disposition

Generally, a special rule applies if you sell or exchange property to a related person on the installment method (first disposition) who then sells, exchanges, or gives away the property (second disposition) under the following circumstances.

• The related person makes the second disposition before making all payments on the first disposition.
• The related person disposes of the property within 2 years of the first disposition. This rule does not apply if the property involved is marketable securities.

Under this rule, you treat part or all of the amount the related person realizes (or the FMV if the disposed property is not sold or exchanged) from the second disposition as if you received it at the time of the second disposition.

See Exception, later.

taxmap/pubs/p537-002.htm#TXMP30a90c19 Related person.(p7)

Related persons include the following.

• Members of a family, including only brothers and sisters (either whole or half), husband and wife, ancestors, and lineal descendants.
• A partnership or estate and a partner or beneficiary.
• A trust (other than a section 401(a) employees trust) and a beneficiary.
• A trust and an owner of the trust.
• Two corporations that are members of the same controlled group as defined in section 267(f) of the Internal Revenue Code.
• The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts.
• A tax-exempt educational or charitable organization and a person (if an individual, including members of the individual's family) who directly or indirectly controls such an organization.
• An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the outstanding stock of the corporation.
• A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the outstanding stock of the corporation.
• The grantor and fiduciary, and the fiduciary and beneficiary, of any trust.
• Any two S corporations if the same persons own more than 50% in value of the outstanding stock of each corporation.
• An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation.
• A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation and more than 50% of the capital or profits interest in the partnership.
• An executor and a beneficiary of an estate unless the sale is in satisfaction of a pecuniary bequest.

taxmap/pubs/p537-002.htm#TXMP7ca27057
Example 1.(p7)

In 2006, Harvey Green sold farm land to his son Bob for $500,000, which was to be paid in five equal payments over 5 years, plus adequate stated interest on the balance due. His installment sale basis for the farm land was $250,000 and the property was not subject to any outstanding liens or mortgages. His gross profit percentage is 50% (gross profit of $250,000 ÷ contract price of $500,000). He received $100,000 in 2006 and included $50,000 in income for that year ($100,000 × 0.50). Bob made no improvements to the property and sold it to Alfalfa Inc., in 2007 for $600,000 after making the payment for that year. The amount realized from the second disposition is $600,000. Harvey figures his installment sale income for 2007 as follows:

Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition	$500,000
Subtract: Sum of payments from Bob in 2006 and 2007	- 200,000
Amount treated as received because of second disposition	$300,000
Add: Payment from Bob in 2007	+ 100,000
Total payments received and treated as received for 2007	$400,000
Multiply by gross profit %	× .50
Installment sale income for 2007	$200,000

Harvey will not include in his installment sale income any principal payments he receives on the installment obligation for 2008, 2009 and 2010 because he has already reported the total payments of $500,000 from the first disposition ($100,000 in 2006 and $400,000 in 2007).

taxmap/pubs/p537-002.htm#TXMP578f2396
Example 2.(p7)

Assume the facts are the same as Example 1 except that Bob sells the property for only $400,000. The gain for 2007 is figured as follows:

Lesser of: 1) Amount realized on second disposition, or 2) Contract price on first disposition	$400,000
Subtract: Sum of payments from Bob in 2006 and 2007	− 200,000
Amount treated as received because of second disposition	$200,000
Add: Payment from Bob in 2007	+ 100,000
Total payments received and treated as received for 2007	$300,000
Multiply by gross profit %	× .50
Installment sale income for 2007	$150,000

Harvey receives a $100,000 payment in 2008 and another in 2009. They are not taxed because he treated the $200,000 from the disposition in 2007 as a payment received and paid tax on the installment sale income. In 2010, he receives the final $100,000 payment. He figures the installment sale income he must recognize in 2010 as follows:

Total payments from the first disposition received by the end of 2010		$500,000
Minus the sum of:
Payment from 2006	$100,000
Payment from 2007	100,000
Amount treated as received in 2007	200,000
Total on which gain was previously recognized		− 400,000
Payment on which gain is recognized for 2010		$100,000
Multiply by gross profit %		× .50
Installment sale income for 2010		$ 50,000

taxmap/pubs/p537-002.htm#TXMP5eed2363 Exception.(p7)

This rule does not apply to a second disposition, and any later transfer, if you can show to the satisfaction of the IRS that neither the first disposition (to the related person) nor the second disposition had as one of its principal purposes the avoidance of federal income tax. Generally, an involuntary second disposition will qualify under the nontax avoidance exception, such as when a creditor of the related person forecloses on the property or the related person declares bankruptcy.

The nontax avoidance exception also applies to a second disposition that is also an installment sale if the terms of payment under the installment resale are substantially equal to or longer than those for the first installment sale. However, the exception does not apply if the resale terms permit significant deferral of recognition of gain from the first sale.

In addition, any sale or exchange of stock to the issuing corporation is not treated as a first disposition. An involuntary conversion is not treated as a second disposition if the first disposition occurred before the threat of conversion. A transfer after the death of the person making the first disposition or the related person's death, whichever is earlier, is not treated as a second disposition.

taxmap/pubs/p537-002.htm#TXMP4341b9e3 Like-Kind Exchange(p7)

1031 Like-Kind Exchange

If you trade business or investment property solely for the same kind of property to be held as business or investment property, you can postpone reporting the gain. These trades are known as like-kind exchanges. The property you receive in a like-kind exchange is treated as if it were a continuation of the property you gave up.

You do not have to report any part of your gain if you receive only like-kind property. However, if you also receive money or other property (boot) in the exchange, you must report your gain to the extent of the money and the FMV of the other property received.

For more information on like-kind exchanges, see Like-Kind Exchanges in chapter 1 of Publication 544.

taxmap/pubs/p537-002.htm#TXMP26412323 Installment payments.(p7)

If, in addition to like-kind property, you receive an installment obligation in the exchange, the following rules apply to determine the installment sale income each year.

• The contract price is reduced by the FMV of the like-kind property received in the trade.
• The gross profit is reduced by any gain on the trade that can be postponed.
• Like-kind property received in the trade is not considered payment on the installment obligation.

taxmap/pubs/p537-002.htm#TXMP0cb1f18c
Example.(p8)

In 2007, George Brown trades personal property with an installment sale basis of $400,000 for like-kind property having an FMV of $200,000. He also receives an installment note for $800,000 in the trade. Under the terms of the note, he is to receive $100,000 (plus interest) in 2008 and the balance of $700,000 (plus interest) in 2009.

George's selling price is $1,000,000 ($800,000 installment note + $200,000 FMV of like-kind property received). His gross profit is $600,000 ($1,000,000 − $400,000 installment sale basis). The contract price is $800,000 ($1,000,000 − $200,000). The gross profit percentage is 75% ($600,000 ÷ $800,000). He reports no gain in 2007 because the like-kind property he receives is not treated as a payment for figuring gain. He reports $75,000 gain for 2008 (75% of $100,000 payment received) and $525,000 gain for 2009 (75% of $700,000 payment received).

taxmap/pubs/p537-002.htm#TXMP1f8ad5e0 Deferred exchanges.(p8)

A deferred exchange is one in which you transfer property you use in business or hold for investment and receive like-kind property later that you will use in business or hold for investment. Under this type of exchange, the person receiving your property may be required to place funds in an escrow account or trust. If certain rules are met, these funds will not be considered a payment until you have the right to receive the funds or, if earlier, the end of the exchange period. See Regulations section 1.1031(k)-1(j)(2) for these rules.

taxmap/pubs/p537-002.htm#TXMP15cb59a7 Contingent Payment Sale(p8)

Contingent Payment Sale

A contingent payment sale is one in which the total selling price cannot be determined by the end of the tax year of sale. This happens, for example, if you sell your business and the selling price includes a percentage of its profits in future years.

If the selling price cannot be determined by the end of the tax year, you must use different rules to figure the contract price and the gross profit percentage than those you use for an installment sale with a fixed selling price.

For rules on using the installment method for a contingent payment sale, see Regulations section 15a.453-1(c).

taxmap/pubs/p537-002.htm#TXMP7c4df17a Single Sale of Several Assets(p8)

Single Sale of Several Assets

If you sell different types of assets in a single sale, you must identify each asset to determine whether you can use the installment method to report the sale of that asset. You also have to allocate part of the selling price to each asset. If you sell assets that constitute a trade or business, see Sale of a Business, later.

Unless an allocation of the selling price has been agreed to by both parties in an arm's-length transaction, you must allocate the selling price to an asset based on its FMV. If the buyer assumes a debt, or takes the property subject to a debt, you must reduce the FMV of the property by the debt. This becomes the net FMV.

A sale of separate and unrelated assets of the same type under a single contract is reported as one transaction for the installment method. However, if an asset is sold at a loss, its disposition cannot be reported on the installment method. It must be reported separately. The remaining assets sold at a gain are reported together.

taxmap/pubs/p537-002.htm#TXMP63afb187
Example.(p8)

You sold three separate and unrelated parcels of real property (A, B, and C) under a single contract calling for a total selling price of $130,000. The total selling price consisted of a cash payment of $20,000, the buyer's assumption of a $30,000 mortgage on parcel B, and an installment obligation of $80,000 payable in eight annual installments, plus interest at 8% a year.

Your installment sale basis for each parcel was $15,000. Your net gain was $85,000 ($130,000 − $45,000). You report the gain on the installment method.

The sales contract did not allocate the selling price or the cash payment received in the year of sale among the individual parcels. The FMV of parcels A, B, and C were $60,000, $60,000 and $10,000, respectively.

The installment sale basis for parcel C was more than its FMV, so it was sold at a loss and must be treated separately. You must allocate the total selling price and the amounts received in the year of sale between parcel C and the remaining parcels.

Of the total $130,000 selling price, you must allocate $120,000 to parcels A and B together and $10,000 to parcel C. You should allocate the cash payment of $20,000 received in the year of sale and the note receivable on the basis of their proportionate net FMV. The allocation is figured as follows:

	Parcels A and B	Parcel C
FMV	$120,000	$10,000
Minus: Mortgage assumed	30,000	-0-
Net FMV	$ 90,000	$10,000
Proportionate net FMV:
Percentage of total	90%	10%
Payments in year of sale:
$20,000 × 90%	$18,000
$20,000 × 10%		$2,000
Excess of parcel B mortgage over installment sale basis	15,000	-0-
Allocation of payments received (or considered received) in year of sale	$ 33,000	$ 2,000

You cannot report the sale of parcel C on the installment method because the sale results in a loss. You report this loss of $5,000 ($10,000 selling price − $15,000 installment sale basis) in the year of sale. However, if parcel C was held for personal use, the loss is not deductible.

You allocate the installment obligation of $80,000 to the properties sold based on their proportionate net FMVs (90% to parcels A and B, 10% to parcel C).

taxmap/pubs/p537-002.htm#TXMP70dde023 Sale of a Business(p8)

Sale of a Business

The installment sale of an entire business for one overall price under a single contract is not the sale of a single asset.

taxmap/pubs/p537-002.htm#TXMP2a3c1cdd Allocation of Selling Price(p8)

Allocation of Selling Price

To determine whether any of the gain on the sale of the business can be reported on the installment method, you must allocate the total selling price and the payments received in the year of sale between each of the following classes of assets.

1. Assets sold at a loss.
2. Real and personal property eligible for the installment method.
3. Real and personal property ineligible for the installment method, including:
   1. Inventory,
   2. Dealer property, and
   3. Stocks and securities.

taxmap/pubs/p537-002.htm#TXMP52434296 Inventory.(p8)

The sale of inventories of personal property cannot be reported on the installment method. All gain or loss on their sale must be reported in the year of sale, even if you receive payment in later years.

If inventory items are included in an installment sale, you may have an agreement stating which payments are for inventory and which are for the other assets being sold. If you do not, each payment must be allocated between the inventory and the other assets sold.

Report the amount you receive (or will receive) on the sale of inventory items as ordinary business income. Use your basis in the inventory to figure the cost of goods sold. Deduct the part of the selling expenses allocated to inventory as an ordinary business expense.

taxmap/pubs/p537-002.htm#TXMP6774f8ef Residual method.(p8)

Except for assets exchanged under the like-kind exchange rules, both the buyer and seller of a business must use the residual method to allocate the sale price to each business asset sold. This method determines gain or loss from the transfer of each asset and the buyer's basis in the assets.

The residual method must be used for any transfer of a group of assets that constitutes a trade or business and for which the buyer's basis is determined only by the amount paid for the assets. This applies to both direct and indirect transfers, such as the sale of a business or the sale of a partnership interest in which the basis of the buyer's share of the partnership assets is adjusted for the amount paid under section 743(b) of the Internal Revenue Code.

A group of assets constitutes a trade or business if goodwill or going concern value could, under any circumstances, attach to the assets or if the use of the assets would constitute an active trade or business under section 355 of the Internal Revenue Code.

The residual method provides for the consideration to be reduced first by cash and general deposit accounts (including checking and savings accounts but excluding certificates of deposit). The consideration remaining after this reduction must be allocated among the various business assets in a certain order.

For asset acquisitions occurring after March 15, 2001, make the allocation among the following assets in proportion to (but not more than) their fair market value on the purchase date in the following order.

1. Certificates of deposit, U.S. Government securities, foreign currency, and actively traded personal property, including stock and securities.
2. Accounts receivable, other debt instruments, and assets that you mark to market at least annually for federal income tax purposes. However, see section 1.338-6(b)(2)(iii) of the regulations for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.
3. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business.
4. All other assets except section 197 intangibles.
5. Section 197 intangibles except goodwill and going concern value.
6. Goodwill and going concern value (whether or not they qualify as section 197 intangibles).

If an asset described in (1) through (6) is includible in more than one category, include it in the lower number category. For example, if an asset is described in both (4) and (6), include it in (4).

taxmap/pubs/p537-002.htm#TXMP5e9a8432 Agreement.(p9)

The buyer and seller may enter into a written agreement as to the allocation of any consideration or the fair market value of any of the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate.

taxmap/pubs/p537-002.htm#TXMP07f1f2aa Reporting requirement.(p9)

Both the buyer and seller involved in the sale of business assets must report to the IRS the allocation of the sales price among section 197 intangibles and the other business assets. Use Form 8594, Asset Acquisition Statement, to provide this information. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred.

taxmap/pubs/p537-002.htm#TXMP4591eaa0 Sale of Partnership Interest(p9)

Sale of Partnership Interest

A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. The sale of a partnership interest is treated as the sale of a single capital asset. The part of any gain or loss from unrealized receivables or inventory items will be treated as ordinary income. (The term unrealized receivables includes depreciation recapture income, discussed earlier.)

The gain allocated to the unrealized receivables and the inventory cannot be reported under the installment method. The gain allocated to the other assets can be reported under the installment method.

For more information on the treatment of unrealized receivables and inventory, see Publication 541.

taxmap/pubs/p537-002.htm#TXMP5118a2a8 Example — Sale of a Business(p9)

Example — Sale of a Business

On June 4, 2007, you sold the machine shop you had operated since 1999. You received a $100,000 down payment and the buyer's note for $120,000. The note payments are $15,000 each, plus 10% interest, due every July 1 and January 1, beginning in 2008. The total selling price is $220,000. Your selling expenses are $11,000.

The selling expenses are divided among all the assets sold, including inventory. Your selling expense for each asset is 5% of the asset's selling price ($11,000 selling expense ÷ $220,000 total selling price).

The FMV, adjusted basis and depreciation claimed on each asset sold are as follows:

		Depre- ciation	Adjusted
Asset	FMV	Claimed	Basis
Inventory	$ 10,000	-0-	$ 8,000
Land	42,000	-0-	15,000
Building	48,000	$9,000	36,000
Machine A	71,000	$27,200	63,800
Machine B	24,000	12,960	22,040
Truck	6,500	18,624	5,376
	$201,500	$67,784	$150,216

Under the residual method, you allocate the selling price to each of the assets based on their FMV ($201,500). The remaining $18,500 ($220,000 - $201,500) is allocated to your section 197 intangible, goodwill.

The assets included in the sale, their selling prices based on their FMVs, the selling expense allocated to each asset, the adjusted basis, and the gain for each asset are shown in the following chart.

	Sale Price	Sale Exp.	Adj. Basis	Gain
Inventory	$ 10,000	$ 500	$ 8,000	$ 1,500
Land	42,000	2,100	15,000	24,900
Building	48,000	2,400	36,000	9,600
Mch. A	71,000	3,550	63,800	3,650
Mch. B	24,000	1,200	22,040	760
Truck	6,500	325	5,376	799
Goodwill	18,500	925	-0-	17,575
	$220,000	$11,000	$150,216	$58,784

The building was acquired in 1999, the year the business began, and it is section 1250 property. There is no depreciation recapture income because the building was depreciated using the straight line method.

All gain on the truck, machine A, and machine B is depreciation recapture income since it is the lesser of the depreciation claimed or the gain on the sale. Figure depreciation recapture in Part III of Form 4797.

The total depreciation recapture income reported in Part II of Form 4797 is $5,209. This consists of $3,650 on machine A, $799 on the truck, and $760 on machine B (the gain on each item because it was less than the depreciation claimed). These gains are reported in full in the year of sale and are not included in the installment sale computation.

Of the $220,000 total selling price, the $10,000 for inventory assets cannot be reported using the installment method. The selling prices of the truck and machines are also removed from the total selling price because gain on these items is reported in full in the year of sale.

The selling price equals the contract price for the installment sale ($108,500). The assets included in the installment sale, their selling price, and their installment sale bases are shown in the following chart.

	Selling Price	Install- ment Sale Basis	Gross Profit
Land	$ 42,000	$17,100	$24,900
Building	48,000	38,400	9,600
Goodwill	18,500	925	17,575
Total	$108,500	$56,425	$52,075

The gross profit percentage (gross profit ÷ contract price) for the installment sale is 48% ($52,075 ÷ $108,500). The gross profit percentage for each asset is figured as follows: