Introduction

Generally, the entire gain on the disposition of property must be reported in the year the property is sold. However, if a significant portion of the price is represented by a purchase money mortgage of the buyer, the seller may receive less cash in the year of sale than the amount of tax, thus placing the seller in a liquidity bind. The installment method relieves this liquidity problem by permitting the seller to spread the income tax over the period during which payments of the sales price are received by him.

Basically, the installment method works as follows: A Gross Profit Ratio is determined at the time of sale (as reported in the Installment Sale Report), and that ratio is applied to all future payments of principal received from the buyer in order to determine the amount of Cost Recovery to be recaptured and the amount of Net Capital Gain to be reported by the seller each year (as reported in the Installment Sale Projection).

If you structure the installment sale by “wrapping” an existing loan, the wrapped loan should be entered in your Assumption Set as a normal planEASe loan (ie: with Loan Pages) using a negative Loan Amount. If you have more than one loan in your Analysis (for instance, a wrapped loan in addition to the Purchase Money loan), you can access the details of the individual loans with Detail Analysis.

Analysis of an installment sale is implemented in planEASe as the Installment Sale Analysis Model (RSA), which you may access from File/Switch Model s and choosing RSA - Installment Sale Analysis from the list. The Basic, Detail, Sensitivity, and Risk Analysis capabilities of planEASe are available with this model (Lease Analysis is not relevant here). If you have purchased the optional Reporting Extension, the Installment Sale Report and Assumptions Report are available on the Reports menu. We have built useful graphs into the Installment Sale Report and the Installment Sale Projection, which are available to you if you have purchased the optional Graphics Extension . The optional Monthly Extension will generate a monthly Installment Sale Projection, although we’re not sure how you might find this useful.

The Installment Sale Analysis Model computes a Net Present Value After Tax, which may be compared to the Net Present Value of other offers to select the most profitable offer.

In order to document the analysis here, we show the assumptions and results from the Example Installment Sale, saved on your planEASe system disk as example.rs. The Example Installment Sale details the projected sale of an Apartment Building for $635,000 on 1 January 1998. There is an existing loan with a balance of $400,000 outstanding, at 7% with 22 of the original 30 years remaining and a monthly payment of $2,974. The seller projects wrapping this loan with a $515,000 purchase money note at 9%, 15 year amortization, all due in 4 years, requiring, therefore, a $120,000 Down Payment. Seller’s transaction costs are estimated at 7%, or $44,450. The property was acquired years ago for a Net Sale Price of $525,000, and the seller has taken $300,000 of straight line Cost Recovery over the years, so the current Adjusted Basis is $225,000, with no suspended passive losses at this time. The seller is in the 35% tax bracket, and, as an individual taxpayer, is subject to a 25% Cost Recovery Recapture Rate and 15% Capital Gain Rate. The seller has a 9% before tax reinvestment (or “hurdle”) rate, and a 6% rate after tax.

Installment reporting automatically applies to a sale of real estate as long as at least one payment is received after the close of the taxable year in which the disposition occurs. However, the seller may elect not to use the method. This is done by reporting the entire gain in the year of sale. Once such an election is made, it is irrevocable without the consent of the IRS. A seller may find it more beneficial to elect out of the installment method where the seller has expiring capital losses in the year of the sale that could offset the capital gain from the sale of the real estate. Another consideration is the likelihood of future tax rate increases, because gain reported in future years will be subject to the applicable tax rates for those years rather than the tax rates in effect at the time the real estate was sold.

In February 1999, the IRS published Proposed Regulation 1.453-12 governing reporting of Installment Sales of Depreciable Realty, implementing the dual-rate treatment of Capital Gain under the Taxpayer Relief Act of 1997. This Proposed Regulation requires that the Cost Recovery Recapture portion of the gain (taxed at 25%) be paid first, before the remainder of the gain (taxed at 20%). An alternative treatment, preferred by the industry and taxpayers, is that both elements of the gain be paid ratably during the Sale Period. The Proposed Regulation provides that, “the IRS will not challenge” taxpayers using the pro-rata method for installment sales reported before the enactment of the Proposed Regulation (if indeed enacted). This RSA Model allows you to choose either reporting method (see the Tax Payment Treatment assumption on the Tax Assumptions Page).

WARNING: When structuring an Installment Sale, seller and buyer must beware of specifying an interest rate for the Purchase Money Loan lower than the “Applicable Federal Rate” published monthly by the IRS and reflecting, in general, current market yields on US securities. If the loan uses an interest rate lower than this AFR the IRS may require a portion of each payment to be treated as interest (by both buyer and seller) rather than principal. The rules for determining the amount of such imputed interest are very complicated and beyond the scope of this Installment Sale Analysis model.