Installment sale tax treatment question

[Cheryl C.]

I've got a property that I've owned a long time and it's been depreciated down to practically nothing (condo, so no land). I'm selling and I have a buyer if I will hold the paper. Say I get 20%dp, interest only and a balloon in 5yrs, what are my tax consequences on an installment? I gather the 20% is taxed this year and the interest each year is ordinary income. Would the 20% down be taxed as a recapture of depreciation? Will they impute other gains during the 5yr interest only period?
I'd rather do a 1031, can I do this in conjunction with an installment sale? We have alot of income this year. Thanks for any clarification. I've never sold on installment.

[Bill Gulley]

I have always treated any down payment and principal received toward by costs first-dep. Say my dep amt was 40K, until I received the 40K there would be no gain. The interest earned on the obligation is interest income from day one.
Then I pay the gain as it is received. Good luck

[Jon Holdman]

Wait a second. If you have a property that starts with a basis of $100K, and then take $75K in depreciation, your basis is $25K. If you sell outright for $150K, you have a $125K gain. $75K of it is subject to depreciation recapture tax (currently your ordinary income rate, caped at 25%) and the rest, $50K, is subject to capital gains tax (15%, assuming long term).

I think you're saying, Bill, that in my example, you would apply any money received to the basis first. So, if the down payment was less than $25K, you would pay no tax on that. If it was, say, $40K, then $25K of that would be to the basis and then $15K would be taxable gain. I think you have to apply that to depreciation recovery first.

To continue the example to Cheryls situation, the interest payments would be taxable ordinary income. Then the balloon ($150K - $40K = $110K) would be all gain. Of that $110K, $60K is subject to depreciation recapture and the remaining $50K is subject to capital gains.

Not a CPA, haven't dealt with this. Consult your CPA.

[Bill Gulley]

Yes Jon, I see I wasn't too clear. The basis is my cost of acquisition and holding costs plus improvements less the amount depreciated, that amount at the date of sale would be my basis. Payments receivied above that would be taxable, including the amounts I had depreciated in prior years and interest earned from the obligation over the entire term.

[Dave Toelkes]

Just to clarify. In an installment sale, the principal received (including downpayment) is first applied to unrecaptured depreciation. Once all the depreciation has been "recaptured", any subsequent receipts of principal are prorated between basis and profit.

The amount applied to basis is not taxable while the amount applied to profit is taxed as capital gain in the year it is received.

[George P.]

Jon, thanks for the thorough response

[Jon Holdman]

Based on Dave T's response, though, mine is incorrect. To use the same example: sales price of $150K, basis of $25K, depreciation of $75K, down payment of $40K and then interest only payments and a balloon of $110K, its taxable like this:

The $40K down payment is fully subject to depreciation recapture tax.
All the interest payments are taxable as ordinary income.
The $110K balloon payment splits out as:
- $35K ($75K-40K in unrecaptured depreciation) subject to depreciation recapture tax.
- $25K (basis) not subject to tax
- $50K (gain) subject to capital gains tax.

Again, consult your CPA.

[Account Closed]

Take your accumulated depreciation on the property and the principal collected until you collect what you had previously depreciated is taxed as a Section 1231 Recapture. The interest only payments are ordinary interest income, and finally the balloon payment will be split into recovering your basis, capital gains, and any interest income owed to you. I've seen several clients do these types of sales. If you end up having to reposses the property before the installment sale is completed...well thats a whole different animal.

Example: $100k property with Accumulated Depreciation of $50k, and original basis of $75k. Sales price of $125k.

Y1: $40k downpayment is taxed as 1231 recapture

Y2: Interest Income

Y3: Interest Income

Y4: Interest Income

Y5: Balloon Payment of $85k = $10k section 1231 recap, $25k basis recovery ($75k orig basis reduced $50k by Accum. Deprecation), $50k capital gains. (I'm assuming all interest payments were current to you)

To save yourself the heartache of knowing if you did it right, and to make your life easier in the event the installment sale does not go as planned, please consult with your CPA.

Hope this helps.

[Joe Wilson]

Jon, Daniel & everyone.....please. You are wrong. The property is not §1231 property. It is §1250 property which recapture is Accelerated Depreciation over Straight line depreciation and there hasn't been Accel Depreciation on real property since 1986 so THERE IS NO DEPRECIATION RECAPTURE OR ORDINARY GAIN to recognize.

Finance guy, you can NOT arbitrarily allocate all of your receipts to basis first on an installment sale. You will get busted by the IRS and get hit with heavy penalties. You must calculate your gross profit % and apply that ratio to the amount of cash (principle) you receive to determine your gain for that tax period.

When they say they aren't CPAs then don't listen to what they say when it comes to taxes. I don't tell people how to do a 5 way bypass even though it is a cookie cutter surgery now a days and there may be a book on it or a software program that might explain how to do it. Listen to CPAs.....good tax CPAs.

1031 transactions have very strict rules to follow. Need to read up on those each time I come across one to keep up to speed on it.

[Jon Holdman]

So, Joe, please explain how this does work. No 1031 exchange, no accelerated depreciation. Sale price of $150K, straight line depreciation of $75K, original basis of $100K, a down payment of $50K, interest only payments and a balloon of $110K. Please explain how this is taxed.

You say there is no depreciation recapture tax or ordinary gain. I beg to differ. There is no accelerated depreciation recapture tax, and hasn't been for a long time, but there certainly is depreciation recapture tax on the portion of the gain up to depreciation taken or allowed. And, yes, I HAVE discussed this very topic with my CPA, who is very experienced with real estate, after another poster claimed, some years ago, there was no depreciation recapture tax.

Are you saying the interest is NOT taxable as ordinary income? I don't believe that, either. If that's not taxable as ordinary income, how is it taxed?

[Joe Wilson]

Jon,
First, I did not mention interest. I was only speaking about the gain on the sale of the real property, §1250 property, which is the condo.

Interest on the note is ordinary income and does not compute in the gain calculation of any asset that is sold nor does it compute in the depreciation recapture rules, if applicable.

Second, you must be confused with §1245 & §1250 property. §1245 property recapture is all depreciation claimed. There will be ordinary recapture, no question, if you allocate any proceeds that are higher than tax basis. §1250 property recapture is the extent of the excess of depreciation over the depreciation that would have been available under the straight-line method. "Residential rental property and nonresidential real property that is placed in service after 1986 and is subject to the MACRS rules must be depreciated under the straight-line MACRS method. Therefore, recapture of depreciation on such property is not required because no depreciation in excess of straight-line could have been taken." 2011 USMTG ¶1780

In your scenerio, Cost $100,000 and depreciated $75,000 so the basis is $25,000. You agree to a sale price of $150,000 and your gain will be $125,000.

Installment sale calculated like so: 125,000/150,000 = 0.8333 profit ratio. You use this to determine your gain on the proceeds you receive over the course of the payments.

Year 1: $50,000 received: 50,000 * 0.8333 = $41,667 Gain recognized (as discussed and proven above - no ordinary recapture)

Years 2 - X: Interest received on the note outstanding is taxed at ordinary rates, but this is not gain on the sale of the property and was never part of my original posting about the gain on the sale of the condo.

Year X: There is $100,000 note left to be repaid and in your scenerio $110,000 is paid. The first $100,000 will be applied to the installment note gain ratio of .8333 so that is $83,333 worth of CAPITAL gain to recognize and then the additional $10,000 amount of extra payment is all gain and would be added to the $83,333 for a total of $93,333. Again, §1250 property does not have Ordinary Recapture so there is no Ordinary Gain to recognize.

In year X, when you receive or change the agreed amount to be paid, you theoretically should go back to amend the original tax filing to adjust the gain ratio and recognize the proper gain in the first year and pay any interest and penalties, if due and recalculate the proper gain in the final year. But there are other factors that would come into play like statute of limitations depending on how long the installment agreement lasted for and then there's substance over form issue that we would just correct in the final year of payment. If you just made a typo, then forget everything I just wrote about in this last paragraph and follow the gain of $83,333.

Again, no Ordinary Recapture on the sale of ANY §1250 property which is buildings and their structural components, and all tangible real property, IE-condo, apartment, home or commercial building. Don't confuse Unrecaptured Gain which is tax at capital gains rates at a maximum of 25%.

I have a ton of experience as well and worked at a BIG 4 firm in the real estate department. I ran a commercial rental real estate engagement that comprisd of 156 consolidated companies (not including the disregarded SMLLCs) and was on the workflow efficiency team to create standardized Excel workbooks for Residential Real Estate Partnerships for all of the offices of the firm to utilize when preparing partnership returns. It helped tremendously when we had to report thousands of GP K-1s to the Upreit partnership that would flow into the REIT tax return.

I am not saying that I am better than anyone or perfect, but I do feel quite confident in saying that I am correct in this little discussion of ours regarding the character of gain recognized in the sale of a condo.

Regards.

[Jon Holdman]

Thanks for that reply, but I'm still a little confused.

I munged the example. I meant to say the down payment was $40K, not $50K. Then the balloon should be $110K for a total of $150K which is the agreed upon price.

I see how you get the 0.8333 factor. With the $40K down, that gives $33,333.33 in taxable gain when the property is first sold. With the $110K balloon, that gives another $91,666.66 in gain at the end. Total of $125K in gain.

How is that gain taxed? Is it all taxed at the long term capital gains rate, assuming it was held at least a year?

[Bill Gulley]

Joe and Dave thanks! You're right and I made a mistake! That's three this year! (LOL) I did allocate notes as I stated but not installment sales. And Dave, I think Joe cover the treatment of accepting a deed-in-lieu of foreclosure in his explanation of Year X. The first one is a surprise, paying taxes on money you never received!

I have a friend who is a real estate developer and a CPA, in the years he did my taxes and school was a long time ago, so I don't claim any expertise in taxation! #3!

[Joe Wilson]

Finance - I don't understand what you are writing there. You seem all over the place. You want me to cover the treatment of accepting a deed-in-lieu in year X? Or is that another thread?

At any rate, you should not pay taxes on money that you have never received which is why you determine a profit ratio and recognize a portion of the gain as you recieve money.

Jon - The gain will all be capital. There is Unrecaptured §1250 Depreciation gain which is taxed at the maximum of 25% rate.

Depending on your filing status, the first $75,000 is taxed at the lower tax rates of 10% & 15% and then 25%. Then the amount above the 1250 Unrecap is taxed at the maximum capital gains rate of 15%. All of this gain is taxed at capital gains rates of some form.

If you have Ordinary income in addition, then that income will use up the lower ordinary tax rates first and more of the Unrecap 1250 gain will be pushed up to the 25% Cap tax, but never more than 25% capital gains rate.

None of the gain on the sale of the condo is ordinary in nature.

[Account Closed]

Joe, you are correct, I always get the numbers 1231 and 1250 flip flopped on which is real property and which is assets used in business. I should have looked it up.

Looking back at my original post, I'm not even sure where I came up with that. What's crazy is I worked about 4 or 5 installment sales for a client who was getting the properties through tax lien foreclosures this tax season and selling them on installments and I just pulled up the files making sure I did them correctly and I did them exactly as you outlined. Scary! Not sure where the above post came from...I must have been working on something else and my mind was occupied when I wrote that.

Being down here in hurricane Katrina land, there are issues with depreciation recapture if the property was qualified Go Zone property and the 50% bonus depreciation was taken in year one. If you're not familiar, Go Zone was a stimulus program put in place by Bush to try to attract money to the Mississippi Gulf Coast after Katrina. If you built and placed in service a rental unit that met certain requirements, you could take 50% of the cost off as first year depreciation.

[Dave Toelkes]

Originally posted by Joe Wilson:

§1250 property does not have Ordinary Recapture so there is no Ordinary Gain to recognize.

Under rules contained in the current Internal Revenue Code, real property is not subject to depreciation recapture.

However, under IRC § 1(h)(1)(D), real property that has experienced a gain after providing a taxpayer with a depreciation deduction is subject to a 25% tax rate--10% higher than the usual rate for a capital gain. This higher tax rate serves as a rough surrogate for depreciation recapture.

Any principal received from the installment sale is first used to offset the "unrecaptured depreciation" and is taxed as ordinary income with the tax rate capped at 25%.

Once the unrecaptured depreciation has been fully "recovered", the tax basis is recalculated to add the depreciation back to the adjusted basis (see IRC § 1245) then the profit ratio is computed to allocate subsequent receipts of principal between profit and return of basis.

Just how I see it.

[Mark Wagner]

Depreciation is recaptured in full in year of sale, irrespective of what the buyer pays down or in payments. There is no "treated first as..." concept here. Fully recaptured in the year of sale. Period.

Capital gain, if any, can be treated as installment gain. This is where the down payment/payments are used to calculate the gain in any given year.

Capital loss, if any, is taken in year of sale.

Interest income is ordinary income on Sch B (or sometimes Sch C, depending on what else you have going on).

Everything else in here is only confusing the issue.