Installment Sales of Multiple Assets

It is not unusual for a group of assets to be sold in which some portion of the purchaser's consideration is an installment obligation. Sec. 453 installment-sale rules apply to dispositions of property when at least one payment will be received in a year after the year of sale. The installment-sale provisions apply unless the seller elects out of the installment method. Assuming the seller intends to report the sale on the installment method, important issues arise when multiple assets are sold.

Determination of Gain and Loss

To determine the character and timing of gain or loss realized on a sale, the sales price must be allocated to the various assets sold. (If the assets constitute a trade or business under Regs. Sec. 1.1060-1(b)(2), see Regs. Sec. 1.338-6.) The allocated sales price is compared to the tax basis of each asset to determine gain or loss on the individual assets. The holding period of Sec. 1231 assets and capital assets sold are then examined to determine the proper classification of gains and losses. Any losses generated from the sale of individual assets are reported in the year of sale (Rev. Rul. 70-430). Any gain allocable to inventory is also recognized in the year of sale under Sec. 453(b)(2)(B). Taxpayers are also required to report certain recapture income in the year of sale under Sec. 453(i).

Calculation of Installment-Sale Income

Once the amount and character of gain and loss from individual assets is determined, the installment-sale gain and gross profit ratio can be computed. That portion of the sales price allocable to inventory or to loss assets sold is ignored. Similarly, the tax basis related to those assets is excluded from the calculation. Unless specifically agreed to by the parties, both the down payment and the installment receivable must be allocated among inventory, loss assets and assets eligible for installment treatment. This allocation is based on the relative fair market values (FMVs) of the respective assets or pursuant to Regs. Sec. 1.338-6 (if the assets constitute a trade or business). However, sales agreements may specifically allocate the down payment to certain assets that are sold (such as inventory); see, e.g., Monaghan, 40 TC 680 (1963), and Rev. Rul. 68-13. Although there appears to be no direct authority, presumably, for tax purposes, the down payment also can be allocated to specific assets in the case of a deemed asset acquisition under Sec. 338.

Example: A sells assets to B in exchange for a cash down payment of $1,500 and the receipt of a $3,500 installment note. The assets sold include inventory with a tax basis of $1,500, a machine with a tax basis of $500 and land with a tax basis of $1,000. The FMVs of the inventory, machine and land on the date of sale were $1,500, $1,000 and $2,500, respectively. Depreciation claimed on the machine subject to recapture totals $500. The total gain realized on the transaction includes a $500 gain on the machine and a $1,500 gain on the land. There is no gain or loss on the sale of inventory. The $500 gain from the machine is recognized in the year of sale under Sec. 453(i). The remaining gain is recognized under the installment method based on payments made each year. Based on proportionate FMVs, 70% of the cash down payment and 70% of the installment note consideration are allocated to the assets sold on the installment method. Accordingly, $450 of gain related to the sale of land is recognized in the year of sale. The remaining gain of $1,050 is deferred under the installment method. If the agreement had provided for an allocation of the down payment to inventory, the entire gain from the sale of land would have been deferred to future years.

Treatment of Liabilities Assumed

The total contract price in the gross profit ratio formula includes current and future direct payments. In addition, the total contract price includes amounts of qualifying debt assumed by the purchaser, to the extent such debt exceeds the basis of assets sold. This excess is also treated as a payment in the year of sale. Importantly, for purposes of this excess debt determination, total assets sold are compared to total debt assumed. The fact that a debt encumbering an individual asset exceeds its basis is irrelevant, based on Butler, 87 TC 734 (1986).

Summary

A sale of multiple assets on the installment method requires careful analysis to determine the proper character and timing of gain and loss recognition. Taxpayers can influence the timing of gains by including specific allocations of sales consideration in their sales documents.

From Jeff Sanders, CPA, Dallas, TX, and Lorin Luchs, CPA, J.D., LL.M., Washington, DC