IRC 453a and Installment Sales: What Taxpayers Need To Know
Carl E. Sera, CMT
April 18, 2023
IRC 453a is a tax provision that allows taxpayers to defer the tax on certain installment sales. This article simplifies and explains this provision in plain language for better comprehension.
In a previous article, we discussed the basics of structured installment sales as a method of deferring capital gains taxes under IRC 453a. As noted in the last article, the installment sales method can be a powerful way of deferring tax where the seller receives payments over time. However, numerous exceptions and special rules exist to report the interest on deferred tax liability under the installment method.
Please keep reading to learn more about IRC 453a and how it affects your installment sales transaction.
What is the Purpose of IRC 453A?
IRC 453A is a section of the Internal Revenue Code (Section 453A) that deals with the installment sale of property. The purpose of IRC 453A is to provide taxpayers with a way to defer the payment of taxes on the gain from the sale of property.
When a taxpayer sells property, they usually must pay taxes on the gain from the sale in the year it occurs. However, through an installment sale, the taxpayer can spread the gain over several years and pay taxes on it as they receive payments from the buyer.
IRC 453A provides rules for how installment sales are structured, including requirements for the timing and amounts of the payments, the interest charged, and the required security. These rules help ensure that installment sales are carried out fairly and equitably for both the seller and the buyer.
Overall, the purpose of IRC 453A is to provide taxpayers with a valuable tool for managing their tax liabilities when they sell property. By allowing for deferred taxes on the gain from a sale, installment sales can help minimize the financial impact of selling property and make it easier for taxpayers to manage their finances.
What are the Regulations of IRC 453A?
IRC 453A is a section of the Internal Revenue Code that deals with the installment sales of certain property. The regulations of IRC 453A are designed to ensure that sellers of such property pay taxes on the sales proceeds over time rather than in one lump sum.
Under IRC 453A, installment sales of property are subject to specific rules and restrictions. The main provisions of the regulations include the following:
1. Eligible property: The property must be either real property or personal property that is subject to depreciation, depletion, or amortization.
2. Reporting requirements: The seller must report the sale on IRS Form 6252, Installment Sale Income, and attach it to their federal income tax return for the year the sale is made.
3. Taxation: Taxes on the sale are deferred until the seller receives the installment payments. The tax liability is spread out over the term of the installment agreement, which can be up to 30 years.
4. Interest: If the seller charges interest on the installment sale, they must pay taxes on the interest income received.
5. Prepayment: If the buyer pays off the installment agreement early, the seller must recognize the remaining gain in the year of prepayment and pay taxes on it.
6. Exceptions: There are certain exceptions to the regulations of IRC 453A, such as when the sale is made to a related party or when the property is sold for $150,000 or less.
When Does IRC 453A Apply?
IRC 453A applies to any property sale for more than $150,000 that is recorded using the installment method. There are a few exceptions to this rule. 453a does not apply to the sale of personal use property, as defined in 1275(b), or property used or produced in the trade or business of farming, as described in 2032a(e).
In IRC 1275(b), personal use property is defined as any property used by the taxpayer for purposes other than their trade, business, or activity listed in IRC 212 (income-producing activity). IRC 2032A(e)(4) and (5) encompass the majority of traditional farming activities, such as growing cattle, crops, fruits, fur-bearing animals, and any agricultural or horticultural commodity.
In addition to the exception for personal use and farm property, IRC 453a does not apply to the sale of residential lots or timeshares sold by a dealer (a taxpayer who holds such property) for sale to customers in the ordinary course of the taxpayer’s trade or business. Instead, the reporting of a sale of such property by a dealer is subject to interest under IRC 453(l)(3).
To apply IRC 453a, all sales or exchanges that are part of the same transaction or any series of transactions shall be treated as a single sale or exchange.
How is the Interest Calculated Under IRC 453A?
The procedure for determining the amount of interest owed is simple and is a matter of mechanically walking through the statute.
Let's walk through it with the following example: In 2022, the taxpayer sells property with the disposition sales price of $1 million on a $100,000 basis. In exchange, the taxpayer obtains a secured promissory note. The buyer pays $100,000 on the note by the end of 2022, leaving the promissory note balance at $900,000. Assume this property is a long-term capital gain property with a tax rate of 20%.
Here’s the formula, with each component, explained below:
Interest on Deferred Tax Liability = Deferred Tax Liability x Applicable Percentage x Underpayment Rate.
First, we need to determine how to calculate the Deferred Tax Liability. This is determined by taking the amount of gain which has not been recognized at the close of the taxable year, multiplied by the maximum tax rate applicable to the taxpayer under §1 (taxpayers other than corporations) or §11 (corporations), provided however, that where the gain is long-term capital gain, the rate used is the net capital gain rate under §1.
It is important to note that the Deferred Tax Liability calculation applies to “any taxable year” and thus must be recalculated each year. In our example, we have a $900,000 gain ($1M-$900K), less the $90,000 recognized on the first $100K payment (gross profit percentage of 90%), leaving an outstanding gain of $810K, multiplied by the long-term capital rate of 20% for a Deferred Tax Liability of $162,000.
Determine the Applicable Percentage
The Applicable Percentage is computed by dividing the amount of the installment obligation outstanding at the end of the taxable year in which the obligation arose by the amount of the installment obligation outstanding at the end of the taxable year the liability arose.
It is crucial to remember that the Applicable Percentage is determined in the first year of the 453a application and remains constant in subsequent years for calculating interest payments.
We have $900k outstanding at the end of 2021, less $500k, which equals $400k, divided by the $900k outstanding total, yielding a 44% Applicable Percentage.
Find the Underpayment Rate
The interest rate is set at the Underpayment Rate in effect at the end of the taxable year as determined by IRC 6621(a). The Underpayment Rate is set quarterly by the IRS and generally announced by a Revenue Ruling. For the second quarter of 2021, the rate is 6%, so that we will use 6% in our example.
Multiplying our Deferred Tax Liability of $162,000 by our Applicable Percentage of 44% is $71,280. Applying the 6% Underpayment Rate brings the interest amount under IRC 453A to $4,277 for 2022.
As mentioned in the explanation of Deferred Tax Liability, the Deferred Tax Liability will alter over time as the balance of the installment obligation is lowered, and the taxpayer recognizes more tax. Nonetheless, the Applicable Percentage is calculated in the first year and remains constant. For specific advice, please get in touch with a competent tax advisor.
Interest on Large Installment Obligations
Under IRC 453a(c)(1), any installment obligation that is subject to IRC 453a carries with it an obligation to pay interest on the deferred tax liability (indebtedness) if any portion of the installment obligation remains outstanding at the close of the taxable year.
However, under IRC 453a(b), for purposes of this additional interest payment, at least some portion of the installment obligation must be outstanding at the close of the taxable year, and the face amount of all installment obligations held by the taxpayer and which arose during the taxable year must exceed $5 Million.
So, in short, if the taxpayer’s total installment obligations to which IRC 453a applies do not exceed $5 Million, the interest component of IRC 453a is not applicable. However, the other rules of IRC 453a remain applicable. Please contact a qualified tax advisor for proper guidance, as we always advise.
How Does IRC 453A Affect Taxation?
IRC 453A, or the Installment Sale of Property, affects taxation in several ways. This section of the Internal Revenue Code provides guidelines for the taxation of income earned from the sale of property that is paid for in installments over a period of time.
Under IRC 453A, the seller and buyer must agree on the installment sale terms, including the payment period's duration, the amount of each payment, and the interest rate charged on the outstanding balance. Once the terms have been agreed upon, the seller is only taxed on the portion of the sale price received each year rather than on the entire sale price at once.
This means that the seller can defer paying taxes on the income earned from the sale until the payments are received, providing an opportunity for potential tax savings. However, certain restrictions exist on installment sales and specific rules that must be followed to qualify for this tax deferral.
One of the most important restrictions is that installment sales cannot be used for the sale of inventory or securities traded on an established market. Additionally, the seller must be an individual, estate, or trust, and the sold property must be held for investment or use in a trade or business.
It is also important to note that if the installment sale arrangement is modified or the buyer defaults on the payments, the seller may be required to recognize the entire gain on the sale in the year of the modification or default rather than deferring the taxes.
The installment method of income tax reporting under IRC 453 is a potent tax deferral tool that can be employed in various planning structures where the taxpayer sells assets in exchange for an installment obligation, as mentioned at the beginning of this article and in my previous article.
Please note that this article is solely for educational purposes and does not replace the guidance of a professional tax consultant or serve as a legal authority. Figures and information are subject to change, and Sera Capital will not be held responsible for any discrepancy.
If you'd like to learn how to take advantage of IRC 453A, schedule your free 30-minute call with Sera Capital today.
Sera Capital is a wealth management consulting firm specializing in all aspects and all available tax-efficient exit options for business owners, real estate investors, and developers. Our team works with you and your advisors to examine all available solutions, including 1031 Exchanges, Delaware Statutory Trusts, 721 UPREITS, Opportunity Zone Funds, and Section 453 Installment Sales, including Deferred Sales Trusts and Structured Installment Sales. We have two mottos. The first is “We help landlords and business owners exit tax efficiently,” and our second is “When you want out, call us in.”
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