Contents
15a.453-0.453-0 Taxable years affected.#
(a)In general. Except as otherwise provided, the provisions of § 15a.453-1 (a) through (e) generally apply to installment method reporting for sales of real property and casual sales of personal property occurring after October 19, 1980. See 26 CFR § 1.453-1 (rev. as of April 1, 1980) for the provisions relating to installment method reporting for sales of real property and casual sales before October 20, 1980 (except as provided in paragraph (b) of this section) and for provisions relating to installment sales by dealers in personal property occurring before October 20, 1980.
(b)Certain limitations. The provisions of prior law (section 453(b) of the Internal Revenue Code of 1954, in effect as of October 18, 1980) which required that the buyer receive no more than 30 percent of the selling price in the taxable year of the installment sale and that at least two payments be received shall not apply to reporting for casual installment sales of personal property and installment sales of real property occurring in a taxable year ending after October 19, 1980.
15a.453-1.453-1 Installment method reporting for sales of real property and casual sales of personal property.#
(a)In general. Unless the taxpayer otherwise elects in the manner prescribed in paragraph (d)(3) of this section, income from a sale of real property or a casual sale of personal property, where any payment is to be received in a taxable year after the year of sale, is to be reported on the installment method.
(b)Installment sale defined—(1) In general. The term “installment sale” means a disposition of property (except as provided in paragraph (b)(4) of this section) where at least one payment is to be received after the close of the taxable year in which the disposition occurs. The term “installment sale” includes dispositions from which payment is to be received in a lump sum in a taxable year subsequent to the year of sale. For purposes of this paragraph, the taxable year in which payments are to be received is to be determined without regard to section 453(e) (relating to related party sales), section (f)(3) (relating to the definition of a “payment”) and section (g) (relating to sales of depreciable property to a spouse or 80-percent-owned entity).
(2)Installment method defined—(i) In general. Under the installment method, the amount of any payment which is income to the taxpayer is that portion of the installment payment received in that year which the gross profit realized or to be realized bears to the total contract price (the “gross profit ratio”). See paragraph (c) of this section for rules describing installment method reporting of contingent payment sales.
(e)Purchaser evidences of indebtedness payable on demand or readily tradable—(1) Treatment as payment—(i) In general. A bond or other evidence of indebtedness (hereinafter in this section referred to as an obligation) issued by any person and payable on demand shall be treated as a payment in the year received, not as installment obligations payable in future years. In addition, an obligation issued by a corporation or a government or political subdivision thereof—
(A)With interest coupons attached (whether or not the obligation is readily tradable in an established securities market),
(B)In registered form (other than an obligation issued in registered form which the taxpayer establishes will not be readily tradable in an established securities market), or
(C)In any other form designed to render such obligation readily tradable in an established securities market, shall be treated as a payment in the year received, not as an installment obligation payable in future years. For purposes of this paragraph, an obligation is to be considered in registered form if it is registered as to principal, interest, or both and if its transfer must be effected by the surrender of the old instrument and either the reissuance by the corporation of the old instrument to the new holder or the issuance by the corporation of a new instrument to the new holder.
(ii)Readily tradable in an established securities market. An obligation will be treated as readily tradable in an established securities market if—
(2)Amounts treated as payment. If under paragraph (e)(1) of this section an obligation is treated as a payment in the year received, the amount realized by reason of such payment shall be determined in accordance with the taxpayer's method of accounting. If the taxpayer uses the cash receipts and disbursements method of accounting, the amount realized on such payment is the fair market value of the obligation. If the taxpayer uses the accrual method of accounting, the amount realized on receipt of an obligation payable on demand is the face amount of the obligation, and the amount realized on receipt of an obligation with coupons attached or a readily tradable obligation is the stated redemption price at maturity less any original issue discount (as defined in section 1232(b)(1)) or, if there is no original issue discount, the amount realized is the stated redemption price at maturity appropriately discounted to reflect total unstated interest (as defined in section 483(b)), if any.
(3)Payable on demand. An obligation shall be treated as payable on demand only if the obligation is treated as payable on demand under applicable state or local law.
(4)Designed to be readily tradable in an established securities market—(i) In general. Obligations issued by a corporation or government or political subdivision thereof will be deemed to be in a form designed to render such obligations readily tradable in an established securities market if—
(A)Steps necessary to create a market for them are taken at the time of issuance (or later, if taken pursuant to an expressed or implied agreement or understanding which existed at the time of issuance),
(B)If they are treated as readily tradable in an established securities market under paragraph (e)(4)(ii) of this section, or
(C)If they are convertible obligations to which paragraph (e)(5) of this section applies.
(A)The obligation is part of an issue or series of issues which are readily tradable in an established securities market, or
(B)The corporation issuing the obligation has other obligations of a comparable character which are described in paragraph (e)(4)(ii)(A) of this section. For purposes of paragraph (e)(4)(ii)(B) of this section, the determination as to whether there exist obligations of a comparable character depends upon the particular facts and circumstances. Factors to be considered in making such determination include, but are not limited to, substantial similarity with respect to the presence and nature of security for the obligation, the number of obligations issued (or to be issued), the number of holders of such obligation, the principal amount of the obligation, and other relevant factors.
(ii)Substantial discount rule. Whether an obligation is convertible at a substantial discount depends upon the particular facts and circumstances. A substantial discount shall be considered to exist if at the time the convertible obligation is issued, the fair market value of the stock or obligation into which the obligation is convertible is less than 80 percent of the fair market value of the obligation (determined by taking into account all relevant factors, including proper discount to reflect the fact that the convertible obligation is not readily tradable in an established securities market and any additional consideration required to be paid by the taxpayer). Also, if a privilege to convert an obligation into stock or an obligation which is readily tradable in an established securities market may not be exercised within a period of one year from the date the obligation is issued, a substantial discount shall be considered to exist.
(6)Effective date. The provisions of this paragraph (e) shall apply to sales or other dispositions occurring after May 27, 1969, which are not made pursuant to a binding written contract entered into on or before such date. No inference shall be drawn from this section as to any questions of law concerning the application of section 453 to sales or other dispositions occurring on or before May 27, 1969.
(iii)Readily tradable. For purposes of paragraph (e)(4)(ii)(A) of this section, an obligation shall be treated as readily tradable if it is regularly quoted by brokers or dealers making a market in such obligation or is part of an issue a portion of which is in fact traded in an established securities market.
(iv)Established securities market. For purposes of this paragraph, the term “established securities market” includes (A) a national securities exchange which is registered under section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f), (B) an exchange which is exempted from registration under section 5 of the Securities Exchange Act of 1934 (15 U.S.C. 78e) because of the limited volume of transactions, and (c) any over-the-counter market. For purposes of this (iv), an over-the-counter market is reflected by the existence of an interdealer quotation system. An interdealer quotation system is any system of general circulation to brokers and dealers which regularly disseminates quotations of obligations by identified brokers or dealers, other than a quotation sheet prepared and distributed by a broker or dealer in the regular course of business and containing only quotations of such broker or dealer.
(v)Examples. The rules stated in this paragraph may be illustrated by the following examples: Example (1).On June 1, 1982, 25 individuals owning equal interests in a tract of land with a fair market value of $1 million sell the land to corporation Y. The $1 million sales price is represented by 25 bonds issued by Y, each having a face value of $40,000. The bonds are not in registered form and do not have interest coupons attached, and, in addition, are payable in 120 equal installments, each due on the first business day of each month. In addition, the bonds are negotiable and may be assigned by the holder to any other person. However, the bonds are not quoted by any brokers or dealers who deal in corporate bonds, and, furthermore, there are no comparable obligations of Y (determined with reference to the characteristics set forth in paragraph (e)(2) of this section) which are so quoted. Therefore, the bonds are not treated as readily tradable in an established securities market. In addition, under the particular facts and circumstances stated, the bonds will not be considered to be in a form designed to render them readily tradable in an established securities market. The receipt of such bonds by the holder is not treated as a payment for purposes of section 453(f)(4), notwithstanding that they are freely assignable. Example (2).On April 1, 1981, corporation M purchases in a casual sale of personal property a fleet of trucks from corporation N in exchange for M's negotiable notes, not in registered form and without coupons attached. The M notes are comparable to earlier notes issued by M, which notes are quoted in the Eastern Bond section of the National Daily Quotation Sheet, which is an interdealer quotation system. Both issues of notes are unsecured, held by more than 100 holders, have a maturity date of more than 5 years, and were issued for a comparable principal amount. On the basis of these similar characteristics it appears that the latest notes will also be readily tradable. Since an interdealer system reflects an over-the-counter market, the earlier notes are treated as readily tradable in an established securities market. Since the later notes are obligations comparable to the earlier ones, which are treated as readily tradable in an established securities market, the later notes are also treated as readily tradable in an established securities market (whether or not such notes are actually traded).
(5)Special rule for convertible securities—(i) General rule. If an obligation contains a right whereby the holder of such obligation may convert it directly or indirectly into another obligation which would be treated as a payment under paragraph (e)(1) of this section or may convert it directly or indirectly into stock which would be treated as readily tradable or designed to be readily tradable in an established securities market under paragraph (e)(4) of this section, the convertible obligation shall be considered to be in a form designed to render such obligation readily tradable in an established securities market unless such obligation is convertible only at a substantial discount. In determining whether the stock or obligation into which an obligation is convertible is readily tradable or designed to be readily tradable in an established securities market, the rules stated in paragraph (e)(4) of this section shall apply, and for purposes of such paragraph (e)(4) if such obligation is convertible into stock then the term “stock” shall be substituted for the term “obligation” wherever it appears in such paragraph (e)(4).
(c)Contingent payment sales—(1) In general. Unless the taxpayer otherwise elects in the manner prescribed in paragraph (d)(3) of this section, contingent payment sales are to be reported on the installment method. As used in this section, the term “contingent payment sale” means a sale or other disposition of property in which the aggregate selling price cannot be determined by the close of the taxable year in which such sale or other disposition occurs. The term “contingent payment sale” does not include transactions with respect to which the installment obligation represents, under applicable principles of tax law, a retained interest in the property which is the subject of the transaction, an interest in a joint venture or a partnership, an equity interest in a corporation or similar transactions, regardless of the existence of a stated maximum selling price or a fixed payment term. See paragraph (c)(8) of this section, describing the extent to which the regulations under section 385 apply to the determination of whether an installment obligation represents an equity interest in a corporation. This paragraph prescribes the rules to be applied in allocating the taxpayer's basis (including selling expenses except for selling expenses of dealers in real estate) to payments received and to be received in a contingent payment sale. The rules are designed appropriately to distinguish contingent payment sales for which a maximum selling price is determinable, sales for which a maximum selling price is not determinable but the time over which payments will be received is determinable, and sales for which neither a maximum selling price nor a definite payment term is determinable. In addition, rules are prescribed under which, in appropriate circumstances, the taxpayer will be permitted to recover basis under an income forecast computation.
(2)Stated maximum selling price—(i) In general. (A) contingent payment sale will be treated as having a stated maximum selling price if, under the terms of the agreement, the maximum amount of sale proceeds that may be received by the taxpayer can be determined as of the end of the taxable year in which the sale or other disposition occurs. The stated maximum selling price shall be determined by assuming that all of the contingencies contemplated by the agreement are met or otherwise resolved in a manner that will maximize the selling price and accelerate payments to the earliest date or dates permitted under the agreement. Except as provided in paragraph (c)(2)(ii) and (7) of this section (relating to certain payment recomputations), the taxpayer's basis shall be allocated to payments received and to be received under a stated maximum selling price agreement by treating the stated maximum selling price as the selling price for purposes of paragraph (b) of this section. The stated maximum selling price, as initially determined, shall thereafter be treated as the selling price unless and until that maximum amount is reduced, whether pursuant to the terms of the original agreement, by subsequent amendment, by application of the payment recharacterization rule (discribed in paragraph (c)(2)(ii) of this section), or by a subsequent supervening event such as bankruptcy of the obligor. When the maximum amount is subsequently reduced, the gross profit ratio will be recomputed with respect to payments received in or after the taxable year in which an event requiring reduction occurs. If, however, application of the foregoing rules in a particular case would substantially and inappropriately accelerate or defer recovery of the taxpayer's basis, a special rule will apply. See paragraph (c)(7) of this section.
(B)The following examples illustrate the provisions of paragraph (e)(2)(i) of this section. In each example, it is assumed that application of the rules illustrated will not substantially and inappropriately defer or accelerate recovery of the taxpayer's basis. Example (1).A sells all of the stock of X corporation to B for $100,000 payable at closing plus an amount equal to 5% of the net profits of X for each of the next nine years, the contingent payments to be made annually together with adequate stated interest. The agreement provides that the maximum amount A may receive, inclusive of the $100,000 down payment but exclusive of interest, shall be $2,000,000. A's basis in the stock of X inclusive of selling expenses, is $200,000. Selling price and contract price are considered to be $2,000,000. Gross profit is $1,800,000, and the gross profit ratio is 9/10 ($1,800,000/$2,000,000). Accordingly, of the $100,000 received by A in the year of sale, $90,000 is reportable as gain attributable to the sale and $10,000 is recovery of basis. Example (2).C owns Blackacre which is encumbered by a long-standing mortgage of $100,000. On January 15, 1981, C sells Blackacre to D under the following payment arrangement: $100,000 in cash on closing; nine equal annual installment payments of $100,000 commencing January 15, 1982; and nine annual payments (the first to be made on March 30, 1982) equal to 5% of the gross annual rental receipts from Blackacre generated during the preceding calendar year. The agreement provides that each deferred payment shall be accompanied by a payment of interest calculated at the rate of 12% per annum and that the maximum amount payable to C under the agreement (exclusive of interest) shall be $2,100,000. The agreement also specifies that D will assume the long-standing mortgage. C's basis (inclusive of selling expenses) in Blackacre is $300,000. Accordingly, selling price is $2,100,000 and contract price is $2,000,000 (selling price of $2,100,000 less the $100,000 mortgage). The gross profit ratio is 9/10 (gross profit of $1,800,000 divided by $2,000,000 contract price). Of the $100,000 cash payment received by C in 1981, $90,000 is gain attributable to the sale of Blackacre and $10,000 is recovery of basis.
(d)Election not to report an installment sale on the installment method—(1) In general. An installment sale is to be reported on the installment method unless the taxpayer elects otherwise in accordance with the rules set forth in paragraph (d)(3) of this section.
(2)Treatment of an installment sale when a taxpayer elects not to report on the installment method—(i) In general. A taxpayer who elects not to report an installment sale on the installment method must recognize gain on the sale in accordance with the taxpayer's method of accounting. The fair market value of an installment obligation shall be determined in accordance with paragraph (d)(2) (ii) and (iii) of this section. In making such determination, any provision of contract or local law restricting the transferability of the installment obligation shall be disregarded. Receipt of an installment obligation shall be treated as a receipt of property, in an amount equal to the fair market value of the installment obligation, whether or not such obligation is the equivalent of cash. An installment obligation is considered to be property and is subject to valuation, as provided in paragraph (d)(2) (ii) and (iii) of this section, without regard to whether the obligation is embodied in a note, an executory contract, or any other instrument, or is an oral promise enforceable under local law.
(ii)Election made after the due date. Elections after the time specified in paragraph (d)(3)(i) of this section will be permitted only in those rare circumstances when the Internal Revenue Service concludes that the taxpayer had good cause for failing to make a timely election. A recharacterization of a transaction as a sale in a taxable year subsequent to the taxable year in which the transaction occurred (e.g., a transaction initially reported as a lease later is determined to have been an installment sale) will not justify a late election. No conditional elections will be permitted. For a special transitional rule relating to certain taxable years for which a return is filed prior to February 19, 1981, see paragraph (d)(5) of this section.
(4)Revoking an election. Generally, an election made under paragraph (d)(1) is irrevocable. An election may be revoked only with the consent of the Internal Revenue Service. A revocation is retroactive. A revocation will not be permitted when one of its purposes is the avoidance of Federal income taxes, or when the taxable year in which any payment was received has closed. For a special transitional rule relating to certain taxable years for which a return is filed prior to February 19, 1981, see paragraph (d)(5) of this section.
(5)Transitional rules. The following transitional rules shall apply with respect to any contingent payment sale made after October 19, 1980 in a taxable year, ending after that date, for which the taxpayer has filed a federal income tax return prior to February 19, 1981. If in such tax return the taxpayer has treated the contingent payment sale under the installment method, consent of the Internal Revenue Service to a late election by the taxpayer not to report the transaction on the installment method will generally be granted if the request for election out of installment method treatment is filed by May 5, 1981. If in such tax return the taxpayer has elected not to report the contingent payment sale under the installment method, consent of the Service to revocation of the election by the taxpayer will generally be granted if the request for revocation is filed by May 5, 1981.
(6)Income forecast method for basis recovery—(i) In general. The rules for ratable recovery of basis set forth in paragraph (c) (2) through (4) of this section focus on the payment terms of the contingent selling price agreement. Except to the extent contemplated by paragraph (c)(7) of this section (relating to a special rule to prevent substantial distortion of basis recovery), the nature and productivity of the property sold is not independently relevant to the basis to be recovered in any payment year. The special rule for an income forecast method of basis recovery set forth in paragraph (c)(6) of this section recognizes that there are cases in which failure to take account of the nature or productivity of the property sold may be expected to result in distortion of the taxpayer's income over time. Specifically, when the property sold is depreciable property of a type normally eligible for depreciation on the income forecast method, or is depletable property of a type normally eligible for cost depletion in which total future production must be estimated, and payments under the contingent selling price agreement are based upon receipts or units produced by or from the property, the taxpayer's basis may appropriately be recovered by using an income forecast method.
(B)The following examples illustrate the provisions of paragraph (d)(2) of this section. Example (1).A, an accrual method taxpayer, owns all of the stock of X corporation with a basis of $20 million. On July 1, 1981, A sells the stock of X corporation to B for $60 million payable on June 15, 1992. The agreement also provides that against this fixed amount, B shall make annual prepayments (on June 15) equal to 5% of the net profits of X earned in the immediately preceding fiscal year beginning with the fiscal year ending March 31, 1982. Thus the first prepayment will be made on June 15, 1982. No stated interest is payable under the agreement and thus the unstated interest provisions of section 483 are applicable. Under section 483, no part of any payment made on June 15, 1982 (which is within one year following the July 1, 1981 sale date), will be treated as unstated interest. Under the price interest recomputation rule, it is presumed that the entire $60 million fixed amount will be paid on June 15, 1982. Accordingly, if A elects not to report the transaction on the installment method, in 1981 A must report $60 million as the amount realized on the sale and must report $40 million as gain on the sale in that year. Example (2).The facts are the same as in example (1) except that A uses the cash receipts and disbursements method of accounting. In 1981 A must report as an amount realized on the sale the fair market value of the installment obligation and must report as gain on the sale in 1981 the excess of that amount realized over A's basis of $20 million. In no event will the fair market value of the installment obligation be considered to be less than the fair market value of the stock of X. In determining the fair market value of the installment obligation, any contractual or legal restrictions on the transferability of the installment obligation, and any remote or incidental contingencies otherwise affecting the amount payable or time of payments under the installment obligation, shall be disregarded.
(iii)Contingent payment obligations. Any installment obligation which is not a fixed amount obligation (as defined in paragraph (d)(2)(ii) of this section) is a contingent payment obligation. If an installment obligation contains both a fixed amount component and a contingent payment component, the fixed amount component shall be treated under the rules of paragraph (d)(2)(ii) of this section and the contingent amount component shall be treated under the rules of this (iii). The fair market value of a contingent payment obligation shall be determined by disregarding any restrictions on transfer imposed by agreement or under local law. The fair market value of a contingent payment obligation may be ascertained from, and in no event shall be considered to be less than, the fair market value of the property sold (less the amount of any other consideration received in the sale). Only in those rare and extraordinary cases involving sales for a contingent payment obligation in which the fair market value of the obligation (determinable under the preceding sentences) cannot reasonably be ascertained will the taxpayer be entitled to assert that the transaction is “open.” Any such transaction will be carefully scrutinized to determine whether a sale in fact has taken place. A taxpayer using the cash receipts and disbursements method of accounting must report as an amount realized in the year of sale the fair market value of the contingent payment obligation. A taxpayer using the accrual method of accounting must report an amount realized in the year of sale determined in accordance with that method of accounting, but in no event less than the fair market value of the contingent payment obligation.
(3)Time and manner for making election—(i) In general. An election under paragraph (d)(1) of this section must be made on or before the due date prescribed by law (including extensions) for filing the taxpayer's return for the taxable year in which the installment sale occurs. The election must be made in the manner prescribed by the appropriate forms for the taxpayer's return for the taxable year of the sale. A taxpayer who reports an amount realized equal to the selling price including the full face amount of any installment obligation on the tax return filed for the taxable year in which the installment sale occurs will be considered to have made an effective election under paragraph (d)(1) of this section. A cash method taxpayer receiving an obligation the fair market value of which is less than the face value must make the election in the manner prescribed by appropriate instructions for the return filed for the taxable year of the sale.
(4)Exceptions. The term “installment sale” does not include, and the provisions of section 453 do not apply to, dispositions of personal property on the installment plan by a person who regularly sells or otherwise disposes of personal property on the installment plan, or to dispositions of personal property of a kind which is required to be included in the inventory of the taxpayer if on hand at the close of the taxable year. See section 453A and the regulations thereunder for rules relating to installment sales by dealers in personal property. A dealer in real property or a farmer who is not required under his method of accounting to maintain inventories may report the gain on the installment method under section 453.
(5)Examples. The following examples illustrate installment method reporting under this section: Example (1).In 1980, A, a calendar year taxpayer, sells Blackacre, an unencumbered capital asset in A's hands, to B for $100,000: $10,000 down and the remainder payable in equal annual installments over the next 9 years, together with adequate stated interest. A's basis in Blackacre, exclusive of selling expenses, is $38,000. Selling expenses paid by A are $2,000. Therefore, the gross profit is $60,000 ($100,000 selling price−$40,000 basis inclusive of selling expenses). The gross profit ratio is 3/5 (gross profit of $60,000 divided by $100,000 contract price). Accordingly, $6,000 3/5 of $10,000) of each $10,000 payment received is gain attributable to the sale and $4,000 ($10,000−$6,000) is recovery of basis. The interest received in addition to principal is ordinary income to A. Example (2).C sells Whiteacre to D for a selling price of $160,000. Whiteacre is encumbered by a longstanding mortgage in the principal amount of $60,000. D will assume or take subject to the $60,000 mortgage and pay the remaining $100,000 in 10 equal annual installments together with adequate stated interest. C's basis in Whiteacre is $90,000. There are no selling expenses. The contract price is $100,000, the $160,000 selling price reduced by the mortgage of $60,000 assumed or taken subject to. Gross profit is $70,000 ($160,000 selling price less C's basis of $90,000). C's gross profit ratio is 7/10 (gross profit of $70,000 divided by $100,000 contract price). Thus, $7,000 ( 7/10 of $10,000) of each $10,000 annual payment is gain attributable to the sale, and $3,000 ($10,000−$7,000) is recovery of basis. Example (3).The facts are the same as in example (2), except that C's basis in the land is $40,000. In the year of the sale C is deemed to have received payment of $20,000 ($60,000−$40,000, the amount by which the mortgage D assumed or took subject to exceeds C's basis). Since basis is fully recovered in the year of sale, the gross profit ratio is 1 ($120,000/$120,000) and C will report 100% of the $20,000 deemed payment in the year of sale and each $10,000 annual payment as gain attributable to the sale. Example (4).E sells Blackacre, an unencumbered capital gain property in E's hands, to F on January 2, 1981. F makes a cash down payment of $500,000 and issues a note to E obliging F to pay an additional $500,000 on the fifth anniversary date. The note does not require a payment of interest. In determining selling price, section 483 will apply to recharacterize as interest a portion of the $500,000 future payment. Assume that under section 483 and the applicable regulations $193,045 is treated as total unstated interest, and the selling price is $806,955 ($1 million less unstated interest). Assuming E's basis (including selling expenses) in Blackacre is $200,000) gross profit is $606,955 ($806,955−$200,000) and the gross profit ratio is 75.21547%. Accordingly, of the $500,000 cash down payment received by E in 1981, $376,077 (75.21547% of $500,000) is gain attributable to the sale and $123,923 is recovery of basis ($500,000−$376,077). Example (5).In 1982, G sells to H Blackacre, which is encumbered by a first mortgage with a principal amount of $500,000 and a second mortgage with a principal amount of $400,000, for a selling price of $2 million. G's basis in Blackacre is $700,000. Under the agreement between G and H, passage of title is deferred and H does not assume and purportedly does not take subject to either mortgage in the year of sale. H pays G $200,000 in cash and issues a wrap-around mortgage note with a principal amount of $1,800,000 bearing adequate stated interest. H is deemed to have acquired Blackacre subject to the first and second mortgages (wrapped indebtedness) totalling $900,000. The contract price is $1,300,000 (selling price of $2 million less $700,000 mortgages within the seller's basis assumed or taken subject to). Gross profit is also $1,300,000 (selling price of $2 million less $700,000 basis). Accordingly in the year of sale, the gross profit ratio is 1 ($1,300,000/$1,300,000). Payment in the year of sale is $400,000 ($200,000 cash received plus $200,000 mortgage in excess of basis ($900,000−$700,000)). Therefore, G recognizes $400,000 gain in the year of sale ($400,000 × 1). In the hands of G the wrap-around installment obligation has a basis of $900,000, equal to G's basis in Blackacre ($700,000) increased by the gain recognized by G in the year of sale ($400,000) reduced by the cash received by G in the year of sale ($200,000). G's gross profit with respect to the note is $900,000 ($1,800,000 face amount less $900,000 basis in the note) and G's contract price with respect to the note is its face amount of $1,800,000. Therefore, the gross profit ratio with respect to the note is 1/2 ($900,000/$1,800,000). Example (6).The facts are the same as example (5) except that under the terms of the agreement H assumes the $500,000 first mortgage on Blackacre. H does not assume and purportedly does not take subject to the $400,000 second mortgage on Blackacre. The wrap-around installment obligation issued by H to G has a face amount of $1,300,000. The tax results in the year of sale to G are the same as example (5) ($400,000 payment received and gain recognized). In the hands of G, basis in the wrap-around installment obligation is $400,000 ($700,000 basis in Blackacre plus $400,000 gain recognized in the year of sale minus $700,000 ($200,000 cash received and $500,000 treated as cash received as a result of H's assumption of the first mortgage)). G's gross profit with respect to the note is $900,000 ($1,300,000 face amount of the wrap-around installment obligation less $400,000 basis in that note) and G's contract price with respect to the note is its face value of $1,300,000. Therefore, the gross profit ratio with respect to the note is 9/13 ($900,000/$1,300,000). Example (7).A sells the stock of X corporation to B for a $1 million installment obligation payable in equal annual installments over the next 10 years with adequate stated interest. The installment obligation is secured by a standby letter of credit (within the meaning of paragraph (b)(3)(iii) of this section) issued by M bank. Under the agreement between B and M bank, B is required to maintain a compensating balance in an account B maintains with M bank and is required by the M bank to post additional collateral, which may include cash or a cash equivalent, with M bank. Under neither the standby letter of credit nor any other agreement or arrangement is A granted a direct lien upon or other security interest in such cash or cash equivalent collateral. Receipt of B's installment obligation secured by the standby letter of credit will not be treated as the receipt of payment by A. Example (8).The facts are the same as in example (7) except that the standby letter of credit is in the drawable sum of $600,000. To secure fully its $1 million note issued to A, B deposits in escrow $400,000 in cash and Treasury bills. Under the escrow agreement, upon default in payment of the note A may look directly to the escrowed collateral. Receipt of B's installment obligation will be treated as the receipt payment by A in the sum of $400,000.
(iv)Subsequent recomputation. A contingent payment sale may initially and properly have been reported under the normally applicable basis recovery rule and, during the term of the agreement, circumstances may show that continued reporting on the original method will substantially and inappropriately defer or accelerate recovery of the unrecovered balance of the taxpayer's basis. In this event, the special rule provided in this paragraph is applicable.
(7)Special rule to avoid substantial distortion—(i) In general. The normal basis recovery rules set forth in paragraph (c) (2) through (4) of this section may, with respect to a particular contingent payment sale, substantially and inappropriately defer or accelerate recovery of the taxpayer's basis.
(v)Examples. The following examples illustrate the application of the special rule of this paragraph. In examples (1) and (2) it is assumed that rulings consistent with paragraph (c)(7)(ii) of this section have been requested. Example (1).A owns all of the stock of X corporation with a basis of $100,000. A sells the stock of X to B for a cash down payment of $1,800,000 and B's agreement to pay A an amount equal to 1% of the net profits of X in each of the next 10 years (together with adequate stated interest). The agreement further specifies that the maximum amount that may be paid to A (exclusive of interest) shall not exceed $10 million. A is able to demonstrate that current and recent profits of X have approximated $2 million annually, and that there is no reason to anticipate a major increase in the annual profits of X during the next 10 years. One percent of $2 million annual profits is $20,000, a total of $200,000 over 10 years. Under the basis recovery rule normally applicable to a maximum contingent selling price agreement, in the year of sale A would recover $18,000 of A's total $100,000 basis, and would not recover more than a minor part of the balance until the final year under the agreement. On a $2 million selling price ($200,000 plus $1,800,000 down payment), A would recover $90,000 of A's total $100,000 basis in the year of sale and 5% of each payment ($100,000/$2,000,000) received up to a maximum of $10,000 over the next ten years. Since the rate of basis recovery under the demonstrated method is more than twice the rate under the normal rule, A will be permitted to recover $90,000 basis in the year of sale. Example (2).The facts are the same as in example (1) except that no maximum contingent selling price is stated in the agreement. Under the basis recovery rule normally applicable when no maximum amount is stated but the payment term is fixed, in the year of sale and in each subsequent year A would recover approximately $9,100 (1/11 of $100,000) of A's total basis. A will be permitted to recover $90,000 of A's total basis in the year of sale. Example (3).The facts are the same as in example (1) except that A sells the X stock to B on the following terms: 1% of the annual net profits of X in each of the next 10 years and a cash payment of $1,800,000 in the eleventh year, all payments to be made together with adequate stated interest. No maximum contingent selling price is stated. Under the normally applicable basis recovery rule, A would recover 1/11 of A's total $100,000 basis in each of the 11 payment years under the agreement. On the facts (see example (1)), A cannot demonstrate that application of the normal rule would not substantially and inappropriately accelerate recovery of A's basis. Accordingly, A will be allowed to recover only $1,000 of A's total basis in each of the 10 contingent payment years under the agreement, and will recover the $90,000 balance of A's basis in the final year in which the large fixed cash payment will be made.
(3)Payment—(i) In general. Except as provided in paragraph (e) of this section (relating to purchaser evidences of indebtedness payable on demand or readily tradable), the term “payment” does not include the receipt of evidences of indebtedness of the person acquiring the property (“installment obligation”), whether or not payment of such indebtedness is guaranteed by a third party (including a government agency). For special rules regarding the receipt of an evidence of indebtedness of a transferee of a qualified intermediary, see §§ 1.1031(b)-2(b) and 1.1031(k)-1(j)(2)(iii) of this chapter. A standby letter of credit (as defined in paragraph (b)(3)(iii) of this section) shall be treated as a third party guarantee. Payments include amounts actually or constructively received in the taxable year under an installment obligation. For a special rule regarding a transfer of property to a qualified intermediary followed by the sale of such property by the qualified intermediary, see § 1.1031(k)-1(j)(2)(ii) of this chapter. Receipt of an evidence of indebtedness which is secured directly or indirectly by cash or a cash equivalent, such as a bank certificate of deposit or a treasury note, will be treated as the receipt of payment. For a special rule regarding a transfer of property in exchange for an obligation that is secured by cash or a cash equivalent held in a qualified escrow account or a qualified trust, see § 1.1031(k)-1(j)(2)(i) of this chapter. Payment may be received in cash or other property, including foreign currency, marketable securities, and evidences or indebtedness which are payable on demand or readily tradable. However, for special rules relating to the receipt of certain property with respect to which gain is not recognized, see paragraph (f) of this section (relating to transactions described in sections 351, 356(a) and 1031). Except as provided in § 15a.453-2 of these regulations (relating to distributions of installment obligations in corporate liquidations described in section 337), payment includes receipt of an evidence of indebtedness of a person other than the person acquiring the property from the taxpayer. For purposes of determining the amount of payment received in the taxable year, the amount of qualifying indebtedness (as defined in paragraph (b)(2)(iv) of this section) assumed or taken subject to by the person acquiring the property shall be included only to the extent that it exceeds the basis of the property (determined after adjustment to reflect selling expenses). For purposes of the preceding sentence, an arrangement under which the taxpayer's liability on qualifying indebtedness is eliminated incident to the disposition (e.g., a novation) shall be treated as an assumption of the qualifying indebtedness. If the taxpayer sells property to a creditor of the taxpayer and indebtedness of the taxpayer is cancelled in consideration of the sale, such cancellation shall be treated as payment. To the extent that cancellation is not in consideration of the sale, see §§ 1.61-12(b)(1) and 1.1001-2(a)(2) relating to discharges of indebtedness. If the taxpayer sells property which is encumbered by a mortgage or other indebtedness on which the taxpayer is not personally liable, and the person acquiring the property is the obligee, the taxpayer shall be treated as having received payment in the amount of such indebtedness.
(8)Coordination with regulations under section 385—(i) In general. The regulations under section 385 do not apply to an instrument (as defined in § 1.385-3(c)) providing for a contingent payment of principal (with or without stated interest) issued in connection with a sale or other disposition of property to a corporation if § 1.385-6 (relating to proportionality) does not apply to such instrument (or to a class of instruments which includes such instrument). Thus, such instrument will be treated as stock or indebtedness under applicable principles of law without reference to the regulations under section 385.
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