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Installment sales and unrecaptured sec. 1250 gains.

The Taxpayer Relief Act of 1997 (TRA '97) made substantial changes in the taxation of capital gains of individuals. However, several capital gains issues were left unresolved. One was the interaction among the new capital gains tax rates, the installment method (Sec. 453) and the rules for taxing certain business property (Sec. 1231). The Internal Revenue Service Restructuring and Reform Act of 1998 made additional substantive changes and technical corrections to capital gains taxation, but did not address the issues of installment sales and Sec. 1231 property. Therefore, in January 1999, Treasury issued Prop. Regs. Sec. 1.453-12, designed to clarify the interaction among the provisions.

The TRA '97 created three rate categories for noncorporate long-term capital gains. The categories are identified by the maximum tax rates that apply to net gains in each category: 28%, 25% and 20/10%. Currently, the 28% rate applies to long-term gains from collectibles and to a portion of the gain on certain qualified small business stock (Sec. 1202 gains). The 25% tax rate applies to unrecaptured Sec. 1250 gains. The 20/10% tax rates apply to an individual's net capital gain, which is any long-term gain not subject to either the 28% or 25% rates. The 20% rate applies to all 20/10% gains, except those that would otherwise be eligible for the 15% regular tax rate. Further, 20/10% gains falling in the 15% regular tax rate bracket are subject to the 10% capital gains rate.

Net Sec. 1231 gains are taxed as long-term capital gains. Sec. 1231 gains can potentially be taxed at either the 25% or 20/10% rates. The TRA '97 requires that, on the sale of Sec. 1231 property, any unrecaptured Sec. 1250 gain be taxed at a maximum tax rate of 25%. The unrecaptured Sec. 1250 gain is that part of the total gain that was not recaptured but would have been recaptured had Sec. 1245 applied to the transaction. Any remaining Sec. 1231 gain is eligible for the 20/10% rates.

The installment method of reporting gains allows taxpayers to recognize gain as cash is collected over the life of a note. An exception to this rule occurs on the installment sale of Sec. 1231 property, when the ordinary income recaptured under Secs. 1245 and 1250 must be recognized in the year of sale; only the remaining Sec. 1231 gain is reported as the note is collected.

Taxpayers that used the installment method to report gain on the sale of Sec. 1250 property when both 25% and 20/10% gains existed had a problem; the TRA '97 did not specify when each type of gain must be recognized. Several alternatives were possible. One was that the 25% gain be frontloaded--all of the 25% gain would be recognized before any 20/10% gain would be reported. Another was that the 20/10% gain be frontloaded--recognized befOre any 25% gain. Still another alternative was that there be a proportionate allocation of any gain recognized between the 25% and 20/10% categories. Prop. Regs. Sec. 1.453-12 has adopted front-loading the 25% gain.

When recapturing Sec. 1231 gains as ordinary gains to the extent of Sec. 1231 losses from the preceding five years (under Sec. 1231(c)), 25% gains are recaptured before 20/10% gains. Similarly, when netting Sec. 1231 gains and losses, Sec. 1231 losses offset 25% gains before they offset 20/10% gains. Both provisions will often provide a taxpayer with the most favorable treatment, by allowing him to offset or recapture the high-tax-rate gains (25%) and pay tax on the gains at the lowest rates (20/10%).

For property sold prior to enactment of the new provisions, Prop. Regs. Sec. 1.453-12 assumes that payments attributable to unrecaptured Sec. 1250 (25%) gain were frontloaded, even though prior net Sec. 1231 gains were taxed at regular capital gain tax rates (a maximum of 28% prior to May 7,1997). Frontloading of the 25% gain also works in the taxpayer's favor here, because it maximizes the proportion of the remaining gain eligible for the lowest (20/10%) tax rates.

Prop. Regs. Sec. 1.453-12 indicates that frontloading is the only allocation method considered to be a reasonable interpretation of the rules. Nonetheless, the IRS will not challenge a pro rata allocation method for collections after the effective date of the section but before the effective date of the final regulations, if a taxpayer used the same allocation method for all payments during the period. Regardless of the allocation method employed, however, the total amount of 25% gain to be recognized on a note must be the amount that would be reported under the frontloaded method. Therefore, for any year in which the recognized 25% gain is less than what would be reported under frontloading, the 25% gain actually recognized is used to calculate the 25% gain left to be reported.

Examples 1-5 illustrate the interaction among the new capital gains rates, the installment method and the taxation of Sec. 1231 property. Prop. Regs. Sec. 1.453-12 is logical and consistent with the treatment of similar provisions, and should provide adequate guidance to practitioners.

Example 1: Residential rental property is acquired before 1987 for $700. Before disposition, $550 of accelerated depreciation is taken, leaving an adjusted basis of $150. Straight-line depreciation would have been $500. In 1999, the taxpayer disposes of the property for $1,000, to be paid over five years at $200 per year plus adequate interest. The taxpayer does not elect out of the installment method. The gain of $850, including $50 of Sec. 1250 depreciation recapture (for excess depreciation) and $500 of unrecaptured Sec. 1250 gain, would be recognized as shown below. All of the 25% gain is recognized before any of the 20/10% gain.
 1999 2000 2001 2002 2003 Total

Ordinary gain
 (Sec. 1250) $50 $0 $0 $0 $0 $50
Unrecaptured Sec. 1250
 gain (25%) 160 160 160 20 0 500
20/10% gain 0 0 0 140 160 300
 Total installment gain 160 160 160 160 160 800
Total gain recognized $210 $160 $160 $160 $160 $850
Remaining 25% gain $340 $180 $20 $0 $0


Example 2: The facts are the same as in Example 1, except that a $200 unrecaptured Sec. 1231 loss is carried over to 1999. The chart below illustrates how, in 1999, all $160 of the 25% gain is recaptured as ordinary gain and, in 2000, $40 of the 25% gain is recaptured as ordinary.
 1999 2000 2001 2002 2003

Ordinary gain(Sec. 1250) $50 $0 $0 $0 $0
Ordinary gain (Sec. 1231(c)) 160 40 0 0 0
Unrecaptured Sec. 1250
 gain (25%) 0 120 160 20 0
20/10% gain 0 0 0 140 160
 Total installment gain 0 120 160 160 160
Total gain recognized 210 $160 $160 $160 $160
Remaining 25% gain 340 $180 $20 $0 $0

 Total

Ordinary gain(Sec. 1250) $50
Ordinary gain (Sec. 1231(c)) 200
Unrecaptured Sec. 1250
 gain (25%) 300
20/10% gain 300
 Total installment gain 800
Total gain recognized $850
Remaining 25% gain


Example 3: The facts are the same as in Example 1, except that in 2001, an additional $260 Sec. 1231 loss on other property is incurred. Because the 2001 Sec. 1231 loss exceeds the Sec. 1231 gain, both are treated as ordinary under Sec. 1231(a). The 25% gain becomes ordinary and offsets $160 of the $260 loss; the remaining $100 is an ordinary loss deduction. In 2002, before any Sec. 1231 gain is recognized, there is a $100 unrecaptured Sec. 1231 loss carryover that causes an equal amount of Sec. 1231 gain to be recaptured as ordinary gain under Sec. 1231(c). First, all $20 of the remaining 25% gain is recaptured, then $80 of the 20/10% gain is recaptured, leaving a $60 gain assigned to the 20/10% category. The chart below illustrates how gain recognized as ordinary under Sec. 1231 (a) or (c) reduces the 25% gain remaining to be recognized.
 1999 2000 2001 2002 2003

Ordinary gain (Sec. 1250) $50 $0 $0 $0 $0
Ordinary gain (Sec. 1231(a)) 0 0 160 0 0
Ordinary gain (Sec. 1231(c)) 0 0 0 100 0
Unrecaptured Sec. 1250
 gain (25%) 160 160 0 0 0
20/10% gain 0 0 0 60 160
 Total installment gain 160 160 0 60 160
Total gain recognized $210 $160 $160 $160 $160
Remaining 25% gain $340 $180 $20 $0 $0

 Total

Ordinary gain(Sec. 1250) $50
Ordinary gain (Sec. 1231(a)) 160
Ordinary gain (Sec. 1231(c)) 100
Unrecaptured Sec. 1250
 gain (25%) 320
20/10% gain 220
Total installment gain 540
Total gain recognized $850
Remaining 25% gain


Example 4: The facts are the same as in Example 1, except that the sale was made in December 1995, with payments to be made in December of each year. The chart below shows that the 28% gain reported before 1997 reduces the potential unrecaptured Sec. 1250 gain to be recognized in 1997 and beyond.
 1999 2000 2001 2002 2003

Ordinary gain (Sec. 1250) $50 $0 $0 $0 $0
28% gain 160 160 0 0 0
Unrecaptured Sec. 1250
 gain (25%) 0 0 160 20 0
20/10% gain 0 0 0 140 160 300
Total installment gain 160 160 160 160 160
Total gain recognized $210 $160 $160 $160 $160
Remaining 25% gain $340 $180 $20 $0 $0

 Total

Ordinary gain (Sec. 1250) $50
28% gain 320
Unrecaptured Sec. 1250
 gain (25%) 180
20/10% gain 0
Total installment gain 800
Total gain recognized $850
Remaining 25% gain


Example 5: The facts are the same as in Example 1, except that the sale was made in December 1997. Without the benefit of the regulations, a pro rata allocation of the 25% gain was used (i.e., the same proportion of each payment was reported as 25% gain). If the regulations become final in 1999, the chart below shows the effects of the change to the frontloaded method at that time. The total amount of 25% gain to be reported over the note's term is the same as if fronfloading had always been used.
 1999 2000 2001 2002 2003

Ordinary gain (Sec. 1250) $50 $0 $0 $0 $0
Unrecaptured Sec. 1250
 gain (25%) 100 100 160 140 0
20/10% gain 60 60 0 20 160
 Total installment gain 160 160 160 160 160
Total gain recognized $210 $160 $160 $160 $160
Remaining 25% gain $400 $300 $140 $0 $0

 Total

Ordinary gain (Sec. 1250) $50
Unrecaptured Sec. 1250
 gain (25%) 500
20/10% gain 300
Total installment gain 800
Total gain recognized $850
Remaining 25% gain


FROM WAYNE M. SCHELL, CPA, PH.D., CHRISTOPHER NEWPORT UNIVERSITY, NEWPORT NEWS, VA (NOT ASSOCIATED WITH DFK INTERNATIONAL)

Philip E. Moore, CPA, MBA Brown, Dakes & Wannall, P.C. DFK International Fairfax, VA3
COPYRIGHT 1999 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:IRC section 1250
Author:Schell, Wayne M.
Publication:The Tax Adviser
Article Type:Statistical Data Included
Geographic Code:1USA
Date:Oct 1, 1999
Words:1805
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