Planning for an installment sale involving depreciation recapture.

Facts: Harry Henderson owns an office building that he purchased as an investment in 1986. He has depreciated the building using the favorable accelerated cost recovery system (ACRS) real property rates in effect for properties purchased in 1986. In 2003, Harry decides to sell the property. He was offered $3 million, with 10% down and the balance to be paid over five years, with adequate interest. The sale details are as follows:

                                      Adjusted           Fair market
                                        basis            value (FMV)

Land                                 $  500,000          $1,000,000

Building (original cost
  $1,250,000--assumed $1,100,000
  accumulated depreciation)             150,000           2,000,000

Total                                $  650,000          $3,000,000

Issue: How does Harry report the sale?

Analysis

For installment sales involving depreciable real property, depreciation recapture in the sale year is more likely to be significant if the property is nonresidential ACRS property (acquired during 1981-1986). These properties had relatively short depreciable lives (15-19 years), and, if ACRS was used, all depreciation would be subject to recapture. For all other depreciable real property, recapture is the excess of accelerated depreciation over straight-line. If the property contains personal property, the depreciation claimed on the personal property would be subject to recapture in the sale year to the extent of the gain attributable to such property.

In Harry's case, the entire $1.1 million of depreciation claimed on the building is subject to recapture, became ACRS depreciation was used and the building is nonresidential property. Also, if the sales contract does not provide for separate payment schedules for the building and land, the cash Harry collects must be allocated between the two based on relative FMVs, according to Rev. Rul. 76-110. The installment sale gross profit percentages (GPPs) are computed as follows:

                                      Land (33.3%)     Building (66.7%)

Sales price                          $1,000,000          $2,000,000
  Less: adjusted basis and             (500,000)           (150,000)
  depreciation recapture                     --          (1,100,000)

Realized installment gain            $  500,000          $  750,000

Sales price                          $1,000,000          $2,000,000
  Less: debt purchaser assumed               --                  --

Contract price                       $1,000,000          $2,000,000
GPP (realized installment gain/
  contract price)                            50%               37.5%

The computations below reflect the gain Harry would recognize in the sale year (2003) if the sales contract remains as originally proposed:

                                      Land (33.3%)     Building (66.7%)

Cash collected in sale year
  ($300,000 downpayment)              $ 100,000          $  200,000
GPP                                          50%               37.5%
Gain to be reported under
  the installment method              $  50,000          $   75,000
Gain attributable to
  depreciation recapture                     --           1,100,000
Total gain to be reported in
  sale year                           $  50,000          $1,175,000

If the sale goes as planned, Harry will receive $300,000 in 2003, but will report $1,225,000 ($50,000 + $1,175,000) gain. The cash received in 2003 is likely to be insufficient to pay the tax on the reported gain.

In view of the gain that must be reported in the sale year, the tax adviser should recommend that Harry consider:

1. Restructuring the sales contract so the downpayment at least covers the tax liability in the sale year;

2. In some cases, an installment note that designates the property to which the payments pertain can reduce the gain reported in the sale year. Here, the gain recognized in the sale year would be decreased if all of the downpayment is attributed to the building (because it has a lower GPP); or

3. A tax-free exchange of like-kind properties.

Variation 1

If Harry had used ACRS straight-line depreciation rather than accelerated depreciation, he would not have any depreciation recapture to report in the sale year. All the gain would be reported when installment note payments are received.

Variation 2

If Harry's building were an apartment building (i.e., residential property) rather than an office building (i.e., nonresidential property), only depreciation in excess of straight-line would be recaptured as ordinary income. Thus, his reportable gain in the sale year would be significantly less; more gain would be reported when installment note payments are received.

Editor's note: This case study has been adapted from "Tax Planning for High Income Individuals," 3d edition, by Anthony J. DeChellis, Douglas L. Weinbrenner, Catherine A. Roeder and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2002 ([phone]; www.ppcnet.com).

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Potomac, MD