Other Rules Luxus-Hotels HeraklionThe rules discussed in this part of the publication apply only incertain circumstances or to certain types of property. The rules coverthe following topics. Electing out of the installment method. Payments received, including those consideredreceived. An escrow account. Depreciation recapture income. A sale to a related person. A like-kind exchange. A contingent payment sale. A single sale of several assets. The sale of a business. Unstated interest. Disposition of an installment obligation. A repossession. Electing Out ofInstallment Method You must use the installment method to report an installment saleunless you elect not to use that method. If you make theelection, you generally report the entire gain in the year of sale,even though you will not be paid all of the selling price in thatyear. To figure the gain to report, use the FMV of the buyer'sinstallment obligation. Notes, mortgages, and land contracts areexamples of obligations that are included at FMV. You must figure the FMV of the buyer's installment obligation,whether or not you would actually be able to sell it. If you use thecash method of accounting, the FMV of the obligation will never beconsidered less than the FMV of the property sold (minus any otherconsideration received). If you use an accrual method of accounting,you must always use the full face value of the installment obligationas its FMV. Example.You sold a parcel of land for $50,000. You received a $10,000 downpayment and will receive the balance over the next 10 years at $4,000a year, plus 8% interest. The buyer gave you a note for $40,000. Thenote had an FMV of $40,000. You paid a commission of 6%, or $3,000, toa broker for negotiating the sale. The land cost $25,000 and you ownedit for more than one year. You decide to elect out of the installmentmethod and report the entire gain in the year of sale. Gain realized: Selling price $50,000 Minus: Property's adj. basis $25,000 Commission      3,000     28,000 Gain realized $22,000 Gain recognized in year of sale: Cash $10,000 Market value of note     40,000 Total realized in year of sale $50,000 Minus: Property's adj. basis $25,000 Commission      3,000     28,000 Gain recognized $22,000 The recognized gain of $22,000 is long-term capital gain. Since youinclude the entire gain in income in the year of sale, you do notinclude in income any principal payments you receive in later taxyears. The interest on the note is ordinary income and is reported asinterest income each year. How to elect out.To make this election, do not report your sale on Form 6252.Instead, report it on Schedule D (Form 1040) or Form 4797, whicheverapplies. When to elect out.Make this election by the due date, including extensions, forfiling your tax return for the year the sale takes place. Once made,the election generally cannot be revoked. However, you can apply tothe IRS to revoke the election not to use the installment method. Youwill not be allowed to revoke the election if either of the followingsituations applies. One of the purposes is to avoid federal income tax. The tax year in which any payment was received hasclosed. Automatic six-month extension.If you timely filed your tax return without making the election,you can still make the election by filing an amended return within 6months of the due date of your return (excluding extensions). Write"Filed pursuant to section 301.9100-2" at the top of theamended return and file it at the same place you filed your originalreturn. PaymentsReceived You must figure your gain each year on the payments you receive, orare treated as receiving, from an installment sale. These paymentsinclude the down payment and each later payment of principal on thebuyer's debt to you. In certain situations, you are considered to have received apayment, even though the buyer does not pay you directly. Thesesituations occur when the buyer assumes or pays any of your debts,such as a loan, or pays any of your expenses, such as a salescommission. Buyer pays seller's expenses.If the buyer pays any of your expenses related to the sale of yourproperty, it is considered a payment to you in the year of sale.Include these expenses in the selling and contract prices whenfiguring the gross profit percentage. Buyer assumes mortgage.If the buyer assumes or pays off your mortgage, or otherwise takesthe property subject to the mortgage, the following rules apply. Mortgage less than basis.If the buyer assumes a mortgage that is less than your installmentsale basis in the property, it is not considered a payment to you. Thecontract price equals the selling price minus the mortgage. Thisdifference is all that you will directly collect from the buyer. Example.You sell property with an adjusted basis of $19,000. You haveselling expenses of $1,000. The buyer assumes your existing mortgageof $15,000 and agrees to pay you $10,000 (a cash down payment of$2,000 and $2,000 (plus 12% interest) in each of the next 4 years). The selling price is $25,000 ($15,000 + $10,000). Your grossprofit is $5,000 ($25,000 - $20,000 installment sale basis). Thecontract price is $10,000 ($25,000 - $15,000 mortgage). Yourgross profit percentage is 50% ($5,000 $10,000). You reporthalf of each $2,000 payment received as gain from the sale. You alsoreport all interest you receive as ordinary income. Mortgage more than basis.If the buyer assumes a mortgage that is more than your installmentsale basis in the property, you recover your entire basis. You arealso relieved of the obligation to repay the amount borrowed. The partof the mortgage greater than your basis is treated as a paymentreceived in the year of sale. This is in addition to the buyer's otherpayments. To figure the contract price, subtract the mortgage from theselling price. This is the total you will actually receive from thebuyer. Add to this amount the "payment" you are considered toreceive (the difference between the mortgage and your installment salebasis). The contract price is then the same as your gross profit fromthe sale. If the mortgage the buyer assumes is equal to or more than yourinstallment sale basis in the property, the gross profit percentagewill always be 100%. Example.The selling price for your property is $9,000. The buyer will payyou $1,000 annually (plus 8% interest) over the next 3 years andassume an existing mortgage of $6,000. Your adjusted basis in theproperty is $4,400. You have selling expenses of $600, for a totalinstallment sale basis of $5,000. The part of the mortgage that ismore than your installment sale basis is $1,000 ($6,000 -$5,000). This amount is included in the contract price and treated asa payment received in the year of sale. The contract price is $4,000: Selling price $9,000 Minus: Mortgage    (6,000) Amount actually received $3,000 Add difference:  Mortgage $6,000  Less: Installment sale basis      5,000      1,000 Contract price $4,000 Your gross profit on the sale is also $4,000: Selling price $9,000 Minus: Installment sale basis    (5,000) Gross profit $4,000 Your gross profit percentage is 100%. Report 100% of each paymentas gain from the sale. Treat the $1,000 difference between themortgage and your installment sale basis as a payment and report 100%of it as gain in the year of sale. Mortgage canceled.If the buyer of your property is the person who holds the mortgageon it, your debt is canceled, not assumed. You are considered toreceive a payment equal to the outstanding canceled debt. Example.Mary Jones loaned you $4,500 in 1995 in exchange for a notemortgaging a tract of land you owned. On April 4, 1999, she bought theland for $7,000. At that time, $3,000 of her loan to you wasoutstanding. She agreed to forgive this $3,000 debt and to pay you$2,000 (plus interest) on August 1, 1999, and August 1, 2000. She didnot assume an existing mortgage. She canceled the $3,000 debt you owedher. You are considered to have received a $3,000 payment at the timeof the sale. Buyer assumes other debts.If the buyer assumes your other debts, such as a loan or backtaxes, it may be considered a payment to you in the year of sale. If the buyer assumes the debt instead of paying it off, only partof it may have to be treated as a payment. Compare the debt to yourinstallment sale basis in the property being sold. If the debt is lessthan your installment sale basis, none of it is treated as a payment.If it is more, only the difference is treated as a payment. If thebuyer assumes more than one debt, any part of the total that is morethan your installment sale basis is considered a payment. These rulesare the same as the rules discussed earlier under Buyer assumesmortgage. However, they apply to only the following two types ofdebts the buyer assumes. Those acquired from ownership of the property you areselling, such as a mortgage, lien, overdue interest, or backtaxes. Those acquired in the ordinary course of your business, suchas a balance due for inventory you purchased. If the buyer assumes any other type of debt, such as a personalloan, it is treated as if the buyer had paid off the debt at the timeof the sale. The value of the assumed debt is then considered apayment to you in the year of sale. Payment of property.If you receive property rather than money from the buyer, it isstill considered a payment. However, see Like-Kind Exchange,later. The amount of the payment is the property's FMV on thedate you receive it. Fair market value (FMV).This is the price at which property would change hands between abuyer and a seller, neither being required to buy or sell, and bothhaving a reasonable knowledge of all necessary facts. If yourinstallment sale fits this description, the value assigned to propertyin your agreement with the buyer is good evidence of its FMV. Third-party note.If the property the buyer gives you is a third-party note (or otherobligation of a third party), you are considered to have received apayment equal to the note's FMV. Because the note is itself a paymenton your installment sale, any payments you later receive from thethird party are not considered payments on your sale. Example.You sold real estate in an installment sale. As part of the downpayment, the buyer assigned to you a $5,000, 8% note of a third party.The FMV of the third-party note at the time of your sale was $3,000.This amount, not $5,000, is a payment to you in the year of sale.Because the third-party note had an FMV equal to 60% of its face value($3,000 $5,000), 60% of each payment of principal you receiveon this note is a nontaxable return of capital. The remaining 40% isordinary income. Report the interest you receive in full as ordinaryincome. Bond.A bond or other evidence of debt you receive from the buyer that ispayable on demand is treated as a payment in the year you receive it.If you receive a government or corporate bond that has interestcoupons attached or that can be readily traded in an establishedsecurities market, you are considered to have received payment equalto the bond's FMV. Accrual basis taxpayers should see section15A.453-1(e)(2) of the regulations. Buyer's note.The buyer's note (unless payable on demand) is not consideredpayment on the sale. Its full face value is included when figuring theselling price and the contract price. Payments you receive on the noteare used to figure your gain in the year you receive them. Guarantee.If a third party or government agency guarantees the buyer'spayments to you on an installment obligation, the guarantee itself isnot considered payment. Caution: At the time this publication was being prepared for print, Congresswas considering legislation that would modify the pledge rulesexplained next. For more information about this and other importanttax changes, see Publication 553, Highlights of 1999 TaxChanges. Installment obligation used as security (pledge rule).If you use an installment obligation to secure any debt, the netproceeds from the debt may be treated as a payment on the installmentobligation. This is known as the pledge rule and it applies if theselling price of the property was over $150,000. It does not apply tothe following dispositions. Sales of property used or produced in farming. Sales of personal-use property. Qualifying sales of time-shares and residential lots. The net debt proceeds are the gross debt minus the direct expensesof getting the debt. The amount treated as a payment is consideredreceived on the later of the following dates. The date the debt becomes secured. The date you receive the debt proceeds. A debt is secured by an installment obligation to the extent thatpayment of principal or interest on the debt is directly secured(under the terms of the loan or any underlying arrangement) by anyinterest in the installment obligation. Limit.The net debt proceeds treated as a payment on the pledgedinstallment obligation cannot be more than the excess of item (1) overitem (2), below. The total contract price on the installment sale. Any payments received on the installment obligation beforethe date the net debt proceeds are treated as a payment. Installment payments.The pledge rule accelerates the reporting of the installmentobligation payments. Do not report payments received on the obligationafter it has been pledged until the payments received are more thanthe amount reported under the pledge rule. Exception.The pledge rule does not apply to debt incurred after December 17,1987, to refinance a debt under the following circumstances. The debt was outstanding on December 17, 1987. The debt was secured by that installment sale obligation onthat date and at all times thereafter until the refinancingoccurred. A refinancing as a result of the creditor's calling of the debt istreated as a continuation of the original debt if a person other thanthe creditor or a person related to the creditor provides therefinancing. This exception applies only to the refinancing that does not exceedthe principal of the original debt immediately before the refinancing.Any excess is treated as a payment on the installment obligation. Escrow Account In some cases, the sales agreement, or a later agreement, may callfor the buyer to establish an irrevocable escrow account from whichthe remaining installment payments (including interest) are to bemade. Generally, these sales cannot be reported on the installmentmethod. The buyer's obligation is paid in full when the balance of thepurchase price is deposited into the escrow account. When an escrowaccount is established, you no longer rely on the buyer for the restof the payments, but on the escrow arrangement. Example.You sell property for $10,000. The sales agreement calls for a downpayment of $1,000 and payment of $1,500 in each of the next 6 years tobe made from an irrevocable escrow account containing the balance ofthe purchase price plus interest. You cannot report the sale on theinstallment method because the full purchase price is consideredreceived in the year of sale. You must report the entire gain in theyear of sale. Escrow established in a later year.If you make an installment sale and in a later year an irrevocableescrow account is established to pay the remaining installments plusinterest, the amount placed in the escrow account represents paymentof the balance of the installment obligation. Therefore, you cannotuse the installment method to report any payments you receive from theescrow account. Substantial restriction.If an escrow arrangement imposes a substantial restriction on yourright to receive the sale proceeds, the sale can be reported on theinstallment method, provided it otherwise qualifies. For an escrowarrangement to impose a substantial restriction, it must serve a bonafide purpose of the buyer, that is, a real and definite restrictionplaced on the seller or a specific economic benefit conferred on thebuyer. DepreciationRecapture Income If you sell property for which you claimed a depreciationdeduction, report any depreciation recapture income in the year ofsale, whether or not an installment payment was received that year.Figure your depreciation recapture income (including the section 179deduction and the section 179A deduction recapture) in Part III ofForm 4797. Report the recapture income in Part II of Form 4797 asordinary income in the year of sale. The recapture income is alsoincluded in Part I of Form 6252. However, the gain equal to therecapture income is not reported on the installment method. Report anygain greater than the recapture income on the installment method. Formore information on depreciation recapture, see chapter 3 inPublication 544. The ordinary recapture income reported in the year of sale isincluded in your installment sale basis in determining your grossprofit on the installment sale. See the discussion under GeneralRules, earlier. Sale toRelated Person Two special rules apply to an installment sale between relatedpersons. Test your sale against Rule 1 first. If Rule 1 does notapply, test your sale against Rule 2. For purposes of these rules,spouses, children, grandchildren, brothers, sisters, and parents areall considered related persons. A partnership or corporation in whichyou have an interest, or an estate or trust with which you have aconnection, can also be considered a related person. For more information on these kinds of sales, see section 453 ofthe Internal Revenue Code. Rule 1--Sale of Depreciable Property If you sell depreciable property to certain related persons, youcannot report the sale using the installment method. Instead, allpayments to be received are considered received in the year of sale.Depreciable property for this rule is any property that the purchasercan depreciate. Payments to be received include the total of all noncontingentpayments and the FMV of any payments contingent as to amount. In the case of contingent payments for which the FMV cannot bereasonably determined, the basis is recovered ratably. The purchasercannot increase the basis of any property acquired in the sale by anyamount before the seller includes the amount in income. Exceptions to Rule 1.Rule 1 will not apply if no significant tax deferral benefit willbe derived from the sale. It does not apply if you can show to thesatisfaction of IRS that avoidance of federal income tax was not oneof the principal purposes of the sale. Rule 2--Sale and Resale Generally, a special rule applies if you (an installment seller)make a first disposition (sale or exchange) to a related person whothen makes a second disposition (sale, exchange, or gift) under thefollowing circumstances. The related person makes the second disposition beforemaking all payments on the first disposition. The related person makes the second disposition within 2years of the first disposition. Under this rule, you treat part or all of the amount therelated person realizes (or the FMV if the disposed property is notsold or exchanged) from the second disposition as if you received itfrom the first disposition at the time of the second disposition. Example 1.In 1998, Harvey Green sold farm land to his son Bob for $500,000,which was to be paid in five equal payments over 5 years, plusadequate stated interest on the balance due. His installment salebasis for the farm land was $250,000 and the property was not subjectto any outstanding liens or mortgages. His gross profit percentage is50% (gross profit of $250,000 contract price of $500,000). Hereceived $100,000 in 1998 and included $50,000 in income for that year($100,000 0.50). Bob made no improvements to the property andsold it to Alfalfa Inc., in 1999 for $600,000 after making the paymentfor that year. The amount realized from the second disposition is$600,000. Harvey figures his installment sale income for 1999 asfollows: Lesser of: 1) Amount realized on seconddisposition, or 2) Contract price on first disposition $500,000 Subtract: Sum of payments from Bob in 1998 and1999  - 200,000 Amount treated as payment because of seconddisposition $300,000 Add: Payment from Bob in 1999  + 100,000 Total payments received and treated as receivedfor 1999 $400,000 Multiply by gross profit %       .50 Installment sale income for 1999 $200,000 Harvey will not include in his installment sale income anyprincipal payments he receives on the installment obligation for 2000,2001, and 2002 because he has already reported the total payments of$500,000 from the first disposition ($100,000 in 1998 and $400,000 in1999). Example 2.Assume the facts are the same as Example 1 except thatBob sells the property for only $400,000. The gain for 1999 is figuredas follows: Lesser of: 1) Amount realized on seconddisposition, or 2) Contract price on first disposition $400,000 Subtract: Sum of payments from Bob in 1998 and1999  - 200,000 Amount treated as payment because of seconddisposition $200,000 Add: Payment from Bob in 1999  + 100,000 Total payments received and treated as receivedfor 1999 $300,000 Multiply by gross profit %       .50 Installment sale income for 1999 $150,000 Harvey receives a $100,000 payment in 2000 and another in 2001.They are not taxed because he treated the $200,000 from thedisposition in 1999 as a payment received and paid tax on the gain. In2002, he receives the final $100,000 payment. He figures the gain hemust recognize in 2002 as follows: Venice luxury hotelsTotal payments from the first dispositionreceived by the end of 2001 $500,000 Minus the sum of:  Payment from 1998 $100,000  Payment from 1999 100,000  Amount treated as payment in 1999    200,000 Total on which gain was previouslyrecognized  - 400,000 ERROR MSGPayment on which gain is recognized for2002 $100,000 Multiply by gross profit %       .50 Installment sale income for2002 $ 50,000 Exceptions to Rule 2.These rules do not apply to a second disposition, and any latertransfer, if you can show, to the satisfaction of the IRS, thatneither the first disposition (to the related person) nor the seconddisposition had as one of its principal purposes the avoidance offederal income tax. Generally, an involuntary second disposition willqualify under the nontax avoidance exception, such as when a creditorof the related person forecloses on the property or the related persondeclares bankruptcy. The nontax avoidance exception also applies to a second dispositionthat is also an installment sale if the terms of payment under theinstallment resale are substantially equal to or longer than those forthe first installment sale. However, the exception does not apply ifthe resale terms permit significant deferral of recognition of gainfrom the first sale as, for example, if amounts from the resale arecollected sooner. In addition, any sale or exchange of stock to the issuingcorporation is not treated as a first disposition. An involuntaryconversion is not treated as a second disposition if the firstdisposition occurred before the threat of conversion. A transfer afterthe death of the person making the first disposition or the relatedperson's death, whichever is earlier, is not treated as a seconddisposition. Like-Kind Exchange If you trade business or investment property for the same kind ofproperty, you can postpone reporting part of the gain. These tradesare known as "like-kind exchanges." The property you receive in alike-kind exchange is treated as if it were a continuation of theproperty you gave up. In a like-kind exchange, you do not have to report any part of yourgain if you receive only like-kind property. However, if you alsoreceive money or other property in the exchange, you must report yourgain to the extent of the money and the FMV of the other propertyreceived. For more information on like-kind exchanges, see Like-KindExchanges in chapter 1 of Publication 544. Installment payments.If, in addition to like-kind property, you receive an installmentobligation in the exchange, the following rules apply. The contract price is reduced by the FMV of the like-kindproperty received in the trade. The gross profit is reduced by any gain on the trade thatcan be postponed. Like-kind property received in the trade is not consideredpayment on the installment obligation. Example.In 1999, George Brown trades personal property with an installmentsale basis of $400,000 for like-kind property having an FMV of$200,000. He also receives an installment note for $800,000 in thetrade. Under the terms of the note, he is to receive $100,000 (plusinterest) in 2000 and the balance of $700,000 (plus interest) in 2001. George's selling price is $1,000,000 ($800,000 installment note +$200,000 FMV of like-kind property received). His gross profit is$600,000 ($1,000,000 - $400,000 installment sale basis). Thecontract price is $800,000 ($1,000,000 - $200,000). The grossprofit percentage is 75% ($600,000 $800,000). He reports nogain in 1999 because the like-kind property he receives is not treatedas a payment for figuring gain. He reports $75,000 gain for 2000 (75%of $100,000 payment received) and $525,000 gain for 2001 (75% of$700,000 payment received). Deferred exchanges.A deferred exchange is one in which you have transferred theproperty and are to receive like-kind property at a later date. Underthis type of exchange, the person receiving your property may berequired to place funds in an escrow account or trust. If certainrules are met, these funds will not be considered a payment until youhave the right to receive the funds or, if earlier, the end of theexchange period. See section 1.1031(k)-1(j)(2) of theregulations for these rules. Contingent Payment Sale For installment sales, a contingent payment sale is one whose totalselling price cannot be determined by the end of the tax year in whichthe sale takes place. If the selling price cannot be determined by the end of the taxyear, the contract price and the gross profit percentage cannot bedetermined (using the same rules that apply to an installment salewith a fixed selling price). This happens, for example, if you sellyour business and the selling price includes a percentage of itsprofits in future years. For rules on using the installment method for a contingent paymentsale or a contingent payment sale with unstated interest, see section15A.453-1(c) of the regulations. Single Saleof Several Assets If you sell different types of assets in a single sale, you mustidentify each asset to determine whether you can use the installmentmethod to report the sale of that asset. You also have to allocatepart of the selling price to each asset. If you sell assets thatconstitute a trade or business, see Sale of a Business,next. Unless an allocation of the selling price has been agreed to byboth parties in an arm's-length transaction, you must allocate theselling price to an asset based on its FMV. If the buyer assumes adebt, or takes the property subject to a debt, you must reduce the FMVby the debt. This is the net FMV. A sale of separate and unrelated assets of the same type under asingle contract is reported as one transaction for the installmentmethod. However, if an asset is sold at a loss, its disposition cannotbe reported on the installment method. It must be reported separately.The remaining assets sold at a gain are reported together. Example.You sold three separate and unrelated parcels of real property (A,B, and C) under a single contract calling for a total selling price of$130,000. The total selling price consisted of a cash payment of$20,000, the buyer's assumption of a $30,000 mortgage on parcel B, andan installment obligation of $80,000 payable in eight annualinstallments, plus interest at 8% a year. Your installment sale basis for each parcel was $15,000. Your netgain was $85,000 ($130,000 - $45,000). You report the gain onthe installment method. The sales contract did not allocate the selling price or the cashpayment received in the year of sale among the individual parcels. TheFMV of parcels A, B, and C were $60,000, $60,000, and $10,000,respectively. Since the installment sale basis for parcel C was more than itsFMV, it was sold at a loss and must be treated separately. You mustallocate the total selling price and the amounts received in the yearof sale between parcel C and the remaining parcels. Of the total $130,000 selling price, you must allocate $120,000 toparcels A and B together and $10,000 to parcel C. You should allocatethe cash payment of $20,000 received in the year of sale and the notereceivable on the basis of the proportionate net FMV. The allocationis figured as follows: ParcelsA and B Parcel C FMV $120,000 $10,000 Minus: Mortgage assumed     30,000        -0- Net FMV $ 90,000 $10,000 Proportionate net FMV: Percentage of total 90% 10% Payments in year of sale: $20,000 90% $18,000 $20,000 10% $2,000 Excess of parcel B mortgage over installmentsale basis     15,000        -0- Allocation of paymentsreceived (or consideredreceived) in year of sale $ 33,000 $ 2,000 You cannot report the sale of parcel C on the installment methodbecause the sale results in a loss. You report this loss of $5,000($10,000 selling price - $15,000 installment sale basis) in theyear of sale. However, if parcel C was held for personal use, the lossis not deductible. You allocate the installment obligation of $80,000 to theproperties sold based on their proportionate net FMVs (90% to parcelsA and B, 10% to parcel C). Sale of a Business The installment sale of an entire business for one overall priceunder a single contract is not the sale of a single asset. Allocation of selling price.The selling price must be allocated for each asset class for thefollowing reasons. The sale of a business generally includes real and personalproperty that can be reported on the installment method and inventoryitems that cannot. Any depreciation recapture income from the sale ofdepreciable property cannot be reported on the installment method. Itis reported in full in the year of the sale. Assets sold at a loss cannot be reported on the installmentmethod. Inventory.The sale of inventory items cannot be reported on the installmentmethod. All gain or loss on their sale must be reported in the year ofsale, even if you are paid in later years. If inventory items are included in an installment sale, you mayhave an agreement stating which payments are for inventory and whichare for the other assets being sold. If you do not, each payment mustbe allocated between the inventory and the other assets sold. Report the amount you receive (or will receive) on the sale ofinventory items as ordinary business income. Use your basis in theitems to figure the cost of goods sold and deduct the part of theselling expenses allocated to inventory as an ordinary businessexpense. Residual method.Except for assets exchanged under the like-kind exchange rules,both the buyer and seller of a business must use the residual methodto allocate the sale price to each business asset transferred. Thismethod determines gain or loss from the transfer of each asset. The residual method must be used for any transfer of a group ofassets that constitutes a trade or business and for which the buyer'sbasis is determined only by the amount paid for the assets. Thisapplies to both direct and indirect transfers, such as the sale of abusiness or the sale of a partnership interest in which the basis ofthe buyer's share of the partnership assets is adjusted for the amountpaid. A group of assets constitutes a trade or business if goodwill orgoing concern value could, under any circumstances, attach to theassets. The residual method provides for the sale price to first be reducedby cash, demand deposits, and similar accounts transferred by theseller. The sale price remaining after this reduction must beallocated among the various business assets in a specified order. The allocation must be made among the following assets inproportion to (but not in excess of) their FMV on the purchase date inthe following order. Certificates of deposit, U.S. Government securities, readilymarketable stock or securities, and foreign currency. All other assets except section 197 intangibles. Section 197 intangibles, except intangible assets in thenature of goodwill and going concern value. Section 197 intangibles in the nature of goodwill and goingconcern value. More information.For more information, see Sale of a Business in chapter2 of Publication 544. For more information on section 197 intangibles,see chapter 12 of Publication 535. How to report the sale of a business.Both the seller and buyer must prepare and attach Form 8594,Asset Acquisition Statement Under Section 1060, to theirincome tax return for the year the sale occurred. If the amountallocated to any asset is increased or decreased after Form 8594 isfiled, a supplemental statement in Part III of a new Form 8594 must becompleted. Sale of partnership interest.A partner who sells a partnership interest at a gain may be able toreport the sale on the installment method. The sale of a partnershipinterest is treated as the sale of a single capital asset. However,the partner must allocate a portion of the proceeds to ordinary incomeif the partnership's assets included unrealized receivables andinventory items. (The term "unrealized receivables" includesdepreciation recapture income, discussed earlier.) The gain allocated to the unrealized receivables and the inventorycannot be reported under the installment method. The gain allocated tothe other assets can be reported under the installment method. For more information on the treatment of unrealized receivables andinventory, see Publication 541. Example On January 4, 1999, you sold the machine shop you operated since1989. You received a $100,000 down payment and the buyer's note for$120,000. The note payments are $15,000 each, plus 10% interest, dueevery July 1 and January 1, beginning in 2000. The total selling priceis $220,000. Your selling expenses are $11,000. The selling expensesare divided among all the assets sold, including inventory. Your selling expense for each asset is 5% of the asset's sellingprice ($11,000 selling expense $220,000 total selling price). The FMV, adjusted basis, and depreciation claimed on each assetsold are as follows: Depreciation Adjusted Asset FMV Claimed Basis Inventory $ 10,000 -0- $ 8,000 Land 42,000 -0- 15,000 Building 48,000 $ 9,000 36,000 Machine A 71,000 27,200 63,800 Machine B 24,000 12,960 22,040 Truck         6,500       18,624      5,376 $201,500 $67,784 $150,216 Under the residual method, you allocate the selling price to eachof the assets based on their FMV ($201,500). The remaining amount isallocated to your section 197 intangible, goodwill ($18,500). The assets included in the sale, their selling prices based ontheir FMVs, the selling expense allocated to each asset, the adjustedbasis, and the gain for each asset are shown in the following chart. Sale Price Sale Exp. Adj.Basis Gain Inventory $ 10,000 $ 500 $ 8,000 $ 1,500 Land 42,000 2,100 15,000 24,900 Building 48,000 2,400 36,000 9,600 Mch. A 71,000 3,550 63,800 3,650 Mch. B 24,000 1,200 22,040 760 Truck 6,500 325 5,376 799 Goodwill     18,500        925        -0-     17,575 $220,000 $11,000 $150,216 $58,784 The building was acquired in 1989, the year the business began, andit is section 1250 property. There is no depreciation recapture incomebecause the building was depreciated using the straight line method. All gain on the truck, machine A, and machine B is depreciationrecapture income since it is the lesser of the depreciation claimed orthe gain on the sale. Figure depreciation recapture in Part III ofForm 4797. The total depreciation recapture income reported in Part II of Form4797 is $5,209. This consists of $3,650 on machine A, $799 on thetruck, and $760 on machine B (the gain on each item since it was lessthan the depreciation claimed). These gains are reported in full inthe year of sale and are not included in the installment salecomputation. Of the $220,000 total selling price, the $10,000 for inventoryassets cannot be reported on the installment method. The sellingprices of the truck and machines are also removed from the totalselling price because gain on these items is reported in full in theyear of sale. The selling price equals the contract price for the installmentsale ($108,500). The assets included in the installment sale, theirselling price, and their installment sale basis are shown in thefollowing chart. Selling Price Installment SaleBasis Gross Profit Land $ 42,000 $17,100 $24,900 Building 48,000 38,400 9,600 Goodwill     18,500        925     17,575 Total $108,500 $56,425 $52,075 The gross profit percentage (gross profit contract price) for the installment sale is 48% ($52,075 $108,500). The gross profit percentage for each asset is figured asfollows: Percentage Land-- $24,900 $108,500 22.95 Building-- $9,600 $108,500 8.85 Goodwill-- $17,575 $108,500            16.20 Total 48.00 Since the sale includes assets sold on the installment method andassets for which the gain is reported in full in the year of sale,payments must be allocated between the installment part of the saleand the part reported in the year of sale. The selling price for theinstallment sale is $108,500. This is 49.3% of the total selling priceof $220,000 ($108,500 $220,000). The selling price of assetsnot reported on the installment method is $111,500. This is 50.7%($111,500 $220,000) of the total selling price. Multiply principal payments by 49.3% to determine the part of thepayment for the installment sale. The balance, 50.7%, is for the partreported in the year of the sale. The gain on the sale of the inventory, machines, and truck isreported in full in the year of sale. When you receive principalpayments in later years, no part of the payment for the sale of theseassets is included in gross income. Only the part for the installmentsale (49.3%) is used in the installment sale computation. The only payment received in 1999 is the down payment of $100,000.The part of the payment for the installment sale is $49,300 ($100,000 49.3%). This amount is used in the installment salecomputation. Installment income for 1999.Your installment income for each asset is the gross profitpercentage for that asset times $49,300, the installment incomereceived in 1999. Income Land--22.95% of $49,300 $11,314 Building--8.85% of $49,300 4,363 Goodwill--16.2% of $49,300      7,987 Total installment income for 1999 $23,664 Installment income after 1999.You figure installment income for years after 1999 by applying thesame gross profit percentages to 49.3% of the total payments youreceive on the buyer's note during the year. Unstated Interest and Original Issue Discount Note: Section references are to the Internal RevenueCode and regulation references are to the Income Tax Regulations underthe Code. An installment sale contract generally provides that each deferredpayment on the sale will include interest or that there will be aninterest payment in addition to the principal payment. Interestprovided in the contract is called stated interest. Malmo hôtelsIf an installment sale contract does not provide for adequatestated interest, part of the stated principal amount of the contractmay be recharacterized as interest. If section 483 applies to thecontract, this interest is called unstated interest. Ifsection 1274 applies to the contract, this interest is calledoriginal issue discount (OID). An installment sale contract does not provide for adequate statedinterest if the stated interest rate is lower than the test rate,defined later. Treatment of unstated interest and OID.Generally, the unstated interest rules do not apply to a debt givenin consideration for a sale or exchange of personal-use property.Personal-use property is any property in which substantially all ofits use by the buyer is not in connection with a trade or business oran investment activity. Rules for the seller.If either section 1274 or section 483 applies to the installmentsale contract, you must treat part of the installment sale price asinterest, even though it is not called interest in the salesagreement. You must reduce the stated selling price of the propertyand increase your interest income by this interest. ERROR MSGYou must include unstated interest in income based on your regularmethod of accounting. You must include OID in income over the term ofthe contract. The OID includible in income each year is based on the constantyield method described in section 1272. (In some cases, the OID on aninstallment sale contract also may include all or part of the statedinterest, especially if the stated interest is not paid at leastannually.) If you do not use the installment method to report the sale, reportthe entire gain in the year of sale. You must reduce the selling priceby any stated principal treated as interest to determine the gain. You must report unstated interest or OID on your tax return, aswell as stated interest. Rules for the buyer.Any part of the stated selling price of an installment salecontract treated by the buyer as interest reduces the buyer's basis inthe property and increases the buyer's interest expense. These rulesdo not apply to personal-use property (for example, property not usedin a trade or business). Adequate stated interest.An installment sale contract generally provides for adequate statedinterest if the contract's stated principal amount is at least equalto the sum of the present values of all principal and interestpayments called for under the contract. The present value of a paymentis determined based on the test rate of interest, defined next. (Ifsection 483 applies to the contract, payments due within six monthsafter the sale are taken into account at face value.) In general, aninstallment sale contract provides for adequate stated interest if thestated interest rate (based on an appropriate compounding period) isat least equal to the test rate of interest. Test rate of interest.The test rate of interest for a contract is the 3-month rate. The3-month rate is the lower of the following applicable federal rates(AFRs). The lowest AFR (based on the appropriate compounding period)in effect during the 3-month period ending with the first month inwhich there is a binding written contract that substantially providesthe terms under which the sale or exchange is ultimatelycompleted. The lowest AFR (based on the appropriate compounding period)in effect during the 3-month period ending with the month in which thesale or exchange occurs. Applicable federal rate (AFR).The AFR depends on the month the binding contract for the sale orexchange of property is made and the term of the instrument. For aninstallment obligation, the term of the instrument is its weightedaverage maturity, as defined in section 1.1273-1(e)(3) of theregulations. The AFR for each term is shown below. For a term of 3 years or less, the AFR is the federalshort-term rate. For a term of over 3 years, but not over 9 years, the AFR isthe federal mid-term rate. For a term of over 9 years, the AFR is the federal long-termrate. Computer: The applicable federal rates are published monthly in the InternalRevenue Bulletin (IRB). You can get this information by contacting anIRS office. IRBs are also available on the Internet atwww.irs.gov. Seller financed sales.For sales or exchanges of property (other than new section 38property, which includes most tangible personal property) involvingseller financing of $3,885,500 or less, the test rate of interestcannot be more than 9%, compounded semiannually. For seller financingover $3,885,500 and for all sales or exchanges of new section 38property, the test rate of interest is 100% of the AFR. For information on new section 38 property, see section 48(b) ofthe Internal Revenue Code, as in effect before the enactment of PublicLaw 101-508. Certain land transfers between related persons.In the case of certain land transfers between related persons(described later), the test rate is no more than 6 percent, compoundedsemiannually. Internal Revenue Code sections 1274 and 483.If an installment sale contract does not provide for adequatestated interest, either section 1274 or section 483 generally willapply to the contract. These sections recharacterize part of thestated principal amount as interest. Whether either of these sectionsapply to a particular installment sale contract depends on severalfactors, including the total selling price and the type of propertysold. Section 1274.Section 1274 applies to a debt instrument issued for the sale orexchange of property if any payment under the instrument is due morethan 6 months after the date of the sale or exchange and theinstrument does not provide for adequate stated interest. Section1274, however, does not apply to an installment sale contract that isa cash method debt instrument (defined next) or that arises from thefollowing transactions. A sale or exchange for which the total payments are $250,000or less. The sale or exchange of an individual's main home. The sale or exchange of a farm for $1,000,000 or less by anindividual, an estate, a testamentary trust, small businesscorporation (defined in section 1244(c)(3)), or a domestic partnershipthat meets requirements similar to those of section 1244(c)(3). Certain land transfers between related persons (describedlater). Cash method debt instrument.This is any debt instrument given as payment for the sale orexchange of property (other than new section 38 property) with astated principal of $2,775,400 or less if the following items apply. The lender (holder) does not use an accrual method ofaccounting and is not a dealer in the type of property sold orexchanged. Both the borrower (issuer) and the lender jointly elect toaccount for interest on the debt instrument under the cash method ofaccounting. Section 1274 would apply except for the election in (2)above. Land transfers between related persons.The section 483 rules (discussed next) apply to debt instrumentsissued in a land sale between related persons to the extent the sum ofthe following amounts does not exceed $500,000. The stated principal of the debt instrument issued in thesale or exchange. The total stated principal of any other debt instruments forprior land sales between these individuals during the calendaryear. The section 1274 rules, if otherwise applicable, apply to debtinstruments issued in a sale of land to the extent the statedprincipal amount is in excess of $500,000, or if any party to the saleis a nonresident alien. Related persons include an individual and the members of theindividual's family and their spouses. Members of an individual'sfamily include the individual's spouse, brother and sister (whole orhalf), ancestors, and lineal descendants. Section 483.Section 483 generally applies to an installment sale contract thatdoes not provide for adequate stated interest and is not covered bysection 1274. Section 483, however, generally does not apply to aninstallment sale contract that arises from the following transactions. A sale or exchange for which no payments are due more thanone year after the date of the sale or exchange. A sale or exchange for which the total payments are $3,000or less. Exceptions to sections 1274 and 483.Sections 1274 and 483 do not apply under the followingcircumstances. An assumption of a debt instrument pursuant to a sale orexchange or the acquisition of property subject to a debt instrument,unless the terms or conditions of the debt instrument are modified ina manner that would constitute a deemed exchange under section1.1001-3 of the regulations. A debt instrument issued pursuant to a sale or exchange ofproperty if either the debt instrument or the property is publiclytraded (for example, traded on an established securitiesmarket). A sale or exchange of all substantial rights to a patent, oran undivided interest in property that includes part or allsubstantial rights to a patent, if any amount is contingent on theproductivity, use, or disposition of the property transferred. SeePublication 544 for more information. An annuity contract issued pursuant to a sale or exchange ofproperty if the contract is described in section 1275(a)(1)(B) of theCode and section 1.1275-1(j) of the regulations. A transfer of property subject to section 1041 of the Code(relating to transfers of property between spouses or incident todivorce). A demand loan that is a below-market loan described insection 7872(c)(1) of the Code (for example, gift loans andcorporation-shareholder loans). A below-market loan described in section 7872(c)(1) of theCode issued pursuant to the sale or exchange of personal-use property.This rule applies only to the holder. Determining whether section 1274 or section 483 applies.For purposes of determining whether section 1274 or section 483applies to an installment sale contract, all sales or exchanges thatare part of the same transaction (or related transactions) are treatedas single sale or exchange and all contracts arising from the sametransaction (or a series of related transactions) are treated as asingle contract. Also, the total consideration due under aninstallment sale contract is determined at the time of the sale orexchange. Any payment (other than a debt instrument) is taken intoaccount at its FMV. More information.For information on figuring unstated interest and OID and otherspecial rules, see sections 1274 and 483 of the Internal Revenue Codeand the related regulations. In the case of an installment salecontract that provides for contingent payments, see sections1.1275-4(c) and 1.483-4 of the regulations. Disposition ofInstallment Obligation A disposition generally includes a sale, exchange, cancellation,bequest, distribution, or transmission of an installment obligation.An "installment obligation" is the buyer's note, deed of trust,or other evidence the buyer will make future payments to you. If you are using the installment method and you dispose of theinstallment obligation, you generally have a gain or loss to report.It is considered gain or loss on the sale of the property for whichyou received the installment obligation. If the original installmentsale produced ordinary income, the disposition of the obligation willresult in ordinary income or loss. If the original sale resulted in acapital gain, the disposition of the obligation will result in acapital gain or loss. Use the following rules to figure your gain or loss from thedisposition of an installment obligation. If you sell or exchange the obligation, or if youaccept less than face value in satisfaction of the obligation, thegain or loss is the difference between your basis in the obligationand the amount you realize. If you dispose of the obligation in any other way,the gain or loss is the difference between your basis in theobligation and its FMV at the time of the disposition. This ruleapplies, for example, when you give the installment obligation tosomeone else or cancel the buyer's debt to you. Basis.Figure your basis in an installment obligation by multiplying theunpaid balance on the obligation by your gross profit percentage.Subtract that amount from the unpaid balance. The result is your basisin the installment obligation. Example.Several years ago, you sold property on the installment method. Thebuyer still owes you $10,000 of the sale price. This is the unpaidbalance on the buyer's installment obligation to you. Because yourgross profit percentage is 60%, $6,000 (60% $10,000) is theprofit owed you on the obligation. The rest of the unpaid balance,$4,000, is your basis in the obligation. Transfer between spouses or former spouses.No gain or loss is recognized on the transfer of an installmentobligation between a husband and wife or a former husband and wife ifincident to a divorce. A transfer is incident to a divorce if itoccurs within one year after the date on which the marriage ends or isrelated to the end of the marriage. The same tax treatment of thetransferred obligation applies to the transferee spouse or formerspouse as would have applied to the transferor spouse or formerspouse. The basis of the obligation to the transferee spouse (orformer spouse) is the adjusted basis of the transferor spouse. The nonrecognition rule does not apply if the spouse or formerspouse receiving the obligation is a nonresident alien. Gift.A gift of an installment obligation is a disposition. The gain orloss is the difference between your basis in the obligation and itsFMV at the time you make the gift. For gifts between spouses or former spouses, see Transfersbetween spouses or former spouses, earlier. Cancellation.If an installment obligation is canceled or otherwise becomesunenforceable, it is treated as a disposition other than a sale orexchange. Your gain or loss is the difference between your basis inthe obligation and its FMV at the time you cancel it. If the partiesare related, the FMV of the obligation is considered to be no lessthan its full face value. Forgiving part of the buyer's debt.If you accept part payment on the balance of the buyer'sinstallment debt to you and forgive the rest of the debt, you treatthe settlement as a disposition of the installment obligation. Thegain or loss is the difference between your basis in the obligationand the amount you realize on the settlement. If you reduce the selling price but do not cancel the rest of thebuyer's debt to you, it is not considered a disposition of theinstallment obligation. You must refigure the gross profit percentageand apply it to payments you receive after the reduction. SeeSelling price reduced under General Rules,earlier. Assumption.If the buyer of your property sells it to someone else and youagree to let the new buyer assume the original buyer's installmentobligation, you have not disposed of the installment obligation. It isnot a disposition even if the new buyer pays you a higher rate ofinterest than the original buyer. Transfer due to death.The transfer of an installment obligation (other than to a buyer)as a result of the death of the seller (or other holder of theobligation) is not a disposition. Any unreported gain from theinstallment obligation is not treated as gross income to the decedent.No income is reported on the decedent's return due to the transfer.This means whoever receives the installment obligation as a result ofthe seller's death is taxed on the installment payments the same asthe seller would have been if the seller had lived to receive thepayments. However, if an installment obligation is canceled, becomesunenforceable, or is transferred to the buyer because of the death ofthe holder of the obligation, it is a disposition. The estate mustfigure its gain or loss on the disposition. If the holder and thebuyer were related, the FMV of the installment obligation isconsidered to be no less than its full face value. Repossession If you repossess your property after making an installment sale,you must figure the following amounts. Your gain (or loss) on the repossession. Your basis in the repossessed property. The rules for figuring these amounts depend on the kind of propertyyou repossess. The rules for repossessions of personal property differfrom those for real property. Special rules may apply if you repossessproperty that was your main home before the sale. The repossession rules apply whether or not title to the propertywas ever transferred to the buyer. It does not matter how yourepossess the property, whether you foreclose or the buyer voluntarilysurrenders the property to you. However, it is not a repossession ifthe buyer puts the property up for sale and you repurchase it. For the repossession rules to apply, the repossession must at leastpartially discharge (satisfy) the buyer's installment obligation toyou. The discharged obligation must be secured by the property yourepossess. This requirement is met if the property is auctioned offafter you foreclose and you apply the installment obligation to yourbid price at the auction. Reporting the repossession.You report gain or loss from a repossession on the same form youused to report the original sale. If you reported the sale on Form4797, use it to report the gain or loss on the repossession. Personal Property If you repossess personal property, you may have a gain or a losson the repossession. In some cases, you may also have a bad debt. To figure your gain or loss, subtract the total of your basis inthe installment obligation and any repossession expenses you have fromthe FMV of the property. If you receive anything from the buyerbesides the repossessed property, it is added to the property's FMVbefore making this calculation. How you figure your basis in the installment obligation depends onwhether or not you reported the original sale on the installmentmethod. The method you used to report the original sale also affectsthe character of your gain or loss on the repossession. For sales not reported on the installment method:See Electing Out of Installment Method, earlier. Basis in installment obligation. Your basis is figuredon its full face value or its FMV at the time of the original sale,whichever you used to figure your gain or loss in the year of sale.From this amount, subtract all payments of principal you have receivedon the obligation. The result is your basis in the installmentobligation. If only part of the obligation is discharged by therepossession, figure your basis in only that part. Gain or loss. Add any repossession costs to yourbasis in the obligation. If the FMV of the property you repossess ismore than this total, you have a gain. Because it is gain on theinstallment obligation, it is all ordinary income. If the FMV of therepossessed property is less than the total of your basis plusrepossession costs, you have a loss. Because you included the fullgain in income in the year of sale, the loss is a bad debt. How youdeduct the bad debt depends on whether you sold business ornonbusiness property in the original sale. See Publication 550 forinformation on nonbusiness bad debts and chapter 14 of Publication 535for information on business bad debts. For sales reported on the installment method: Basis in installment obligation. Multiply the unpaidbalance of your installment obligation by your gross profitpercentage. Subtract that amount from the unpaid balance. The resultis your basis in the installment obligation. Gain or loss. If the FMV of the repossessedproperty is more than the total of your basis in the obligation plusany repossession costs, you have a gain. If the FMV is less, you havea loss. Your gain or loss on the repossession is of the same character(capital or ordinary) as your gain on the original sale. Pencil: Use the following worksheet to determine the taxable gain or losson a repossession of personal property reported on the installmentmethod. 1) FMV of property repossessed            2) Unpaid balance of installment obligation              3) Unrealized profit(line 2 gross profit %)              4) Basis of obligation(line 2 - line 3)              5) Plus: Repossession costs                         6) Gain or loss on repossession(line 1 - line 5) Example.You sold your piano for $1,500 in December 1998 for $300 down and$100 a month (plus interest). The payments began in January 1999. Yourgross profit percentage is 40%. You reported the sale on theinstallment method on your 1998 income tax return. After the fourthmonthly payment, the buyer defaults on the contract (which has anunpaid balance of $800) and you are forced to foreclose on the piano.The FMV of the piano on the date of repossession is $1,400. The legalcosts of foreclosure and the expense of moving the piano back to yourhome total $75. You figure your gain on the repossession as follows: 1) FMV of property repossessed $1,400 2) Unpaid balance of installment obligation $800 3) Unrealized profit(line 2 gross profit %)          320 4) Basis of obligation(line 2 - line 3) 480 5) Plus: Repossession costs           75        555 6) Gain on repossession(line 1 - line 5) $ 845 Basis in repossessed property.Your basis in repossessed personal property is its FMV at the timeof the repossession. Fair market value (FMV).The FMV of repossessed property is a question of fact to beestablished in each case. If you bid for the property at a lawfulpublic auction or judicial sale, its FMV is presumed to be the priceit sells for, unless there is clear and convincing evidence to thecontrary. Real Property The rules for the repossession of real property allow you to keepessentially the same adjusted basis in the repossessed property as youhad before the original sale. You can recover this entire adjustedbasis when you resell the property. This, in effect, cancels out thetax treatment that applied to you on the original sale and puts you inthe same tax position you were in before that sale. Therefore, the total payments you have received from the buyer onthe original sale must be considered income to you. You report, asgain on the repossession, any part of the payments you have not yetincluded in income. These payments are amounts you previously treatedas a return of your adjusted basis and excluded from income. However,the total gain you report is limited, as discussed later. Mandatory rules.The rules concerning basis and gain on repossessed real propertyare mandatory. You must use them to figure your basis in therepossessed real property and your gain on the repossession. Theyapply whether or not you reported the sale on the installment method.However, they apply only if all of the following conditionsare met. The repossession must be to protect your security rights inthe property. The installment obligation satisfied by the repossessionmust have been received in the original sale. You cannot pay any additional consideration to the buyer toget your property back, unless either of the situations listed belowapply. The reacquisition and payment of the additionalconsideration were provided for in the original contract ofsale. The buyer has defaulted, or default is imminent. "Additional consideration" includes money and otherproperty you pay or transfer to the buyer. For example, additionalconsideration is paid if you reacquire the property subject to a debtthat arose after the original sale. Conditions not met.If any one of these three conditions is not met, use the rulesdiscussed under Personal Property, earlier, as if theproperty you repossess were personal rather than real property. Do notuse the rules for real property. Figuring gain on repossession.Your gain on repossession is the difference between the followingamounts. The total payments received, or considered received, on thesale. The total gain already reported as income. See the earlier discussions under Payments Receivedfor items considered payment on the sale. Limit on taxable gain.Taxable gain is limited to your gross profit on the original saleminus the sum of the following amounts. The gain on the sale you reported as income before therepossession. Your repossession costs. This method of figuring taxable gain, in essence, treats allpayments received on the sale as income, but limits your total taxablegain to the gross profit you originally expected on the sale. Indefinite selling price.The limit on taxable gain does not apply if the selling price isindefinite and cannot be determined at the time of repossession. Forexample, a selling price stated as a percentage of the profits to berealized from the buyer's development of the property is an indefiniteselling price. Character of gain.The taxable gain on repossession is ordinary income or capitalgain, the same as the gain on the original sale. However, if you didnot report the sale on the installment method, the gain is ordinaryincome. Repossession costs.Your repossession costs include money or property you pay toreacquire the real property. This includes amounts paid to the buyerof the property, as well as amounts paid to others for such items asthose listed below. Court costs. Legal fees. Publishing, acquiring, filing, or recording of title. Lien clearance. Repossession costs do not include the FMV of the buyer'sobligations to you that are secured by the real property. Pencil: Use the following worksheet to determine the taxable gain on arepossession of real property reported on the installment method. 1) Payments received before repossession            2) Minus: Gain reported            3) Gain on repossession            4) Gross profit on sale            5) Gain reported (line 2)              6) Plus: Repossession costs                         7) Subtract line 6 from line 4            8) Taxable gain (lesser of line 3 or7) Example.You sold a tract of land in January 1997 for $25,000. You acceptedfrom the buyer a $5,000 down payment, plus a $20,000 mortgage securedby the property and payable at the rate of $4,000 annually plusinterest (9.5%). The payments began on January 1, 1998. Your adjustedbasis in the property was $19,000 and you reported the transaction asan installment sale. Your selling expenses were $1,000. You figuredyour gross profit as follows: Selling price $25,000 Minus:  Adjusted basis $19,000  Selling expenses        1,000     20,000 Gross profit $ 5,000 For this sale, the contract price equals the selling price. Thegross profit percentage is 20% ($5,000 gross profit $25,000contract price). In 1997, you included $1,000 in income (20% $5,000 downpayment). In 1998, you reported a profit of $800 (20% $4,000annual installment). In 1999, the buyer defaulted and you repossessedthe property. You paid $500 in legal fees to get your property back.Your taxable gain on the repossession is figured as follows: 1) Payments received before repossession $9,000 2) Minus: Gain reported      1,800 3) Gain on repossession     $7,200 4) Gross profit on sale $5,000 5) Gain reported (line 2) $1,800 6) Plus: Repossession costs          500      2,300 7) Subtract line 6 from line 4     $2,700 8) Taxable gain (lesser of line 3 or7) $2,700 Basis.Your basis in the repossessed property is determined as of the dateof repossession. It is the sum of the following amounts. Your adjusted basis in the installment obligation. Your repossession costs. Your taxable gain on the repossession. To figure your adjusted basis in the installment obligation atthe time of repossession, multiply the unpaid balance by the grossprofit percentage. Subtract that amount from the unpaid balance. Pencil: Use the following worksheet to determine the basis of real propertyrepossessed. 1) Unpaid balance of obligation            2) Minus: Unrealized profit(line 1 gross profit %)            3) Adjusted basis (date of repossession)            4) Plus: Taxable gainon repossession            Repossession costs                       5) Basis of repossessed realproperty Example.Assume the same facts as the preceding example. The unpaid balanceof the installment obligation (the $20,000 note) is $16,000 at thetime of repossession because the buyer made a $4,000 payment. Thegross profit percentage on the original sale was 20%. Therefore,$3,200 (20% $16,000 still due on the note) is unrealizedprofit. You figure your basis in the repossessed property as follows: Unpaid balance of obligation $16,000 Minus: Unrealized profit      3,200 Adjusted basis (date of repossession) $12,800 Plus: Taxable gainon repossession $2,700 Repossession costs          500      3,200 Basis of repossessed realproperty $16,000 Holding period for resales.If you resell the repossessed property, the resale may result in acapital gain or loss. To figure whether the gain or loss is long-termor short-term, your holding period includes the period you owned theproperty before the original sale plus the period after therepossession. It does not include the period the buyer owned theproperty. If the buyer made improvements to the reacquired property, theholding period for these improvements begins on the day after the dateof repossession. Bad debt.If you repossess real property under these rules, you cannot take abad debt deduction for any part of the buyer's installment obligation.This is true even if the obligation is not fully satisfied by therepossession. If you took a bad debt deduction before the tax year ofrepossession, you are considered to have recovered the bad debt whenyou repossess the property. You must report the bad debt deduction youtook in the earlier year as income in the year of repossession.However, if any part of the earlier deduction did not reduce your tax,you do not have to report that part as income. Your adjusted basis inthe installment obligation is increased by the amount you report asincome from recovering the bad debt.