Individuals with a gain from selling property in exchange for payments over more than one year incur special installment sales tax rules. The gain on these sales is taxed over the years that payments are received. A taxpayer in this situation often turns to the expertise of someone with enrolled agent certification for tax assistance.
After subtracting the interest portion of payments – which is taxed as ordinary income – the remaining principal payments require application of the installment sale tax method. The procedure, as covered in enrolled agent courses, is to first calculate the gross profit percentage. This is determined from dividing the seller’s cost basis by the gain from the sale. That percentage of each payment is the seller’s gain.
After all the payments are collected, the entire gain will have been taxed. However, what happens if a taxpayer repossesses the property secured by a note receivable from a prior year installment sale?
Foreclosures are becoming more common in the present economy. Therefore, understanding how to correctly handle these situations is an important part of enrolled agent employment. When property is repossessed after making an installment sale, there is a gain or loss on the repossession. This determination requires knowing the note holder’s basis and the fair market value of the repossessed property.
In order for repossession tax rules to apply, the installment obligation must be partially discharged by taking back the originally sold property. The installment obligation must be secured by the repossessed property. This can occur when a public foreclosure auction is satisfied by a bid from the installment note holder of the obligation’s balance.
Repossession tax rules are applicable even if title to sold property was never transferred. The effective act is default of the installment obligation from prior sale of the property. Also irrelevant is the manner in which the property is repossessed. The process may involve formal foreclosure or voluntary surrender of the property. Knowledge about these conditions from enrolled agent training permits proper tax reporting.
The tax professional with an EA license calculates the tax consequence of foreclosure by first determining the basis in the installment obligation. To do this, the gross profit percentage is multiplied by the remaining balance of the installment note. The result is subtracted from the note balance to derive the basis. The taxpayer has a gain or loss represented by the difference between the basis and the fair market value of the repossessed property. There is a gain if the basis is lower.
The tax treatment of the gain or loss on the repossession depends upon the type of property. This affected how the gain on original property sale was reported. Some special tax rules apply if the repossessed property is the former main home of the installment note holder. If Form 4797 was used to report the gain from originally selling the property, that form is used to report the gain or loss from the repossession. Otherwise, the gain or loss for repossessing most property is reported on Schedule D.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.