Installment Sale

[Kram BergGold]

Taxpayer inherits the income stream of an installment sale. The item sold, by the decedent, was a rental property (passive). The Taxpayer has suspended losses from other activities. My software is allowing the gain from the principal payments from the installment sale to trigger the suspended losses. So my question is, does the inherited installment sale income retain it's passive status to the heir?

[Koss]

Installment Sale

Kram BergGold wrote:

Does the inherited installment sale income retain its passive status to the heir?

Maybe not.

I don't have a definite answer, but I'm going to raise a much broader question.

Why does this asset even retain its character as an installment sale in the hands of the heir?

An installment sale is a promissory note. The special treatment of an installment sale, i.e., the fact that the gain from the sale of the underlying asset is spread over the life of the installments, arises out of the fact that the holder of the note is also the party who sold the asset.

I don't think your client inherited "the income stream of an installment sale." I think your client inherited a promissory note.

Put another way: Suppose the decedent had made an unsecured loan to his brother in-law, to be paid in installments over 10 years. Brother in-law signs a promissory note and begins making payments. Three years into the note, the holder of the note dies, and your client inherits the note. Your client now gets the rest of the payments.

I see this as no different from a case where someone inherits a corporate bond or a certificate of deposit. Each payment consists of interest and principal. The interest is taxable as interest. The principal component is not taxable at all. It's an inheritance.

Your client probably inherited a promissory note that is secured by the rental property. It should be either a land contract or a seller-financed mortgage.

But your client did not inherit the rental property. I'm not convinced that the principal portion of each payment is taxable to your client.

But if I'm correct, that raises a different question.

Does the decedent, and his estate, get to walk away from paying tax on the remaining portion of the gain?

My intuition says no. But that may not be your client's problem. It may be an issue for the estate.

But if the estate doesn't deal with it, the IRS might be able to recover unpaid taxes from assets that were distributed out of the estate...

From a theoretical standpoint, I don't think you can inherit a capital gain. Your client inherited an asset. That asset is a promissory note--not an installment sale.

BMK

[Burke]

I agree. IMO, the only thing the TP inherited (at this point) was a promissory note with -- hopefully -- a lien on the property. Therefore, the asset (outstanding principal) was an inherited, income-producing asset and not taxable. (Think of a bond.) However, the interest income retains its same character and it would be taxable as ordinary income. This interest would simply be reported as seller-financed interest on Sche B. No 6252. The principal would be treated as a return of capital and decrease his basis each month. Now, suppose the buyer defaults on the installment note, and the TP/heir has to foreclose and take back the property. Then he could sell it at a higher/lower price than the basis of the remaining principal -- and he would have a taxable gain/loss on that difference. Or he could keep it.

[Gene V]

Pub. 559 page 9 and 10

Installment obligations. If the decedent had
sold property using the installment method and
you collect payments on an installment obliga-
tion you acquired from the decedent, use the
same gross profit percentage the decedent used
to figure the part of each payment that repre-
sents profit. Include in your income the same
profit the decedent would have included had death
not occurred. For more information, see
Publication 537, Installment Sales.

If you dispose of an installment obligation
acquired from a decedent (other than by transfer
to the obligor), the rules explained in Publication
537 for figuring gain or loss on the disposition
apply to you.

[Burke]

Well, I stand corrected and am humbled. But I doth protest! That circumvents the entire premise of inherited property (assets) not being taxed to the recipient in the US Code. But on the other hand, think of an annuity -- which does not receive stepped-up basis and is taxable to the recipient as ordinary income. So there are certain exceptions, and I guess we have to stipulate this is one of them. I suppose he is lucky he would be allowed favorable capital gains treatment on any gain reported. And therefore, KramBergold's scenario as posted is properly allowing the gain to release other suspended passive losses.

[Koss]

Inherited Installment Obligation

Obviously, I was wrong. Gene found the answer in Publication 559.

I'll have to begin advising my clients that if they sell something on the installment method, and they don't want to stick their heirs with the tax bill, they need to postpone death until the installment obligation is fully paid.



Or... well... hmmm.

If the heirs have accumulated a lot of suspended passive losses, as in the case presented in the original post, then maybe the person who sold property on the installment method should actually plan to die early, and that way no one pays tax on the gain.





BMK

[Roland Slugg]

Transmission of an installment obligation at death doesn't result in gain or loss to the decedent. (Code §453B(c) and Regs §1.451-1(b)(2))

The installment obligation retains its same character in the hands of the inheriting beneficiary, including the taxable percentage, the type of gain, and even the portion that represents Unrecaptured §1250 Gain. If the latter exists, is taken into account first as payments are collected. (Regs §1.453-12(a))

There is nothing unusual about inherited assets being taxable to the recipient. The most common example is probably an IRA, which is taxed to the bene in the same amount as it would have been taxed to the decedent.

Regarding the original question, gain from payments made on an inherited obligation retains the same character as it had in the hands of the decedent. Thus, the gain portion of payments (but not the interest portion) may be used to offset PALs the new owner may have. The decedent's unused PALs, however, do not carry over. They are lost.

[taxea]

When the issuer of the installment agreement died , for all intent and purpose the agreement died with him. Most people will call in the note by advising the loanee that the issuer died and you are demanding payment in full.

[Burke]

Depends on the wording in the contract agreement. But if that did happen, the heir would have to report the entire remaining gain on his tax return in that year. I have never liked installment agreements for a variety of reasons, and this thread's scenario is one of them.

[TAX4US]

I have seen some of these where if the payor was not contractically late the heirs or the estate could not call in the loan, but be 1 day late and the payors goose was cooked. Just my observance.

[taxea]

Depends on the wording in the contract agreement. But if that did happen, the heir would have to report the entire remaining gain on his tax return in that year.

Burke isn't the principal on the loan the inheritance?
What should have been done is, the call-in on the loan should have been done while the estate was open rather than distributing the installment agreement to the benficiary. It seems to me that the TP may be able to call in the note and take the gross from the payment minus any included interest as inheritance. The interest would be taxable income. The note isn't being sold so where does the capital gain come in? The principal on the inheritance would be deducted from beneficiary's FMV basis.

[Burke]

Burke isn't the principal on the loan the inheritance?
The note isn't being sold so where does the capital gain come in? The principal on the inheritance would be deducted from beneficiary's FMV basis.

Well, that was my (and Koss') original premise, which has been disproved by the information in this thread and instructions from Pub 559. Paying off the installment obligation would not change that. The TP (inheritor) would still be bound by that ruling, and the entire principal would be subject to the profit-percentage of gain treatment if it were settled in advance of the terms of the promissory note.

[Burke]

It came to me last night -- this often happens at 3:00 am, don't ask me why -- that it was never definitively established that this was a true installment sale, and not just a note assumed by the original seller. In other words, if the (now) deceased original owner elected out of the installment gain treatment and elected to report the entire gain in the year of sale, we have an entirely different scenario. To KramBergold, do you know for sure this did not happen, or were you able to review the deceased's previous year's tax return to see how it was being treated? If it was just an assumed mortgage, then only the interest is income and there is no gain to report by the inheritor.