Capital Gains, Installment Sales, Unrecaptured Section 1250 Gain

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-110524-98]

RIN 1545-AW85

Capital Gains, Installment Sales, Unrecaptured Section 1250 Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed amendments to the regulations

relating to the taxation of capital gains on installment sales of

depreciable real property. The proposed regulations interpret changes

made by the Taxpayer Relief Act of 1997, as amended by the Internal

Revenue Service Restructuring and Reform Act of 1998 and the Omnibus

Consolidated and Emergency Supplemental Appropriations Act of 1999. The

proposed regulations affect persons required to report capital gain

from an installment sale where a portion of the capital gain is

unrecaptured section 1250 gain and a portion is adjusted net capital

gain.

DATES: Written comments or requests for a public hearing must be

received by April 22, 1999.

ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-110524-98), room

5226, Internal Revenue Service, POB 7604, Ben Franklin Station,

Washington, DC 20044. In the alternative, submissions may be hand

delivered Monday through Friday between the hours of 8 a.m. and 5 p.m.

to: CC:DOM:CORP:R (REG-110524-98), Courier's Desk, Internal Revenue

Service, 1111 Constitution Avenue, NW, Washington, DC. Alternatively,

taxpayers may submit comments electronically via the Internet by

selecting the ``Tax Regs'' option on the IRS Home Page, or by

submitting comments directly to the IRS Internet site at http://

www.irs.ustreas.gov/prod/tax__regs/comments.html.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Susan

Kassell, (202) 622-4930; concerning submissions, LaNita VanDyke, (202)

622-7190 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax

Regulations (26 CFR Part 1) relating to the taxation of capital gains

on installment sales of depreciable real property.

Prior to 1997, the maximum rate on net capital gain for individuals

was 28 percent. In the Taxpayer Relief Act of 1997, Public Law 105-34

(111 Stat. 788, 831) (1997 Act), Congress amended section 1(h)

generally to reduce the maximum capital gain tax rates for individuals.

Certain substantive changes and technical corrections to section 1(h)

were enacted as part of the Internal Revenue Service Restructuring and

Reform Act of 1998, Public Law 105-206 (112 Stat. 685), including the

repeal of an 18-month holding period requirement for amounts properly

taken into account after December 31, 1997, and by the Omnibus

Consolidated and Emergency Supplemental Appropriations Act, 1999,

Public Law 105-277 (112 Stat. 2681).

As amended, section 1(h) generally divides net capital gain into

three rate groups based on the nature of the property, the nature of

the gain, and the holding period of the property.

A maximum marginal rate of 28 percent applies to 28-percent rate

gain (28-percent gain), the combination of (1) capital gains and losses

from the sale or exchange of collectibles held for more than one year;

(2) an amount equal to gain excluded from income on the sale or

exchange of certain small business stock under section 1202; (3)

capital gains and losses determined under special transition rules in

section 1(h)(13) for certain amounts taken into account in 1997; (4)

net short-term capital loss for the tax year; and (5) any long-term

capital loss carryover to the tax year under section 1212.

A maximum marginal rate of 25 percent applies to unrecaptured

section 1250 gain (25-percent gain), which is defined in section

1(h)(7)(A) as the amount of long-term capital gain (not otherwise

treated as ordinary income) that would be treated as ordinary income if

section 1250(b)(1) included all depreciation and the applicable

percentage under section 1250(a) were 100 percent, reduced by any net

loss in the 28-percent rate category. Effectively, the amount of gain

taxed at 25 percent is the amount of straight-line depreciation allowed

for the property. Thus, the 25-percent rate category partially

recaptures such depreciation, but the recapture is limited, inter alia,

in that the recapture rate may be less than the marginal rates that

applied to the depreciation deductions. Section 1(h)(7)(B) limits the

unrecaptured section 1250 gain from section 1231 assets for any tax

year to the net section 1231 gain for that year.

A maximum marginal rate of 20 percent generally applies to adjusted

net capital gain (20/10-percent gain), defined in section 1(h)(4) as

the portion of net capital gain that is not taxed at the 28-percent or

25-percent rates. Under section 1(h)(1)(B), a 10-percent rate applies

to any portion of adjusted net capital gain that would otherwise be

taxed at a 15-percent rate if capital gains were taxed as ordinary

income.

For amounts properly taken into account after July 28, 1997, and

before January 1, 1998, an 18-month holding period is required to

obtain the maximum 25-percent, 20-percent, or 10-percent rates.

Section 453 provides that, unless taxpayers elect out, gain from an

installment sale is recognized as payments on the installment

obligation are received. Before the 1997 Act, reporting capital gain

under the installment method was relatively straightforward: the

capital gain portion of each payment was taxed at the maximum capital

gain rate of 28 percent. Section 1(h) provides for multiple rates, but

does not address how to treat an installment sale of depreciable real

property when the gain to be reported consists of both 25-percent gain

and 20/10-percent gain.

Explanation of Provisions

Front-Loaded Allocation of Unrecaptured Section 1250 Gain

Under the proposed regulations, if a portion of the capital gain

from an

[[Page 3458]]

installment sale is 25-percent gain and a portion is 20/10-percent

gain, the taxpayer is required to take the 25-percent gain into account

before the 20/10-percent gain, as payments are received. (Because sales

that result in 28-percent gain cannot also yield 25-percent gain or 20/

10-percent gain, an allocation rule for 28-percent gain is

unnecessary.)

A front-loaded allocation method for 25-percent gain is generally

consistent with the statute, under which 20/10-percent gain (that is,

adjusted net capital gain) is defined as the residual category of

capital gain not taxed at maximum rates of 28 percent or 25 percent.

The front-loaded method precludes taxpayers from recognizing some 20/

10-percent gain from an installment sale even when the amount

ultimately recognized proves to be less than the amount subject to

recapture at the 25-percent rate. Absent a front-loaded allocation

method this inappropriate result could arise, for example, when a

taxpayer later disposes of an installment obligation at a discounted

price or when the amount to be received is contingent.

The IRS and Treasury Department have previously adopted analogous

front-loaded allocation methods with respect to installment sales. For

example, before 1984--when Congress enacted section 453(i), which

requires immediate recognition of recapture gain at ordinary rates

under sections 1245 and 1250-- taxpayers were permitted to defer

recognition of this ordinary-rate recapture gain under the installment

method. Thus, an installment payment could contain both capital gain

and gain taxed at ordinary rates. By regulation, a front-loaded

allocation of the ordinary-rate recapture gain was required.

Secs. 1.1245-6(d); 1.1250-1(c)(6). See Dunn Construction v. United

States, 323 F. Supp. 440 (N.D. Ala. 1971) (upholding Sec. 1.1245-6(d)

as ``reasonable and consistent with the underlying statute'' and a

valid exercise of the regulatory authority under section 453). See also

Secs. 1.1251-1(e)(6), 1.1252-1(d)(3), 1.1254-1(d), and 16A.1255-

1(c)(3).

Interaction With Section 1231

Section 1(h) also does not address the interaction of the capital

gain rates, the installment method, and the rules in section 1231.

Section 1231(a) generally provides that, when gains from the sale or

exchange of property used in a trade or business exceed losses from

such property, the gains and losses are treated as long-term capital

gains and losses. Conversely, when section 1231 losses exceed section

1231 gains, the gains and losses are treated as ordinary. The capital

nature of net section 1231 gain is subject to an exception: under

section 1231(c), net section 1231 gain is treated as ordinary income to

the extent of the taxpayer's non-recaptured net section 1231 losses for

the preceding five years.

With respect to the interaction of section 1231(c) and the capital

gain rates, the IRS and Treasury Department have already provided that

section 1231 gain that is recharacterized as ordinary gain under

section 1231(c) is deemed to consist first of 28-percent gain, then 25-

percent gain, and finally 20/10-percent gain. See Notice 97-59 (1997-45

IRB 7, 8). An example in the proposed regulations illustrates the

application of this principle in the installment sale context.

Consistent with this treatment and with the general rule that 25-

percent gain is front-loaded, another example in the proposed

regulations illustrates that--in a year in which installment gain is

characterized as ordinary gain under section 1231(a) because there is a

net section 1231 loss for the year--the gain is treated as consisting

of 25-percent gain first, before 20/10-percent gain, for purposes of

determining how much 25-percent gain remains to be taken into account

in later payments.

The examples in the proposed regulations--regarding the interaction

of sections 1(h), 453, and 1231--are specific applications of the

general rule that, for any given installment payment, gain from all

previous payments is treated as consisting first of 25-percent gain,

rather than 20/10-percent gain, in determining how much of each

category of gain remains to be reported with respect to current and

subsequent payments. Under the regulations, in making this

determination it is generally irrelevant how such prior gain was

actually reported and taxed. For example, an installment payment that

is taxed at 15 percent because the taxpayer is in a low tax bracket may

be treated as consisting of 25-percent gain (that is, unrecaptured

section 1250 gain) for allocation purposes, even though the gain is not

actually taxed at 25 percent. The proposed regulations focus on

examples involving section 1231 since they are the most common.

Treatment of Installment Payments From Sales Prior to the Effective

Date of the 1997 Act

The capital gains provisions of the 1997 Act were effective for

taxable years ending after May 6, 1997. However, the maximum rate of 28

percent was not reduced for gains properly taken into account before

May 7, 1997. Under settled authority, originating in Snell v.

Commissioner, 97 F.2d 891 (5th Cir. 1938), the law in effect when an

installment payment is received controls the tax treatment of the

payment. Unless otherwise provided, installment payments received after

a change in the law are taxed under the new law, whether favorable or

unfavorable, looking back to the original transaction for the facts

necessary to apply the changed law. In Snell, for example, installment

payments from what was a capital asset in the sale year were taxed as

ordinary income after Congress changed the definition of a capital

asset. See also Estate of Kearns v. Commissioner, 73 T.C. 1223 (1980);

Klein v. Commissioner, 42 T.C. 1000 (1964); Rev. Rul. 79-22 (1979-1 CB

275). Congress also implicitly has recognized the Snell principle by

enacting grandfather exceptions when the application of Snell would be

unfavorable. For example, when Congress extended the holding period

requirement for capital gain in 1976, the legislation specifically

excepted from the new, harsher requirements post-1976 installment gain

from pre-1976 sales.

The legislative history of the 1997 Act reflects the Snell

principle, providing that section 1(h) ``generally applies to sales and

exchanges (and installment payments received) after May 6, 1997.''

Conf. Rep. 105-220, 105th Cong., 1st Sess. 382, 383 (1997). Thus, under

these settled principles, gain on installment payments received after

May 6, 1997, from sales on or before that date, is taxed at the new,

lower maximum rates of 25 percent, 20 percent, or 10 percent if it

qualifies as unrecaptured section 1250 gain or adjusted net capital

gain. However, as in the case of gain from post-effective-date sales,

section 1(h) does not specify how to allocate the two categories of

gain.

The proposed regulations provide that the capital gain rates

applicable to installment payments that are received on or after the

effective date of the 1997 Act from sales prior to the effective date

are determined as if, for all payments received after the date of sale

but before the effective date, 25-percent gain had been taken into

account before 20/10-percent gain. This approach is consistent with the

Snell principle in that it provides for the same method of allocation,

whether the sale occurred before or after the effective date of the

1997 Act. For taxpayers who sold property and received installment

payments before the effective date of the 1997 Act, this provision is

favorable, since it generally reduces or eliminates the amount of 25-

percent gain to be reported on installment payments

[[Page 3459]]

received after the effective date. The approach is also simple--because

it is generally irrelevant how the prior gain was actually reported and

taxed, in most cases taxpayers will simply calculate the total amount

of 25-percent gain on the sale and subtract from that all gain

previously reported, in order to arrive at the amount of 25-percent

gain remaining to be reported.

Treatment of Installment Payments Received Between the Effective Date

of the Statute and the Effective Date of the Final Regulations

The proposed regulations also address the treatment of gain in

installment payments that are received during the period between the

effective date of section 1(h) and the effective date of the final

regulations. The proposed regulations provide that, in the event the

cumulative amount of 25-percent gain actually reported in installment

payments received during this period was less than the amount that

would have been reported using the front-loaded allocation method of

the regulations, the amount of 25-percent gain actually reported,

rather than an amount determined under a front-loaded allocation

method, must be used in determining the amount of 25-percent gain that

remains to be reported. This provision ensures that taxpayers cannot

underreport the total amount of 25-percent gain by taking inconsistent

positions with respect to payments received before and after the

effective date of the regulations. By providing for this rule, no

inference is intended that any allocation method other than the method

provided for by the regulations was a reasonable interpretation of

section 1(h) in this context. However, the IRS will not challenge the

use of a pro rata allocation method--that is, a method under which the

amounts of 25-percent gain and 20/10-percent gain in each installment

payment bear the same relationship as the total amounts of 25-percent

and 20/10-percent gain to be reported on the sale--for installment

payments received before the effective date of the final regulations,

if the taxpayer used the same pro rata method for all installment

payments during such period.

Proposed Effective Date

The regulations are proposed to be effective for payments properly

taken into account after the date the regulations are published as

final regulations in the Federal Register.

Special Analyses

It has been determined that this notice of proposed rulemaking is

not a significant regulatory action as defined in EO 12866. Therefore,

a regulatory assessment is not required. It also has been determined

that section 553(b) of the Administrative Procedure Act (5 U.S.C.

chapter 5) does not apply to these regulations, and, because the

regulations do not impose a requirement for the collection of

information on small entities, the Regulatory Flexibility Act (5 U.S.C.

chapter 6) does not apply. Pursuant to section 7805(f) of the Internal

Revenue Code, this notice of proposed rulemaking will be submitted to

the Chief Counsel for Advocacy of the Small Business Administration for

comment on its impact on small business.

Comments and Requests for a Public Hearing

Before these proposed regulations are adopted as final regulations,

consideration will be given to any written comments (a signed original

and eight (8) copies) that are submitted timely to the IRS. The IRS and

Treasury Department request comments on the clarity of the proposed

rules and how they can be made easier to understand. All comments will

be available for public inspection and copying. A public hearing may be

scheduled if requested in writing by a person that timely submits

written comments. If a public hearing is scheduled, notice of the date,

time, and place for the hearing will be published in the Federal

Register.

Drafting Information

The principal authors of these regulations are Susan Kassell and

Rob Laudeman, Office of the Assistant Chief Counsel (Income Tax &

Accounting). However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendment to the Regulations

Accordingly, the IRS proposes to amend 26 CFR part 1 as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.453-12 is added to read as follows:

Sec. 1.453-12 Allocation of unrecaptured section 1250 gain reported on

the installment method.

(a) General rule. Unrecaptured section 1250 gain, as defined in

section 1(h)(7), is reported on the installment method if that method

otherwise applies under section 453 or 453A and the corresponding

regulations. If gain from an installment sale includes unrecaptured

section 1250 gain and adjusted net capital gain (as defined in section

1(h)(4)), the unrecaptured section 1250 gain is taken into account

before the adjusted net capital gain.

(b) Installment payments from sales before May 7, 1997. The amount

of unrecaptured section 1250 gain in an installment payment that is

properly taken into account after May 6, 1997, from a sale before May

7, 1997, is determined as if, for all payments properly taken into

account after the date of sale but before May 7, 1997, unrecaptured

section 1250 gain had been taken into account before adjusted net

capital gain.

(c) Installment payments received after May 6, 1997, and before the

effective date of the final regulations. If the amount of unrecaptured

section 1250 gain in an installment payment that is properly taken into

account after May 6, 1997, and before the effective date of the final

regulations, is less than the amount that would have been taken into

account under this section, the lesser amount is used to determine the

amount of unrecaptured section 1250 gain that remains to be taken into

account.

(d) Examples. In each example, the taxpayer, an individual whose

taxable year is the calendar year, does not elect out of the

installment method. The installment obligation bears adequate stated

interest, and the property sold is real property held in a trade or

business that qualifies as both section 1231 property and section 1250

property. In all taxable years, the taxpayer's marginal tax rate on

ordinary income is 28 percent. The following examples illustrate the

rules of this section:

Example 1. General rule. This example illustrates the rule of

paragraph (a) of this section.

(i) In 1998, A sells property for $10,000, to be paid in ten

equal annual installments beginning on December 1, 1998. A

originally purchased the property for $5,000, held the property for

several years, and took straight-line depreciation deductions in the

amount of $3,000. In each of the years 1998-2007, A has no other

capital or section 1231 gains or losses.

(ii) A's adjusted basis at the time of the sale is $2,000. Of

A's $8,000 of section 1231 gain on the sale of the property, $3,000

is attributable to prior straight-line depreciation

[[Page 3460]]

deductions and is unrecaptured section 1250 gain. The gain on each

installment payment is $800.

(iii) As illustrated in the following table, A takes into

account the unrecaptured section 1250 gain first. Therefore, the

gain on A's first three payments, received in 1998, 1999, and 2000,

is taxed at 25 percent. Of the $800 of gain on the fourth payment,

received in 2001, $600 is taxed at 25 percent and the remaining $200

is taxed at 20 percent. The gain on A's remaining six installment

payments is taxed at 20 percent. The table is as follows:

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1998 1999 2000 2001 2002 2003-2007 Total gain

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Installment gain............................................. 800 800 800 800 800 4000 8000

Taxed at 25%................................................. 800 800 800 600 ........... ........... 3000

Taxed at 20%................................................. ........... ........... ........... 200 800 4000 5000

Remaining to be taxed at 25%................................. 2200 1400 600 ........... ........... ........... ...........

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Example 2. Installment payments from sales prior to May 7, 1997.

This example illustrates the rule of paragraph (b) of this section.

(i) The facts are the same as in Example 1 except that A sold

the property in 1994, received the first of the ten annual

installment payments on December 1, 1994, and had no other capital

or section 1231 gains or losses in the years 1994-2003.

(ii) As in Example 1, of A's $8000 of gain on the sale of the

property, $3000 was attributable to prior straight-line depreciation

deductions and is unrecaptured section 1250 gain.

(iii) As illustrated in the following table, A's first three

payments, in 1994, 1995, and 1996, were received before May 7, 1997,

and taxed at 28 percent. Under the rule described in paragraph (b)

of this section, A determines the allocation of unrecaptured section

1250 gain for each installment payment after May 6, 1997, by taking

unrecaptured section 1250 gain into account first, treating the

general rule of paragraph (a) of this section as having applied

since the time the property was sold, in 1994. Consequently, of the

$800 of gain on the fourth payment, received in 1997, $600 is taxed

at 25 percent and the remaining $200 is taxed at 20 percent. The

gain on A's remaining six installment payments is taxed at 20

percent. The table is as follows:

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1994 1995 1996 1997 1998 1999-2003 Total gain

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Installment gain............................................. 800 800 800 800 800 4000 8000

Taxed at 28%................................................. 800 800 800 ........... ........... ........... 2400

Taxed at 25%................................................. ........... ........... ........... 600 ........... ........... 600

Taxed at 20%................................................. ........... ........... ........... 200 800 4000 5000

Remaining to be taxed at 25%................................. 2200 1400 600 ........... ........... ........... ...........

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Example 3. Effect of section 1231(c) recapture. This example

illustrates the rule of paragraph (a) of this section when there are

non-recaptured net section 1231 losses, as defined in section

1231(c)(2), from prior years.

(i) The facts are the same as in Example 1, except that in 1998

A has non-recaptured net section 1231 losses from the previous four

years of $1000.

(ii) As illustrated in the table at the end of this example, in

1998, all of A's $800 installment gain is recaptured as ordinary

income under section 1231(c). Under the rule described in paragraph

(a) of this section, for purposes of determining the amount of

unrecaptured section 1250 gain remaining to be taken into account,

the $800 recaptured as ordinary income under section 1231(c) is

treated as reducing unrecaptured section 1250 gain, rather than

adjusted net capital gain. Therefore, A has $2200 of unrecaptured

section 1250 gain remaining to be taken into account.

(iii) In 1999, A's installment gain is taxed at two rates.

First, $200 is recaptured as ordinary income under section 1231(c).

Second, the remaining $600 of gain on A's 1999 installment payment

is taxed at 25 percent. Because the full $800 of gain reduces

unrecaptured section 1250 gain, A has $1400 of unrecaptured section

1250 gain remaining to be taken into account.

(iv) The gain on A's installment payment received in 2000 is

taxed at 25 percent. Of the $800 of gain on the fourth payment,

received in 2001, $600 is taxed at 25 percent and the remaining $200

is taxed at 20 percent. The gain on A's remaining six installment

payments is taxed at 20 percent. The table is as follows:

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1998 1999 2000 2001 2002 2003-2007 Total gain

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Installment gain............................................. 800 800 800 800 800 4000 8000

Taxed at ordinary rates under section 1231(c)................ 800 200 ........... ........... ........... ........... 1000

Taxed at 25%................................................. ........... 600 800 600 ........... ........... 2000

Taxed at 20%................................................. ........... ........... ........... 200 800 4000 5000

Remaining non-recaptured net section 1231 losses............. 200 ........... ........... ........... ........... ........... ...........

Remaining to be taxed at 25%................................. 2200 1400 600 ........... ........... ........... ...........

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Example 4. Effect of a net section 1231 loss. This example

illustrates the application of paragraph (a) of this section when

there is a net section 1231 loss.

(i) The facts are the same as in Example 1 except that A has

section 1231 losses of $1000 in 1998.

(ii) In 1998, A's section 1231 installment gain of $800 does not

exceed A's section 1231 losses of $1000. Therefore, A has a net

section 1231 loss of $200. As a result, under section 1231(a) all of

A's section 1231 gains and losses are treated as ordinary gains and

losses. As illustrated in the table at the end of this example, A's

entire $800 of installment gain is ordinary gain. Under the rule

described in paragraph (a) of this section, for purposes of

determining the amount of unrecaptured section 1250 gain remaining

to be taken into account, A's $800 of ordinary section 1231

installment gain in 1998 is treated as reducing unrecaptured section

1250 gain. Therefore, A has $2200 of unrecaptured section 1250 gain

remaining to be taken into account.

(iii) In 1999, A has $800 of section 1231 installment gain,

resulting in a net section 1231 gain of $800. A also has $200 of

non-recaptured net section 1231 losses. The $800 gain is taxed at

two rates. First, $200 is taxed at ordinary rates under section

1231(c), recapturing the $200 net section 1231 loss sustained in

1998. Second, the remaining $600 of gain on A's 1999 installment

payment is taxed at 25 percent. As in

[[Page 3461]]

Example 3, the $200 of section 1231(c) gain is treated as reducing

unrecaptured section 1250 gain, rather than adjusted net capital

gain. Therefore, A has $1400 of unrecaptured section 1250 gain

remaining to be taken into account.

(iv) The gain on A's installment payment received in 2000 is

taxed at 25 percent, reducing the remaining unrecaptured section

1250 gain to $600. Of the $800 of gain on the fourth payment,

received in 2001, $600 is taxed at 25 percent and the remaining $200

is taxed at 20 percent. The gain on A's remaining six installment

payments is taxed at 20 percent. The table is as follows:

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1998 1999 2000 2001 2002 2003-2007 Total gain

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Installment gain............................................. 800 800 800 800 800 4000 8000

Ordinary gain under section 1231(a).......................... 800 ........... ........... ........... ........... ........... 800

Taxed at ordinary rates under section 1231(c)................ ........... 200 ........... ........... ........... ........... 200

Taxed at 25%................................................. ........... 600 800 600 ........... ........... 2000

Taxed at 20%................................................. ........... ........... ........... 200 800 4000 5000

Net section 1231 loss........................................ 200 ........... ........... ........... ........... ........... ...........

Remaining to be taxed at 25%................................. 2200 1400 600 ........... ........... ........... ...........

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(e) Effective date. This section applies to installment payments

properly taken into account after the date these regulations are

published as final regulations in the Federal Register.

Robert E. Wenzel,

Deputy Commissioner of Internal Revenue.

[FR Doc. 99-1148 Filed 1-21-99; 8:45 am]

BILLING CODE 4830-01-U