Capital Gains, Installment Sales, Unrecaptured Section 1250 Gain

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8836]

RIN 1545-AW85

Capital Gains, Installment Sales, Unrecaptured Section 1250 Gain

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

taxation of capital gains on installment sales of depreciable real

property. The 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 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: Effective Date: These regulations are effective August 23, 1999.

Applicability Date: These regulations apply to installment payments

properly taken into account after August 23, 1999.

FOR FURTHER INFORMATION CONTACT: Susan Kassell, (202) 622-4930 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26

CFR Part 1). On January 22, 1999, a notice of proposed rulemaking

relating to the taxation of capital gains on installment sales of

depreciable real property was published in the Federal Register (64 FR

3457). No comments were received from the public in response to the

notice of proposed rulemaking. No public hearing was requested or held.

The proposed regulations are adopted without substantive change by this

Treasury decision.

Explanation of Provisions

In 1997 Congress amended section 1(h) generally to reduce the

maximum capital gain tax rates for individuals. As amended, section

1(h) generally divides a taxpayer's net capital gain into several rate

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

rate gain, which is not pertinent to these final regulations. 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. A maximum marginal rate of 20 percent 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. A reduced rate of 10 percent is applied to the portion

of the taxpayer's adjusted net capital gain that would otherwise be

taxed at a 15-percent rate.

Under the final regulations, if a portion of the capital gain from

an installment sale of real depreciable property consists of 25-percent

gain, and a portion consists of 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. In addition, an example in the

regulations illustrates that section 1231 gain from an installment sale

that is recharacterized as ordinary gain under section 1231(c) is

deemed to consist first of 25-percent gain, and then 20/10-percent

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

percent gain is taken into account first, another example in the

regulations illustrates that, where there is installment gain that 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 final regulations also 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. The regulations further

[[Page 45875]]

provide that, in the event the cumulative amount of 25-percent gain

actually reported in installment payments received during the period

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

these regulations 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.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in Executive Order 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

these regulations do not impose a 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, the

notice of proposed rulemaking preceding these regulations was submitted

to the Chief Counsel for Advocacy of the Small Business Administration

for comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Susan Kassell and

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

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

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended 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 on or

before August 23, 1999. If the amount of unrecaptured section 1250 gain

in an installment payment that is properly taken into account after May

6, 1997, and on or before August 23, 1999, 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 as follows:

(i) In 1999, A sells property for $10,000, to be paid in ten

equal annual installments beginning on December 1, 1999. A

originally purchased the property for $5000, held the property for

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

amount of $3000. In each of the years 1999-2008, A has no other

capital or section 1231 gains or losses.

(ii) A's adjusted basis at the time of the sale is $2000. Of A's

$8000 of section 1231 gain on the sale of the property, $3000 is

attributable to prior straight-line depreciation deductions and is

unrecaptured section 1250 gain. The gain on each installment payment

is $800.

(iii) As illustrated in the table in this paragraph (iii) of

this Example 1., A takes into account the unrecaptured section 1250

gain first. Therefore, the gain on A's first three payments,

received in 1999, 2000, and 2001, is taxed at 25 percent. Of the

$800 of gain on the fourth payment, received in 2002, $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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Total

1999 2000 2001 2002 2003 2004-2008 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

as follows:

(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:

[[Page 45876]]

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Total

1994 1995 1996 1997 1998 1999-2003 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 as follows:

(i) The facts are the same as in Example 1, except that in 1999

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

years of $1000.

(ii) As illustrated in the table in paragraph (iv) of this

Example 3, in 1999, 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 the year 2000, 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 year 2000

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 2001 is

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

received in 2002, $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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Total

1999 2000 2001 2002 2003 2004-2008 gain

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

Taxed at ordinary rates under 800 200 ......... ......... ......... ......... 1000

section 1231(c)...................

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

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

Remaining non-recaptured net 200 ......... ......... ......... ......... ......... .........

section 1231 losses...............

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 as follows:

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

section 1231 losses of $1000 in 1999.

(ii) In 1999, 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 following table, 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 1999

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 the year 2000, 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

1999. Second, the remaining $600 of gain on A's year 2000

installment payment is taxed at 25 percent. As in 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 2001 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 2002, $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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Total

1999 2000 2001 2002 2003 2004-2008 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 ......... 200 ......... ......... ......... ......... 200

section 1231(c)...................

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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[[Page 45877]]

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

properly taken into account after August 23, 1999.

John M. Darymple,

Acting Deputy Commissioner of Internal Revenue.

Approved: August 9, 1999.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 99-21755 Filed 8-20-99; 8:45 am]

BILLING CODE 4830-01-U