Installment Reporting and Section 453

The coordination between the two regimes is set out in a paragraph of the deferred exchange regulation that most readers never reach, and it is unusually generous. This chapter works through what it provides, what conditions it, and how seller financing fits inside an exchange.

44.1 Straddle-year exchanges

An installment sale is a disposition of property where at least one payment is to be received after the close of the taxable year in which the disposition occurs.¹ Under the installment method, the income recognized for any year is the proportion of the payments received in that year that the gross profit bears to the total contract price.²

The question in an exchange is when the taxpayer received a payment, and the answer would ordinarily be adverse. The relinquished property closed, the buyer paid, and the proceeds are held by a person the taxpayer engaged. Two coordination rules displace that answer.

The escrow rule. Where the transferee's obligation to transfer replacement property is or may be secured by cash or a cash equivalent, the determination of whether the taxpayer has received a payment for purposes of section 453 is made without regard to the fact that the obligation is so secured, if the cash is held in a qualified escrow account or a qualified trust.³

The intermediary rule. Where the transfer of relinquished property involves a qualified intermediary, the determination of whether the taxpayer has received a payment for purposes of section 453 is made as if the intermediary is not the agent of the taxpayer.⁴

Both cease to apply at the earlier of the time the taxpayer obtains an immediate ability or unrestricted right to the funds or the end of the exchange period.⁵

Two conditions limit the rules, and both should be confirmed before a taxpayer relies on the timing benefit.

The taxpayer must have had a bona fide intent to enter into a deferred exchange at the beginning of the exchange period, meaning that it was reasonable to believe, on all the facts and circumstances as of that date, that like-kind replacement property would be acquired before the end of the exchange period.⁶

The relinquished property must not be disqualified property, meaning property not held for productive use in a trade or business or for investment, or property described in section 1031(a)(2).⁷

The result in the ordinary partial exchange. A taxpayer transfers relinquished property in September, receives replacement property the following March, and takes the residual cash from the escrow at that time. Gain is recognized under section 1031(b) to the extent of the cash. Because the escrow is disregarded for section 453 purposes, the taxpayer is not treated as having received payment in the year of the transfer, and payment occurs in the following year when the cash is released. Subject to the other requirements of sections 453 and 453A, the gain may be reported in the later year under the installment method.⁸

That is a full year of additional deferral on the boot, obtained by nothing more than the ordinary structure.

44.2 Failed exchanges as installment sales

The provision that makes this chapter matter is a single sentence, and it is the most taxpayer-favorable sentence in the deferred exchange regulation.

For purposes of the intermediary rule, a person who otherwise satisfies the definition of a qualified intermediary is treated as a qualified intermediary even though that person ultimately fails to acquire identified replacement property and transfer it to the taxpayer.⁹

An exchange that fails completely therefore retains the payment timing benefit. The taxpayer is not treated as having received the sale proceeds when the intermediary received them, and payment occurs when the funds are released.

The regulation works it twice. In the first, the taxpayer transferred relinquished property in December, had a bona fide intent to exchange, identified no replacement property, and received the entire proceeds at the end of the identification period in the following year. The realized gain was recognized in full under section 1001, but the taxpayer was treated as receiving payment in the later year and could report the gain then under the installment method.¹⁰

In the second, a corporation's directors authorized a like-kind exchange, the relinquished property closed in late November, and in January the directors concluded that the planned expansion was not feasible because of a business downturn and instructed the intermediary to stop searching. Both decisions were recorded in the minutes. The directors' authorization, the terms of the exchange agreement, and the absence of other relevant facts established the bona fide intent, and the taxpayer reported the gain in the following year.¹¹

What that establishes for practice.

A fourth quarter seller who engages an intermediary and fails obtains a year of deferral. A fourth quarter seller who simply sells does not. The structure costs an intermediary fee and is worth having even where the exchange is doubtful.

Bona fide intent is proved contemporaneously or not at all. Board minutes, an engagement letter reciting the exchange objective, correspondence with brokers about replacement property, and the exchange agreement are the evidence. The regulation's second example is essentially a lesson in what a file should contain.

The release date depends on whether the taxpayer identified. A taxpayer who identified nothing may take the funds after the identification period. A taxpayer who identified is locked until the end of the exchange period, absent a written contingency.¹² In a fourth quarter transaction both dates fall in the following year, so the timing result is similar; in a first quarter transaction the difference is months.

The installment method is a default, not a requirement. A taxpayer may elect out, and the election must be made by the due date, including extensions, of the return for the year of the disposition, and is revocable only with consent.¹³ Electing out makes sense where rates are expected to rise, where expiring losses or credits can absorb the gain, or where the taxpayer prefers to close the year.

Section 453A should be checked and usually does not apply. It reaches obligations arising from a disposition under the installment method only where the sales price exceeds $150,000,¹⁴ and its interest charge applies for a year only if the obligation is outstanding at the close of that year and the face amount of all such obligations arising during and outstanding at the close of the year exceeds $5,000,000.¹⁵ Where it does apply, the tax is increased by interest at the underpayment rate on the applicable percentage of the deferred tax liability,¹⁶ and the pledging rules treat a pledge of the obligation as a receipt of proceeds.¹⁷

44.3 Seller financing within an exchange

A buyer who will not pay all cash presents a structural problem, because a note is not real property. It is other property received, and under Chapter 33 it is boot at its fair market value. It is also boot the taxpayer cannot reinvest, since the intermediary cannot buy replacement property with a promissory note.

The general rule preserves installment treatment for the note. For purposes of section 453, the term payment does not include the receipt of evidences of indebtedness of the person acquiring the property, whether or not payment of the indebtedness is guaranteed by another person.¹⁸ The exception is narrow but real: an obligation payable on demand or readily tradable is treated as receipt of payment.¹⁹

The coordination rule solves a problem that would otherwise be fatal. In an intermediated exchange the note is given by the buyer to the intermediary, and the taxpayer receives it from the intermediary. On those facts the note is not an obligation of the person who acquired property from the taxpayer, because the taxpayer's transferee was the intermediary. The regulation supplies the fiction: in a transaction involving a qualified intermediary, the taxpayer's receipt of an evidence of indebtedness of the intermediary's transferee is treated as the receipt of an evidence of indebtedness of the person acquiring property from the taxpayer.²⁰

The regulation's illustration. A taxpayer transferred relinquished property through an intermediary for $80,000 in cash and the buyer's ten year installment obligation for $20,000, bearing adequate stated interest and neither payable on demand nor readily tradable. The intermediary acquired replacement property worth $80,000 and delivered it, along with the obligation, to the taxpayer.

Under section 1031(b), $20,000 of the gain, being the amount of the installment obligation received, did not qualify for nonrecognition. But the receipt of the obligation was not treated as a payment, and subject to the other requirements of sections 453 and 453A the taxpayer could report the $20,000 of gain under the installment method as payments were received on the note.²¹

Special computational rules apply where a transaction is partly within section 1031(b). The total contract price is reduced to take into account the amount of property permitted to be received without recognition of gain; the gross profit is reduced to take into account any amount not recognized by reason of section 1031(b); and the term payment, when used elsewhere in section 453, does not include property permitted to be received without recognition of gain.²²

Four structuring points.

The note must not be payable on demand and must not be readily tradable, or the installment benefit is lost at the outset.

The note should bear adequate stated interest, both because the regulation's example assumes it and because the imputed interest provisions apply on their own terms.

The note should be taken by the intermediary and delivered to the taxpayer as part of the exchange, so that the coordination rule applies on its face. A note run directly from the buyer to the taxpayer at the closing table is a different transaction and should be avoided.

Where the taxpayer wants the full purchase price available for replacement property rather than a note, one technique used in practice is for the taxpayer to purchase the note from the intermediary with outside funds, leaving the intermediary holding cash. The technique should be analyzed against the restrictions of 27.6 before it is used, since it involves the taxpayer transacting with the exchange account, and it should not be improvised at a closing.

Involuntary conversions, which raise the parallel question of how a condemnation award interacts with an exchange in progress, are the subject of Chapter 45.