Installment sales and unrecaptured sec. 1250 gains.

• Author: Schell, Wayne M.
• Position: IRC section 1250 - Statistical Data Included

The Taxpayer Relief Act of 1997 (TRA '97) made substantial changes in the taxation of capital gains of individuals. However, several capital gains issues were left unresolved. One was the interaction among the new capital gains tax rates, the installment method (Sec. 453) and the rules for taxing certain business property (Sec. 1231). The Internal Revenue Service Restructuring and Reform Act of 1998 made additional substantive changes and technical corrections to capital gains taxation, but did not address the issues of installment sales and Sec. 1231 property. Therefore, in January 1999, Treasury issued Prop. Regs. Sec. 1.453-12, designed to clarify the interaction among the provisions.

The TRA '97 created three rate categories for noncorporate long-term capital gains. The categories are identified by the maximum tax rates that apply to net gains in each category: 28%, 25% and 20/10%. Currently, the 28% rate applies to long-term gains from collectibles and to a portion of the gain on certain qualified small business stock (Sec. 1202 gains). The 25% tax rate applies to unrecaptured Sec. 1250 gains. The 20/10% tax rates apply to an individual's net capital gain, which is any long-term gain not subject to either the 28% or 25% rates. The 20% rate applies to all 20/10% gains, except those that would otherwise be eligible for the 15% regular tax rate. Further, 20/10% gains falling in the 15% regular tax rate bracket are subject to the 10% capital gains rate.

Net Sec. 1231 gains are taxed as long-term capital gains. Sec. 1231 gains can potentially be taxed at either the 25% or 20/10% rates. The TRA '97 requires that, on the sale of Sec. 1231 property, any unrecaptured Sec. 1250 gain be taxed at a maximum tax rate of 25%. The unrecaptured Sec. 1250 gain is that part of the total gain that was not recaptured but would have been recaptured had Sec. 1245 applied to the transaction. Any remaining Sec. 1231 gain is eligible for the 20/10% rates.

The installment method of reporting gains allows taxpayers to recognize gain as cash is collected over the life of a note. An exception to this rule occurs on the installment sale of Sec. 1231 property, when the ordinary income recaptured under Secs. 1245 and 1250 must be recognized in the year of sale; only the remaining Sec. 1231 gain is reported as the note is collected.

Taxpayers that used the installment method to report gain on the sale of Sec. 1250 property when both 25% and 20/10% gains existed had a...