Treatment of capital gains on installment sales under the TRA '97.

• Author: Riviezzo, Alice M.
• Position: Taxpayer Relief Act of 1997

Generally, the Taxpayer Relief Act of 1997 (TRA '97) reduced the maximum capital gains rate to 20%. However, some other changes have been made to the taxation of gains on depreciable real property. Complexities arise in administering these new provisions to depreciable real estate sold subject to an installment sale agreement. Recapture of all depreciation is now required for sales of real property. In the past, this applied only when accelerated depreciation had been taken on real property subject to Sec. 1250 or for personal property subject to Sec. 1245. Sec. 1250 recaptures, as ordinary income, the gain up to the amount of actual depreciation in excess of straight-line. New Sec. 1(h)(1)(B) and (h)(6) recapture the accumulated depreciation to the extent of straight-line depreciation at a 25% rate; only gain in excess of the initial predepreciation basis will qualify for the new 20% long-term capital gains rate. These rules are effective for transactions occurring after May 6, 1997.

Under the old law, Sec. 1231 gain component on the sale of depreciable real property was recognized proportionately as installment principal payments were received. One question that arises with regard to installment sales that predate May 7, 1997 is whether gain associated with depreciation will have to be broken out and taxed at the different rates. At this time, the IRS has not taken an official position. Unofficial sources, however, have indicated that it is likely that the Service will not require recapture amounts to be taxed at the higher rate, in effect taxing all gains on these installment sales at 20%. Recalculating the gain on all old installment sales to break out recapture amounts would be costly and burdensome to taxpayers. The new rate is beneficial for taxpayers who structured installment sale contracts with the expectation of a 28% capital gains rate over the life of the agreement who may now have the gains taxed at only 20%. For an installment sale of a building prior to the effective date of the TRA '97, it appears the new law's treatment is as illustrated in Table 1 on page 86.

[TABULAR DATA 1 NOT REPRODUCIBLE IN ASCII]

The economic capital gains subject to Sec. 1231 and depreciation component of the gain not subject to Sec. 1250 were both taxed at the capital gain rate of 28% under old law. If the IRS does not require recapture at the higher rate, the 20% rate would apply to all installment payments received after May 6, 1997, even if the...