Taxes On Installment Sales for both U.S. and Non-U.S. Residents

When you sell something on installment, you are essentially accepting multiple payments over a period of time for the property you are selling. As far as the IRS is concerned, an installment sale is one in which at least one payment is received outside of the year of sale. At the time of the passage of title, a gross profit percentage is calculated based on the number of payments, value of the property, and agreed payment price. The general rule (IRC §453) is that you pay taxes on the gain against the gross profit percentage as it is received, so each year that there is a payment, there is income to be reported, this is known as the “installment method”.

There is a way to pay all expected tax on gain at once. This is by opting out of the installment method via IRC §453(d) – Electing Out of the Installment Method. In order to elect out you would file one of two IRS Forms: 4797 – Sales of Business Property; or 8949 – Sales and Other Distributions of Capital Assets. (DO NOT REPORT THE SALE ON Form 6252.) When selecting one of these options, you are reporting all of the gain to be realized over the life of the installment at one time. This election must be made for the tax return submitted in the year of sale. If the year of sale has passed then you may not make the election, unless you have reasonable cause for not having filed on time. (Reg. 15a(d)(3)(ii)) Should the IRS not believe your reason for late filing, it may deny you the opportunity to elect out.

What if you are a non-resident taxpayer looking to become a resident and you are being paid installments on property you sold prior to making the election to become a resident? Do you have to claim the payments received in your U.S. income, even if the sale was not closely related to a U.S. Trade or business?

The generic answer is yes, you will need to claim any payments that are made after filing for U.S. residency status in your yearly income tax return. (IRC §453) However, you may elect out of the §453 rule on your first 1040 filing as a U.S. resident, thereby forgoing payment of income on any gain from the installment payments. The election must be filed with the first tax return. Just as there is an election to pay all the tax at once for U.S. residents who sell property on installment, this election is so that a foreign person wishing to become a U.S. resident who sold non-U.S. property to a non-U.S. purchaser, will not have to pay income tax on a sale, that outside of the installment element, would have had nothing to do with U.S. taxes. However, as of right now, there is no regulatory and/or legislative direction on how to make this election as a nonresident. Because of this, the consensus (until proper regulation is created) is to not attempt the election, and not to claim the payments on any future tax returns. The reason for this consensus is based on two separate PLRs, 8708002 and 9412008, (both of which dealt with non-U.S. residents at the time). In these PLRs the IRS stated “Under installment method rules of present law, these gains do not become taxable as payment are received after the seller becomes a resident or citizen subject to U.S. income tax for a taxable year subsequent to the year in which the sale was made. It is intended that the election regulations will continue this treatment in appropriate cases. Based upon consideration of legislative history and the particular circumstances of the case, we conclude that the tax consequences of the subject installment sale should be determined as if the taxpayer had elected under IRC §453(d) of the code not to report the sale on the installment method.” The IRS directed that because of the legislative history behind the act, the taxpayers would be deemed to have retroactively elected out of the installment sale method of tax, and would not be obligated to pay tax on any of the installment payments. The legislative history that the IRS is referring to can be found on page 12 of the Installment Sales Revision Act of 1980, Session Report Number 1000, 96th Congress, 2nd Session (1980).

Always remember there are other determinations that should be considered as well, such as the location of the property, what the property is etc. It’s always best to contact an experienced tax professional before making any big changes to your tax return or financial situation.