The Related Party Rules for an Installment Sale

An installment sale allows a seller to defer recognizing gain on a property sale over several years, aligning tax payments with when cash is received. The buyer makes periodic payments, and the portion of each payment representing profit is taxed in the year it is received, rather than the entire gain being taxed in the year of the sale. This can lower the overall tax liability by keeping the seller in a lower tax bracket.

These tax deferral rules are limited when the transaction is between related parties. The Internal Revenue Service (IRS) has regulations to prevent the misuse of installment sales as a tax avoidance mechanism within families or closely-held businesses. These rules curb situations where a related party could resell the property for a lump sum shortly after the initial sale, allowing the family to receive the full cash proceeds while the original seller continues to defer the tax gain.

Defining a Related Party for Tax Purposes

The Internal Revenue Code (IRC) defines a “related party” to identify relationships that have the potential for tax manipulation. For the purposes of installment sale rules, this definition is broad and encompasses both family and business relationships. These relationships are scrutinized because they are not considered “arm’s-length” transactions, meaning the parties may not have independent interests.

Family relationships under this definition include:

• An individual’s spouse
• Children and grandchildren
• Parents, and other ancestors and lineal descendants
• Siblings

The definition of a related party extends to various entities and fiduciary relationships, including:

• A corporation or partnership where an individual directly or indirectly owns more than 50% of the stock or capital interest.
• Two corporations that are members of the same controlled group.
• A fiduciary of a trust and a beneficiary of that trust.
• An estate and a beneficiary of that estate.

These rules are designed to capture situations where the seller maintains a degree of control or influence over the buyer.

The Second Disposition Rule

The “second disposition rule” accelerates the deferred gain for the original seller if the related party buyer quickly resells the property. If the related party disposes of the property before the original seller has received all installment payments, the original seller is treated as having received the proceeds from that second sale, which negates the tax deferral benefit.

The rule generally applies if the second disposition occurs within two years of the initial installment sale. For example, a parent sells land with a tax basis of $20,000 to their child for $100,000, to be paid over ten years. If the child sells that land to a third party for $110,000 the next year, the parent must recognize their remaining $80,000 deferred gain in the year of the child’s sale.

The amount the initial seller must recognize is limited to the total contract price minus the payments already received. For marketable securities, the two-year time limit does not apply; any resale before the installment obligation is fully paid triggers the rule. The two-year period can also be suspended if the related buyer’s risk of loss is substantially diminished through certain financial instruments.

Exceptions to the Second Disposition Rule

The tax code provides several specific exceptions that prevent the acceleration of gain for the original seller. These exceptions recognize that not all subsequent dispositions by a related party are motivated by tax avoidance. When one of these exceptions applies, the original seller can continue to report their gain using the installment method as originally planned, even if the related party resells the property within the two-year window.

One exception involves the death of either the original installment seller or the related party buyer. If the second disposition occurs after the death of either individual, the gain acceleration rule does not apply. This provision acknowledges that death is an involuntary event and the subsequent transfer is not part of a prearranged tax-avoidance plan.

Another exception is for an involuntary conversion of the property. This applies if the property is destroyed, stolen, seized, or condemned, and the second disposition is the result of this event. For this exception to apply, the threat of the condemnation or seizure must not have been present at the time of the initial installment sale.

The law includes a broad exception for transactions where it can be proven to the satisfaction of the IRS that tax avoidance was not a principal purpose of either the first or second disposition. This is a high standard to meet and requires compelling evidence of a legitimate non-tax reason for both sales.

Special Rule for Depreciable Property

A separate and more stringent rule applies to installment sales of depreciable property between related parties. The installment method is generally disallowed for these transactions. This means that if you sell property that the related buyer can depreciate, such as a building or equipment, you cannot defer the gain. Instead, all payments are treated as being received in the year of the sale, forcing the immediate recognition of the entire gain.

This rule is intended to prevent a specific type of tax arbitrage. Without it, a seller could recognize a capital gain over many years while the related buyer immediately begins taking depreciation deductions on a stepped-up basis, which would offset ordinary income. To prevent this, the law requires the entire gain to be reported upfront.

Furthermore, any gain recognized on the sale of depreciable property to a related person is treated as ordinary income, not capital gain. This is a significant disadvantage, as ordinary income is taxed at higher rates. An exception may apply if the seller can demonstrate to the IRS that tax avoidance was not a principal purpose of the sale.

Reporting the Installment Sale

Properly reporting an installment sale to the IRS is a multi-year process that requires careful record-keeping. The primary document for this is Form 6252, Installment Sale Income. This form must be filed with the seller’s tax return for the year of the sale and for each subsequent year in which a payment is received.

To complete Form 6252, the seller must gather the total selling price, the property’s adjusted basis, and any selling expenses. The adjusted basis is the original cost of the property plus any improvements, minus any depreciation that was allowed or allowable. The difference between the selling price and the sum of the adjusted basis and selling expenses determines the total gross profit on the sale.

The form guides the taxpayer through calculating the gross profit percentage, which is the gross profit divided by the contract price. This percentage is then applied to each principal payment received during the year to determine the amount of taxable gain to report. If the property was sold to a related party, Part III of Form 6252 must be completed for the year of the sale and for two years after, to track any potential second dispositions.