673 / What are the results if an installment sale between related parties is cancelled or payment is forgiven?

If an installment sale between related parties is canceled or payment is forgiven, the seller must recognize gain in an amount equal to the difference between the fair market value of the obligation on the date of cancellation (but in no event less than the face amount of the obligation) and the seller’s basis in the obligation.¹ The seller’s basis in the obligation is the difference between the face value of the obligation less the amount of income that would be includible in gross income had the obligation been actually satisfied.²

Example: Asher sells a tractor to Samuel for $10,000 with an adjusted basis of $2,000. In exchange, Samuel conveys five installment notes ($2,000 each). Asher’s gross profit ratio would be 80 percent (see Q 666) meaning that 80 percent of each payment would be included in gross income ($1,600) and 20 percent ($400) would be tax-free return of basis. Therefore, each note would have a basis of $400 ($2,000 face value less $1,600 income). So, if Asher were to forgive a $2,000 installment note, he would recognize a gain of $1,600 (the difference between the face amount of the note and his basis in the note). In other words, a forgiven note is essentially taxed in the same way as it would have been had the seller actually received payment.

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1. IRC § 453B(f).

2. IRC § 453B(b).

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