Sale of Real Estate Involving Deferred Payments. Deferred payment sales of real estate ordinarily fall into two classes when considered with respect to the terms of sale, as follows: (1) Installment transactions, in which the initial payment is relatively small (generally less than one-fourth of the purchase price) and the deferred payments usually numerous and of small amount. They include (a) sales where there is immediate transfer of title when a small initial payment is made, the seller being protected by a mortgage or other lien as to deferred payments, and (b) agreements of purchase and sale which contemplate that a conveyance is not to be made at the outset, but only after all or a substantial portion of the agreed installments have been paid. (2) Deferred payment sales not on the installment plan, in which there is a substantial initial payment (ordinarily not less than one-fourth of the purchase price), deferred payments being secured by a mortgage or other lien. Such sales are distinguished from sales on the installment plan by the substantial character of the initial payment and also usually by a relatively small number of deferred payments. In determining how these classes shall be treated in levying the income tax, the question in each case is whether the income to be reported for taxation shall be based only on amounts actually received in a taxing year, or on the entire consideration made up in part of agreements to pay in the future.40 SALE OF REAL ESTATE ON INSTALLMENT PLAN. In the two kinds of transactions included in class (1) in the foregoing paragraph, installment obligations assumed by the buyer are not ordinarily to be regarded as the equivalent of cash, and the vendor may report as his income from such transactions in any year that proportion of each payment actually received in that year which the gross profit to be realized when the property is paid for bears to the gross contract price. If the return is made on this basis and the vendor repossesses the property after default by the buyer, retaining the previous payments, the entire amount of such payments, less the profit previously returned, will be income to the vendor, and will be so returned for the year in which the property was repossessed, and the property repossessed must be included in the inventory less any depreciation. 40 Reg. 45, Art. 44. If the taxpayer chooses, as a matter of settled practice consistently followed, to treat the obligations of the purchaser as equivalent to cash and to report the profit derived from the entire consideration, cash and deferred payments, as income for the year when the sale is made, this is permissible. If so treated the rule prescribed in the following paragraph will apply.41 DEFERRED PAYMENT SALES OF REAL ESTATE NOT ON THE INSTALLMENT PLAN. In class (2) in the next to the last paragraph above the obligations assumed by the buyer are much better secured because of the margin afforded by the substantial first payment, and experience shows that the greater number of such sales are eventually carried out according to their terms. These obligations for deferred payments are therefore to be regarded as equivalent to cash, and the profit indicated by the entire consideration is taxable income for the year in which the initial payment was made and the obligations assumed. If the buyer defaults and the seller regains title to the land by agreement or process of law, retaining payments previously made, he may deduct from his gross income as a loss in the year of repossession any excess of the amount previously reported as income over the amount actually received, and must include such real estate in his inventory at its original cost to himself less any depreciation,42 41 Reg. 45, Art. 45. 42 Reg. 45, Art. 46. CHAPTER 18 INCOME FROM INTEREST, RENT AND ROYALTIES The Revenue Act of 1918 expressly provides that gross income shall include gains, profits, and income derived from "interest" and from "rent." It does not expressly cover income from royalties, which falls, however, under the broad expression "income derived from sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property; also gains or profits and income derived from any source whatever." Interest is ordinarily taxable in the hands of citizens and residents and domestic corporations, whether received from debtors in this country or debtors in foreign countries. It is taxable in the hands of non-resident aliens and foreign corporations when it is paid on bonds, notes or other interestbearing obligations of residents, corporate or otherwise.1 Interest Exempt from Tax. The Revenue Act of 1918 expressly provides that interest upon the obligations of a State, territory or political subdivision thereof, or the District of Columbia or any possession of the United States, or securities issued under provisions of the Federal Farm Loan Act of July 17, 1916, or interest upon the obligations of the United States issued prior to September 1, 1917, (and to a limited extent the interest on obligations issued after that date) and bonds issued by the War Finance Corporation (to a limited extent) shall not be included in gross income, and shall be exempt from income tax.2 Interest upon United States Obligations. Although interest upon the obligations of the United States is in general exempt 1 Revenue Act of 1918, § 213 (a), 233. See Chapter 4. As to interest, see Reg. 33, Art. 67; Letter from Treasury Department dated February 18, 1915; I. T. S. 1919; ¶923, Reg. 45, Art. 54. As to rent, see Letters from Treasury Department dated February 9 and February 26, 1915. I. T. S. 1919, ¶920. Unless the taxpayer keeps his books on a basis other than that of actual receipts, he should report interest, rent and royalties as income of the year in which payment thereof is actually or constructively received by him. 2 Revenue Act of 1918, § 213 (b) 4. from tax, in the case of such obligations issued after September 1, 1917, which include Treasury certificates of indebtedness, war savings certificates and the liberty bond issues (except the First Liberty Loan 312 per cent. bonds), the interest is exempt from tax only if and to the extent provided in the acts authorizing the issue thereof, as amended and supplemented.3 There are five issues of so-called Liberty Loan bonds comprising ten different classes of bonds and notes. These ten classes are as follows: (1) First Liberty Loan 32% Bonds; (2) First Liberty Loan Converted 4% Bonds; (3) First Liberty Loan Converted 44% Bonds (dated May 9, 1918); (4) First Liberty Loan 44% Bonds (dated October 24, 1918); (5) Second Liberty Loan 4% Bonds; (6) Second Liberty Loan Converted 44% Bonds; (7) Third Liberty Loan 44% Bonds; (8) Fourth Liberty Loan 44% Bonds; (9) Victory (Fifth) Liberty Loan 34% Notes; (10) Victory (Fifth) Liberty Loan 434% Notes. The respective acts authorizing the issue of these obligations grant exemption in every case from any normal 5 tax upon the interest therefrom. Some of the obligations are wholly exempt from the surtax or the excess-profits tax (in the case of corporations), while others carry no exemption from such taxes. In addition, many of the obligations carry limited or partial exemptions as appears in the following paragraph. TAX EXEMPTIONS OF LIBERTY BONDS AND VICTORY NOTES. I. The following bonds and notes are exempt from all Federal, State, and local taxation, except (a) estate or inheritance taxes and (b) Federal income surtaxes and profits taxes, as follows: 3 Reg. 45, Art. 77. Under earlier income tax laws, interest upon the obligations of the United States was expressly included as taxable income (see Act of March 2, 1867). Under the 1909 Law the Attorney General held that interest on national bonds should be included as income of corporations, since the tax was not on property, but a tax on the privilege of carrying on business (28 Op. Atty. Gen. 138). 4 Act of April 24, 1917; Act of September 24, 1917; Act of April 4, 1918; Act of July 9, 1918; Act of March 3, 1919. 5 This word applies to the income tax on corporations as well as the normal tax on individuals. (Official announcement by Treasury Department. dated April 23, 1919; I. T. S. 1919, ¶ 3311.) 1. First Liberty loan converted 4 per cent bonds of 19321947 (first 4s). 2. First Liberty loan converted 1947 (first 4/4s, issue of 3. First Liberty loan second 4. Second Liberty loan 4 per cent bonds of 1927-1942 (second 4s). 5. Second Liberty loan converted 44 per cent bonds of 1927-1942 (second 414s). 6. Third Liberty loan 44 per cent bonds of 1928 (third 414s). 7. Fourth Liberty loan 414 per cent bonds of 1933-1938 (fourth 414s). 8. Victory Liberty loan 434 per of 1922-1923 (434 per cent Are exempt, both as to principal and interest, from all taxation now or hereafter imposed by the United States, any State, or any of the possessions of the United States or by any local taxing authority except (a) estate or inheritance taxes, and (b) graduated additional income taxes, commonly known as surtaxes, and excess-profits and war-profits taxes, now or hereafter imposed by the United States, upon the income or profits of individuals, partnerships, associations, or corporations. II. 4 per cent and 41⁄44 per cent bonds are entitled to limited exemptions from Federal income surtaxes and excess-profits taxes, as follows: 4 per cent and 44 per cent Liberty bonds (but not 434 per cent Victory notes) are entitled to certain limited exemptions from graduated additional income taxes, commonly known as surtaxes, and excess-profits and war-profits taxes, now or hereafter imposed by the United States, upon the income or profits of individuals, partnerships, associations, or corporations, in respect to the interest on principal amounts thereof, as follows: |