The buyer and seller have tentatively agreed to a contract for the sale of a building that the buyer will use in its business. The buyer will pay the seller $100,000 (principal and interest) each year for five years. The seller’s cost of the asset is $200,000, and he will report the capital gain using the installment method. The buyer and seller are now negotiating the interest rate that will be used to compute the interest included in each $100,000 payment. The relevant Federal rate is 5%, but the market rate on similar contracts is in the area is 7%.
a.Why would the seller bargain for a 5% interest rate for the contract rather than a 7% interest rate?b.How does the interest rate affect the buyer’s future taxable income?
What will be an ideal response?
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| a. | The total payments the seller will receive is not affected by the interest rate included in the contract. However, the interest rate will affect the seller’s ordinary income and capital gain. The seller would bargain for a 5% interest rate rather than 7% because the lower interest rate will result in less ordinary income and more capital gain with no change in the total taxable income from the contract. Also, with the lower interest rate, more of each payment is allocable to the recovery of capital and thus more of the gain is deferred.? |
| b. | The interest rate affects the buyer’s interest and cost recovery deductions. Each dollar allocated to interest will result in a deduction for the buyer in each year for the 5 years of the installment contract. However, the amount allocated to the building must be recovered over the MACRS cost recovery period, which may be more than 30 years. Therefore, the present value of the tax benefits of the interest deductions are much greater than the cost recovery deductions. |
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