In 2014, Sophia sold real estate (adjusted basis of $500,000) for $1,500,000. Under the terms of the sale, she received two notes of $750,000 each, with 9% interest provided. One note is due in 2015 and the other in 2016. She did not elect out of the installment method of recognizing gain. In 2015 and before the first note matures, Sophia gives both notes to her adult children. At this time, the notes are worth a total of $1,400,000. Disregarding the interest element, a tax result of these transactions is:

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Sophia sold real estate for $1,500,000, with an adjusted basis of $500,000, resulting in a gain of $1,000,000. Since she did not elect out of the installment method, she must recognize a proportionate amount of gain each year based on the ratio of the payments received to the total sale price. In this case, each note represents 50% of the sale price, so Sophia must recognize 50% of the gain, or $500,000, in 2014. When she gives the notes to her children in 2015, she realizes the value of the notes, which is $1,400,000. Since this amount is less than the outstanding principal balance on the notes, there is no gift tax consequence. However, Sophia is still required to recognize the remaining gain from the sale, which is the difference between the sale price and the adjusted basis less the gain already recognized. This amount is $1,000,000 - $500,000 = $500,000. Therefore, Sophia must recognize a gain of $500,000 in 2015. Combined with the gain recognized in 2014, Sophia must recognize a total gain of $900,000.

In 2014, Sophia Sold Real Estate (Adjusted Basis of $500,000)