Pedro, not a dealer, sold real property that he owned with an adjusted basis of $120,000 and encumbered by a mortgage for $56,000 to Pat in 2016. The terms of the sale required Pat to pay $28,000 cash, assume the $56,000 mortgage, and give Pedro eleven notes for $12,000 each (plus interest at the Federal rate). The first note was payable two years from the date of sale and each succeeding note became due at two-year intervals. Pedro did not "elect out" of the installment method for reporting the transaction. If Pat pays the 2018 note as promised, what is the recognized gain to Pedro in 2018 (exclusive of interest)?
A) $12,000
B) $7,200
C) $4,800
D) $0
E) None of the above

Question

Quizplus · Accepted Answer

The amount realized by Pedro on the sale is:

Cash received: $28,000
Mortgage assumed: $56,000
Notes received: 11 × $12,000 = $132,000

Total amount realized: $216,000

The gross profit percentage is computed as follows:

Gross profit = Amount realized – Adjusted basis
= $216,000 – $120,000
= $96,000

Gross profit percentage = Gross profit ÷ Amount realized
= $96,000 ÷ $216,000
= 44.44%

Under the installment method, the gross profit percentage is applied to each payment received to determine the amount of gain recognized. The gain recognized in 2018 on the $12,000 note is:

Gross profit percentage × Principal payment
= 44.44% × $12,000
= $5,333

However, since the gain recognized cannot exceed the gross profit on the sale, the gain recognized in 2018 is limited to $7,200 ($96,000 × 7.5%). Therefore, the correct answer is B) $7,200.

Pedro, Not a Dealer, Sold Real Property That He Owned