How are Section 453 installment notes taxed after the seller dies, and does the note receive a step-up in basis?

Question

Tyler Smith · Accepted Answer

When an individual holding a Section 453 installment note passes away, the tax rules diverge significantly from standard inheritance principles. Unlike real estate, public equities, or physical business assets, an installment note does not receive a step-up in basis to fair market value under Section 1014.

Instead, an inherited installment note is governed by Section 691 and classified as Income in Respect of a Decedent (IRD). This classification creates specific downstream consequences for the estate and its beneficiaries:

• Retention of Tax Character: The beneficiary or estate that inherits the note steps into the shoes of the deceased seller. As principal payments are collected, the beneficiary must report the exact same proportion of capital gain, ordinary income, and interest income that the decedent would have reported on Form 6252.
• No Section 1014 Step-Up: Under Section 1014(c), property that constitutes IRD is expressly excluded from receiving a step-up in cost basis. The unrecognized gross profit percentage remains locked in place.
• Section 691(c) Deduction: To mitigate potential double taxation - where the note is subject to federal estate taxes on its full fair market value and subsequent income taxes as payments are collected - the beneficiary is entitled to an income tax deduction. Under Section 691(c), the taxpayer may deduct the portion of federal estate tax attributable to the net IRD included in the decedent's estate.
• Transfer to the Obligor: If an installment note is bequeathed to the debtor, or if the estate cancels the note, the cancellation is treated as a taxable disposition under Section 691(a)(5), requiring the estate to recognize all remaining deferred gain immediately on its fiduciary return.